Pinning the Tail On the Fed-Timing Donkey

Wall Street has underestimated the speed and magnitude of past rate hikes

Jun 12, 2015 at 8:45 AM
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Everybody keeps trying to play "Pin the Tail On the Fed-Timing Donkey" game. And if history is any guide, we're not likely to play the game very well. From Business Insider

"Last time the Fed raised rates, the market was wrong.

On Twitter on Thursday, the FT's Robin Wigglesworth tweeted the following chart, showing the market's expectations for the Fed during the previous cycle in which the Fed was raising rates from 2004-2006. Every step of the way, the market thought the Fed would raise rates less than it actually did."

The takewaway, of course, is that the masses underestimated the speed and magnitude of the hikes during the last tightening cycle. And most importantly, the market itself did very well from 2004-2006, while volatility got crushed.

Fast-forward to 2015, and we have a general expectation that the Fed will drag its heels but start raising rates slowly soon. That will, of course, tank the markets, since the only reason stocks are this level is the Fed. And, of course, this will beget a Dystopian Hellscape of rising volatility, taking the CBOE Volatility Index (VIX) all the way into the 20s, and ensuring that everyone who has rolled out-of-the-money VIX calls for five years now will lose slightly less money.

Fortunately, as the 2004-06 example demonstrates, none of this has to come to pass. I don't remember exactly how obsessed we were with the "Fed tightening cycle" back then, but I suspect it was nothing like the mania today. And it's a sample size of one, so there's absolutely no saying history repeats itself.

It does highlight a good point, though. Rate tightening in and of itself will not end the bull run. That's because it's presumably accompanied by a rising economic tide, or else they likely would cease the hiking. The real risk is that the Fed does a lousy job of gauging the economy. So, if you feel they're tightening into a downturn, then yeah --sell, Mortimer, sell. But, if it's just a knee-jerk, "Fed tightens, must sell" reaction, then it's likely a bad idea. Rates are zero now -- there's a lot of tightening to go before we start getting to the point where it's a serious crimp.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research



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