The Fed’s Macro-Model Is Woefully Lost
You and I are watching financial history in the making. It’s that rare moment when the world’s largest financial market, the US Treasuries, directly opposes the Federal Reserve’s higher interest rate policy.
This morning the Fed’s Open Market Committee begins its two-day meeting to determine the next level of short-term interest rates. They will announce their results tomorrow at 2 pm eastern time.
Unfortunately, for the Fed, they have already been overruled. It doesn’t matter what the Fed says tomorrow. A more significant force is at work that has already decided the outcome.
Here’s the story of how this is all unfolding.
I knew we were in trouble when I heard Fed Chairman Jerome Powell repeat the well-worn phrase, “the Fed is data dependent.” It’s the Fed’s favorite response whenever they feel their backs are against a wall. It’s an easy out for the Fed. If things go wrong, they can always say, “well, we were just following the data.”
Powell’s predecessor, Janet Yellen, used the phrase often. And Powell institutionalized his “data dependence” use in a 2019 Speech entitled: “Data-Dependent Monetary Policy In An Evolving Economy.”
Powell summarized his reliance on data this way:
“In summary, data dependence is, and always has been, at the heart of policy making at the Federal Reserve. We are always seeking out new and better sources of information and refining our analysis of that information to keep us abreast of conditions as our economy constantly reinvents itself.”
Sounds great.
And it worked like a charm for the Fed for over a decade. Whenever Yellen or Powell find themselves in a pickle, when the press or Congress start to ask those hard questions, the Fed spokesperson replies, “we’re data-dependent.” And as easy as that, the Fed is off the hook. After all, nobody can argue with “the data.”
But somebody is arguing with “the data,” and that somebody is the massive US Treasuries Market. The chart shows the 30-year US Treasury Bond yield as the Long Bond’s yield peaked on October 24 last year at 4.4%. Recently the Bond’s yield was 3.7%, a 16% drop in yield in less than five months. In Treasuries terms, that’s a massive move, which reflected a strong rally in Treasury Bonds. Bond prices move inversely to yield. The lower the yield, the higher the bond price.
This rally, which incidentally occurs across all maturities, is a sure sign that the bond markets see lower interest rates ahead, not higher — the exact opposite of what the Fed is trying to accomplish. The red line in our chart shows that the Fed keeps raising interest rates while the bond yield (interest rate) is falling.
How can this be? You may ask. Bond yields are a “data point,” yet the Fed seems to ignore the bond markets. Yes, that’s what is happening. The Fed needs to watch the bond market and a host of other indicators that we used to rely on.
Instead, today’s Fed is becoming increasingly reliant on Econometric Models. Although they collect specific data sets, models then interpret that data using primarily statistical analysis to provide an overall picture of the economy.
In the last report I saw, the Fed invested heavily in its model-making capability, employing over 400 Ph.D.-level economists and massive data processing computers and equipment. The Fed is committed to using models in its policy decisions.
The essential function of the Models, in my opinion, is to take responsibility for those policy decisions away from the Board. It’s a “Don’t blame me, I just follow the data” attitude expressed by both Yellen and Powell.
Model-based investment management has had a checkered past on Wall Street. Initially, the Street was enamored with the computer-based investment model as an objective way to allocate capital. After all, IT systems can collect much data and make 100% objective decisions.
In the late 1990s, John Meriwether, the former Vice Chairman of Solomon Brothers, put together what seems to be the ideal model-based Hedge Fund. The fund would use the Black-Scholes Investment Model, considered by many on the Street the best. He even went so far as to hire the two Nobel Laureate Economists who created the Model.
To make a long story short, the Model went off-track. Although the numbers still added up, the Model lost track of the actual markets where stocks and bonds trade. Ultimately, Long Term Capital Management was one of the most significant failures in Wall Street history, requiring a 3 ½ billion dollar bail-out to restore creditors.
Since then, Wall Street has been highly wary of Model-based investing. Yes, you’ll still find several firms who do invest based on Models. However, you’ll note that they make a special effort to keep those models market-based. They are carefully ensuring that their Model stays on track.
But getting “off track” is what we see at the Fed. Just like Long Term Capital Management, the Fed’s Model is now far afield from the actual US Treasury Market. Treasuries have been saying interest rates need to go lower for nearly five months. Bonds are taking long-term interest rates lower. (The bond market controls long-term rates, while the Fed controls short-term rates).
This divergence between the Bonds and the Fed is extremely dangerous and indicates just how large the Delta is between the Fed’s current Model and reality.
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