Interest Rates, the Fed and Equities

By: Tim Wood | Sat, Dec 11, 2010
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Of late it seems that rising interest rates and the Fed's ability to "keep rates low" have become a focal point for many of the news commentators. The vast majority of the public believes that the Fed is actually controlling interest rates and as a result that they are controlling the credit markets as well as the equity markets. I am about to show you the proof that the Fed follows the short-term credit market and that in reality they do not lead. The data simply does not support the widely held belief that the Fed is in "control" of the markets. I realize that this may come as a shock to you, but reality is what it is. The data speaks for itself.

In the first chart below is the Discount Rate, plotted in the upper window, and the 3-month T-bill rate is plotted in the lower window along with my Trend Indicator. I realize that you cannot tell it from this chart because given the time period that is covered the details are lost, but the fact is that the 3-month T-bill rate moves first and the Fed simply follows. Given that this is a well documented fact, with a 60 year history, I am simply amazed by the fact that so many people put so much emphasis on what the Fed does and says in regard to interest rates. Fact is, the media propaganda machine has conditioned the vast majority of the public that they somehow control rates and as a result control the markets. If you go to www.cyclesman.info/Fedfollows.htm I have posted more detailed charts. All you have to do is start at the beginning and move forward in time and you will clearly see that the Fed follows the short-term credit market.

The one exception I found was at the February 2010 increase in which the Fed raised rates .25 point prior to my Fed model officially signaling that we had moved into a rate hiking environment. But, even then my Fed model was telling me that the rate cutting cycle had ended and it was very close to an upturn signaling that we had moved back into a rate hiking cycle. As we move into 2011, you can clearly see in the chart below that the Trend Indictor has turned up on the 3-month T-bill. This tells us that we are in the early stages of a rate hiking cycle, which means that the bias for short-term rates is to the upside. If the Trend Indicator remains positive, rates will begin to rise and if rates begin to rise, the Fed will again be forced to follow.

3-Month T-Bill Trend Indicator

Now that this fact has been established I want to talk about another myth. I think you will also agree that the perception is that the Fed saved the market back in 2001 and 2002 with their aggressive rate cuts. Well, we just established the fact that the Fed follows 3-month T-bill rates. Fact is, the 3-month T-bill rate fell from 6.22% in November 2000 to 5.70% in December 2000. It was then at the January 2001 Federal reserve meeting that the Fed made the first cut of the Discount Rate taking it from 7.50% to 7.25%. Both the stock market and the 3-month T-bill rate continued to fall and the Fed continued to more aggressively cut rates to keep up with the falling T-bill rate. Now, look at the chart below. In the upper window of this chart I have again plotted the Discount Rate. In the lower window I have plotted the S&P 500. As you can see, the rate cuts did nothing to stop the decline. From the time the rate cuts began in January 2001 the S&P 500 fell from 1,283 all the way down to its final low at 768. This was a 40% slide in the S&P in spite of the rate cuts. Fact is, these rate cuts did absolutely nothing to hold the market up and in many cases they made multiple cuts and still the market fell. This was particularly true from early 2001 into the fall of 2001. There was a bounce after the 911 bottom, but even the rate cuts following 911 did not prevent the continued decline into the 4-year cycle low in 2002. I don't have the data during the 1920's and 30's, but I do know that the Fed also cut rates and it did nothing to save the market then either.

S&P500

As the stock market began clawing its way back up out of the 2002 4-year cycle low, the 3-month T-bill continued to decline into June 2003. As a result, the Fed continued cutting rates even further as they continued following the 3-month T-bill rate down. If you go back to the charts posted at www.cyclesman.info/Fedfollows.htm you can see that the 3-month T-bill rate bottomed at .82% in June 2003. From this point rates leveled off and in May 2004 rates began to climb. In mid-June 2004 the 3-month T-bill rate had advanced to 1.39%. Then in July 2004 the Fed began to raise rates and continued to do so as they once again followed the T-bill rate higher. It was not until the 3-month T-bill rate got hit hard in August 2007 that the Fed began cutting rates and for the record, the Trend Indicator turned down in June 2007 telling us that we had entered into another rate cutting cycle. Also, for the record, the decline by equities that began in October 2007 was associated with the 4-year cycle top that was stretched due to the liquidity bubble to "fix" everything following the decline into 2002. We all know how that ended with the decline into the 2009 low and once again as you can see in the chart above, the Fed cut rates all the way down. Then, the propaganda spread by the media, was once again that they were cutting rates in order to help save the market. But, if that were the case it obviously did not work any better than it did in association with the decline into the 2002 low. Fact is, when you look at the charts, the Fed was once again merely following the lead of the 3-month T-bill. As the 3-month T-bill hit bottom in 2009, the Fed stopped cutting rates. Of course, the story is that they stopped cutting rates because the equity market hit bottom, which is more propaganda. Fact is, the rate cuts did nothing to stop the market from falling, which again was the case into the 2002 low, and they stopped cutting rates because the 3-month T-bill found a bottom.

Now, here we sit with interest rates rising. My subscribers have known about the structural issue with bonds that set the stage for this round of rising rates for months. I reported at the close of 2009 that we were entering into an environment of rising rates. It was then in February 2010 that the Fed made a proactive rate increase as my Fed model was bottoming. This model has now been positive since March and if something doesn't change, this model is telling us that the propensity is still toward higher rates as we move into 2011. The question now on the news is, what will rising rates do to the equity markets?

If we push the mainstream opinion to the side and look at the historical facts, we find that there are times in which equities have advanced in conjunction with rising rates and there are times in which equities have declined in conjunction with rising rates. To say that rising rates are automatically good or bad for equities is putting the cart before the horse. A complete study of the correlation between interest rates and equity price is outside of the scope of this article, but to give you just a couple of examples, during the 1966 to 1968 bear market rally, interest rates rose. During the 1970 to 1973 bear market rally interest rates declined. During the 1973 to 1974 meltdown by equities into their final bear market bottom, interest rates rose. During the 1982 to early 1994 bull market in equities, interest rates declined, but then from mid-1994 into 2000 they rose. Between 2004 and 2007 equities advanced as rates again rose and the recent advance seen by equities out of the 2009 low has occurred with interest rates basically flat.

So, the fact that we are now in a rate hiking cycle and interest rates are beginning to move up no doubt begs the question as to whether this will be good or bad for equities. But, my take is rather than to draw an erroneous conclusion, we should look at the markets independently. Until my Fed model changes, I know that the bias for rates is to the upside. As for equities, I have identified a common cyclical DNA Marker/trait that has occurred at every major top since 1896. Thus, it is my opinion that the answer to the question with interest rates and the market lies in simply taking the markets independently of one another and to implement the tools that we have and in doing so these tools will tell us.

I have begun doing free market commentary that is available at www.cyclesman.info/Articles.htm The specifics on Dow theory, my statistics, model expectations, and timing are available through a subscription to Cycles News & Views and the short-term updates. I have gone back to the inception of the Dow Jones Industrial Average in 1896 and identified the common traits associated with all major market tops. Thus, I know with a high degree of probability what this bear market rally top will look like and how to identify it. These details are covered in the monthly research letters as it unfolds. I also provide important turn point analysis using the unique Cycle Turn Indicator on the stock market, the dollar, bonds, gold, silver, oil, gasoline, the XAU and more. A subscription includes access to the monthly issues of Cycles News & Views covering the Dow theory, and very detailed statistical based analysis plus updates 3 times a week.

 


 

Tim Wood

Author: Tim Wood

Tim W. Wood
Cyclesman.info

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