Market To Fed: Plata O Plomo?

In “Narcos,” the Netflix show chronicling the rise and fall of Pablo Escobar, there is a gripping scene in the first episode that sets the stage for the entire series. When stopped at a bridge crossing by Colombian authorities, Escobar gives them a choice:

“Plata (Silver, take the bribe) o

Plomo (Lead, take the bullets)?”

They choose silver and appeasement, turning a blind to Escobar’s nefarious activities. In the short-run, everyone was happy: a potentially deadly confrontation was avoided and the easy-money profits of the cocaine trade were shared by all. But the joyful times did not last and the complicity of the authorities would come back to haunt them. They created a monster in Escobar and the drug trade would become impossible to control.

Over the past few years, financial markets have held the Fed hostage with a similar message. Armed with the knowledge that the Federal Reserve was openly targeting higher stock prices (via Bernanke’s “wealth effect” theory), the market delivered the following warning:

“Plata (Silver, keep rates at 0% and adding rounds of Quantitative Easing) o

Plomo (Lead, suffer a stock market decline and potential loss of your precious “wealth effect”)?”

In 2010, 2011 and 2012, when the Fed started talking about normalizing interest rates, the market made good on this warning: 17%, 21% and 11% corrections in the S&P 500 would follow. Each time, the Fed quickly reversed course, pleading “Plata, Plata, y más Plata” (seeStock Market Tail Wags Fed Dog).

In 2010, they initiated QE2 and promised to hold off on raising rates. In 2011, they initiated Operation Twist. In 2012, they initiated QE3 and promised to keep rates at 0% until the middle of 2015. And for a while, everyone was happy. The markets surged higher and the Fed was given credit for sticking with Mr. Zero Interest Rate Policy.

But in 2015, with QE3 over the Fed once again talking about raising rates, the market became volatile again. A 13% decline ensued which saw the VIX Index briefly spike above 50.  The volatility didn’t fully subside until the Fed pleaded “no Más,” holding off on a September rate hike. We learned once more that the Fed’s “data dependent” process is code for “stock market and volatility dependent.”