Santoli: Here's why the Fed is suddenly hawkish

Published Tue, May 31 20167:14 AM EDTUpdated Thu, Jun 2 201610:18 AM EDT

Investors are unnerved and perplexed by the Federal Reserve 's insistence that it might well lift interest rates this summer, and perhaps make two or three moves by year's end. And this uneasy confusion is exactly the response the Fed is looking for. Aside from the formal goals of fostering full employment and moderate inflation, Fed officials seek to promote "financial stability." This means they don't want markets to grow so comfortable in their outlook for minimal interest rates and a forgiving Fed that risk-taking behavior runs out of control, producing bubbly excesses that can lead to future problems. So when the bond market a few months ago began pricing out the chance of rate hikes for nearly all of 2016, Fed voices rose in near unison to convince the market that this view didn't match their intentions. But what are these pockets of financial-market recklessness that Janet Yellen and colleagues are looking to restrain? After all, the Standard & Poor's 500 index has been stalled near current levels around 2,100 for more than 18 months after a couple of sharp downward stabs. The housing market, epicenter of the last cycle's wildness, is improving in a measured and fitful way. And big banks are loaded with protective capital to the point that they can't manage attractive returns for their shareholders. But what about corporate credit? Companies have been on a multiyear borrowing binge, taking advantage of low rates and global investors' hunger for safe-seeming income. As this chart from Deutsche Bank economists shows, debt levels of nonfinancial U.S. companies relative to the size of the economy are approaching the peaks of the past two cycles and is higher than when prior Fed tightening cycles began. Source: Deutsche Bank And while the stock market has gone sideways for one of the longest periods on record, its valuation relative to corporate earnings is near the very top of the long-term range. The price-to-earnings ratio of the S & P 500 based on the past 12 months' reported earnings — not adjusted "operating" profits — is above 24. Investor spirits are muted and the public has been pulling money from stocks at a brisk clip this year. That's a positive from a sentiment perspective. But stocks themselves are arguably stretched tight given recent profits — with some of the most expensive stocks being the reputedly "safer" blue chips with decent dividend yields. In other words, the kind of stocks that get driven higher when people think rates will be low forever. So maybe it's in the Fed's interest to refocus investors on the chance that the price of money in future months and years might not be so predictable. The Fed's unusually methodical and transparent tightening pattern of 2005-06 is partially blamed for the acceleration in credit misbehavior that culminated in the financial crisis. One of the last things Yellen wants is to feel forced to tighten to puncture an outright financial bubble when the real economy isn't in a position to handle it. Read More Byron Wien on market, election and Wall Street A while back, hedge-fund manager and financial blogger Mark Dow of Behavioral Macro introduced a tidy metaphor for the Fed's approach: avalanche patrol. In the way Alpine authorities might trigger smaller disturbances as snow builds up to prevent a cataclysmic avalanche, the Fed has tried to thwart the accumulation of risky behaviors before they get out of hand. I asked Dow how he reads the Fed's posture right now. He says the Fed realizes that risk to financial stability grows as a function of how long rates stay very low and how certain the market is of the future rate trajectory. So the Fed is eager to hike as soon as it can once it sees a "very, very low probability of having to reverse later." If in their shoes, he says, "In my talk, err on the hawkishness; in my actions, err on the side of dovishness" until it becomes clear that labor-market slack is disappearing and oil stops dragging on inflation measures. Oh, and "keep market participants from getting too complacent with the Fed path and don't let them go too far with errant narratives." One such errant narrative was the idea of "one and done" on rate hikes that grew out of the winter market tumult. Does this mean the Fed is bluffing about June? No. If conditions are in place, the Fed will look to do another rate move, as officials keep saying. The market, of course, sometimes adjusts to uncertainty with jerky, petulant moves. This entire cycle has been tough because the financial markets raced ahead of the real economy and by the time the economy was ready for a rate hike corporate profits were dropping. Read More Memorial Day week is often a good one for stocks The strategy team at Bank of America Merrill Lynch has been forecasting a tough summer for stocks, in part because the Fed wants to inject rate uncertainty while the fundamentals are soft. The firm sees present conditions, in terms of stock-market levels and Fed expectations, as similar to those last November, ahead of a stormy season for stocks. This, clearly, is the trick with the Fed massaging market expectations — markets can overreact and take control. On the other hand, there is precedent for markets to react badly on the first suggestion of a policy shift (as with the 2013 "taper tantrum") before getting used to the idea once it's in place. Content might not indisputably be king any more, but good entertainment assets are scarce enough that they can still fetch a princely sum. The reports last week that an Apple executive had perhaps broached the notion of acquiring Time Warner restarted the intense chatter over what good entertainment producers are worth in a world of media consumption at all times in all places on any device. In this world, Lions Gate Entertainment becomes an intriguing play. Known in the past for its low-cost/high-reward movie franchises such as "Hunger Games" and "Saw," the company is now the only remaining pure-play studio on the market, with a digestible enterprise value near $5 billion. CNBC parent Comcast is buying Dreamworks Animation and Viacom is shopping a minority stake in its Paramount division. Lions Gate had OK earnings last week, but the Street was pleased enough that the TV business is tracking well and the monetization of its film library has room to run. It is not a cheap stock based on present earnings and cash flow, and there is a 20 percent shareholder in place. But Lions Gate's strategic value to another player is significant. Gamco Investors founder Mario Gabelli noted in an aside on CNBC's "Squawk Box" on Friday that Viacom could be a buyer. And would it be crazy if Netflix , now with a $40 billion market value, saw efficiencies in buying a studio given its growing appetite for original programming? Lions Gate is a volatile stock that often trades skittishly based on coming box-office expectations. So in coming weeks, maybe the success of "Now You See Me 2" will drive the shares; after that, it'll be the desire for original stories in a TV Everywhere world.

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Investors are unnerved and perplexed by the Federal Reserve's insistence that it might well lift interest rates this summer, and perhaps make two or three moves by year's end.

And this uneasy confusion is exactly the response the Fed is looking for.

Aside from the formal goals of fostering full employment and moderate inflation, Fed officials seek to promote "financial stability." This means they don't want markets to grow so comfortable in their outlook for minimal interest rates and a forgiving Fed that risk-taking behavior runs out of control, producing bubbly excesses that can lead to future problems.

So when the bond market a few months ago began pricing out the chance of rate hikes for nearly all of 2016, Fed voices rose in near unison to convince the market that this view didn't match their intentions.

But what are these pockets of financial-market recklessness that Janet Yellen and colleagues are looking to restrain?