"There is no mechanical formula."
This is the response Federal Reserve Chair Janet Yellen gave to a reporter who tried to press her on the rules and timing for the first hike in interest rates. This was also the final statement in the press conference to the latest policy decision, and I think it sums up the entire event. Yet, despite the Federal Reserve staying on-message, some observers managed to get all twisted in disappointment, dismay, and even surprise. I claim that two camps in particular were likely frustrated with the Fed's seeming refusal to talk directly about accelerating the presumed schedule for rate hikes (currently projected around the second half of 2015): stock market bears and several major central banks.
A Trigger Lying In Wait for Market Bears
The S&P 500 (NYSEARCA:SPY) has cloaked itself in the slipperiest Teflon as one negative catalyst after another has failed to shake the market out of its volatility slumber. A more hawkish Fed could certainly stir things up. However, the irony for bears here is that a more hawkish Fed only comes with a more bullish economy. Moreover, I imagine the Fed, or at least Yellen, is keenly (painfully?) aware that rate hikes could very well signal the recovery cycle is closer to its end than its beginning. Below, I post a chart I first produced last December to explain potentially why the market was all hot and bothered over tapering (see "A 1-Chart Explanation For The Market's Obsession With Fed Tapering And Tightening"). The 4-week moving average of unemployment claims has just about reached the lows of all the economic cycles since the late 1970s. A rising rate environment at this point has pretty consistently preceded a recession just over the horizon.
A rising rate environment at the common lows of initial claims has typically closely preceded the next recession
Source: St. Louis Federal Reserve
In other words, bets against the stock market could bear a lot more fruit once the Fed finally indicates it is truly serious about hiking rates. A stock market at all-time highs and major lows in volatility strikes me as particularly vulnerable to talk of higher interest rates.
Antsy Central Bankers With Stubbornly Strong Currencies?
I am really stretching the speculation by claiming major central banks are also getting frustrated with the Federal Reserve, but I think the rationale deserves consideration.
Last week, I claimed that the Governor of the Bank of England, Mark Carney, had no interest in driving the British pound (NYSEARCA:FXB) higher even as he warned the market might get higher rates sooner than expected. Looking back, I now suspect part of his comfort in surprising the markets in this way may have come from an expectation that the U.S. Federal Reserve would join in a little more hawkish behavior, thus keeping the British pound in check. Instead, Carney now has a breakout above the psychologically important 1.70 level that could lead to a fresh sustained rise in the currency. Outside of carry trade currencies, the British pound may look particularly attractive to traders looking for long positions given the strength of the United Kingdom's underlying economic fundamentals. I am looking for Carney to do some soft-pedaling in coming months if the currency does indeed float ever higher.
The British pound continues its relentless push higher against the U.S. dollar
Despite the potential tailwinds for the British pound, I am not doing a quick reversal back to my bullish stance. I am staying "non-bullish" and opportunistic. For example, I played the recent fade back to 1.70 as such levels tend to act like magnets for a while before the next sustained move.
In continental Europe, the European Central Bank (ECB) is scrambling the jets to aggressively attack deflationary pressures. The euro (NYSEARCA:FXE) has been stubbornly strong and hampering the fight. While the currency was slightly lower for a while after the ECB rolled out further easing policies, a lack of "cooperation" from the Fed may have just put a floor under the euro until Draghi can figure out yet stronger measures.
The euro is slowly breaking down but may have reached a floor for now against the U.S. dollar
I am staying bearish on the euro, but greatly prefer shorting it against the Australian dollar (NYSEARCA:FXA) as a carry trade that has worked very well for a while now and against the British pound.
The Bank of Canada has consistently projected the U.S. as a beacon of economic strength for the global economy in 2014 while downgrading its outlook on the Canadian economy. Governor Stephen Poloz does not talk about purposely pressuring the Loonie (NYSEARCA:FXC), but his rhetoric has helped to weaken the currency and provide some much needed relief for Canadian exporters. His effectiveness is reflected in a recent Bloomberg article that pointed out:
"His public pronouncements have had almost three times more impact on his nation's currency than his colleagues in Japan and Australia, according to Citigroup Inc. Even the European Central Bank's Mario Draghi, who took the unprecedented step of moving to negative interest rates after months of warning about the euro's strength, has had less effect."
Poloz has a major challenge ahead with the double whammy of a non-cooperative Federal Reserve AND May consumer price index readings which came in unexpectedly high on Friday, June 20. The hot inflation numbers pressured the USD/CAD currency pair below my old target of 1.08. It looks increasingly unlikely that the currency pair will hit my revised 1.16 target by early next year.
Increasingly, it seems the U.S. dollar has topped out against the Canadian dollar for this year
The most frustrated central bankers may be down in Australia where Governor Glenn Stevens and crew have regularly expressed their surprise that the Australian dollar remains so high. Yet, in the last several monetary policy decisions, the Reserve Bank of Australia (RBA) has toned down its rhetoric and Stevens has not jawboned in quite some time. The RBA has even made it clear that rates will stay in neutral for quite some time. I now suspect that comfort partially came from an expectation that the U.S. dollar would strengthen against the Aussie in due time. With the ECB loosening and the Fed avoiding any hawkish impressions, carry trades look more attractive than ever. So, even with the price of iron ore continuing its plunge, the Australian dollar has floated higher. I am guessing the RBA may not be able to wait until the market decides to wake up to the economic implications of plunging iron ore even though in the past the RBA has chosen not to react directly to commodity prices.
Has the Australian dollar finally topped out or is it just resting ahead of the next push higher?
Overall, the U.S. dollar index (NYSEARCA:UUP) is off its recent lows. Its recent ascent, mostly thanks to the euro, has likely stalled out for the time-being. Notice the index is right where it was when the Fed first announced bond tapering. The index also continues to trade comfortably between its levels when QE2 and QE3 were first announced.
The U.S. dollar continues to meander with no trend
Source for charts: FreeStockCharts.com
Another Over-Reaction to the Federal Reserve
So now I bring this full circle back to the Federal Reserve's last decision on monetary policy. The reaction to this decision is indicative of a market groping for a catalyst that changes the balance of power in financial markets; something that provides some excitement (aka volatility) even. I was so surprised at all the hand-wringing over a "business as usual" policy statement that I rolled the tape on the press conference. Wondering what I missed, I actually listened to the conference call a second time (yes, it was painful). The experience made me even more convinced the market over-reacted just as much as it did when Yellen carelessly suggested rates might increase earlier than the late 2015 market projection.
Recent inflation numbers apparently increased expectations that the Fed might show a more hawkish tone. This is reflected best in the first question of the press conference from Steve Liesman from CNBC:
"Is every reason to expect, Madam Chair, that the PCE inflation rate, which is followed by the Fed, looks likely to exceed your 2016 consensus forecast next week? Does this suggest that the Federal Reserve is behind the curve on inflation? And what tolerance is there for higher inflation at the Federal Reserve? And if it's above the 2 percent target, then how is that not kind of blowing through a target the same way you blew through the six and a half percent unemployment target in that they become these soft targets?"
This was a leading question, especially considering that Yellen made it very plain in her introduction that the inflation readings remain benign. Moreover, long-term expectations for inflation are still well in-check (also see the Fed's latest projections). Most importantly, the year-over-year change in the PCE, the Personal Consumption Expenditure, reached the 2.0% target in early 2012 only to quickly plunged from there. Not only might it be premature to project a 2% reading for next week's release, but there is nothing to suggest that this time is different. Sure, recent deterioration in Iraq is threatening to send oil prices a lot higher, but Fed rates have little to no impact on such temporary spikes. The Fed is already well-versed in looking through such temporary price changes, especially non-core price changes.
The Fed still can't tease the market into sustaining pre-recession inflation levels…
Source: St. Louis Federal Reserve
Yellen's response left a lot to be desired. Perhaps that ignited the flames of disappointment. Yellen did not address PCE directly (does she already know something about next week's PCE numbers?!) and instead talked about the noise in the Consumer Price Index (CPI) while reiterated the Fed's standard guidance on inflation:
"So, I think recent readings on, for example, the CPI index have been a bit on the high side, but I think it's-the data that we're seeing is noisy. I think it's important to remember that broadly speaking, inflation is evolving in line with the committee's expectations. The committee it has expected a gradual return in inflation toward its 2 percent objective. And I think the recent evidence we have seen, abstracting from the noise, suggests that we are moving back gradually over time toward our 2 percent objective and I see things roughly in line with where we expected inflation to be."
Ironically, Yellen did not even need to refer to noise in the CPI. She could have just pointed to the longer-term trend in the CPI:
The overall trend on CPI continues to point downward
Source: St. Louis Federal Reserve
The most bizarre part of the buzz on the Fed's supposed willingness to ignore inflation is that Yellen re-affirmed, re-emphasized that the Fed is all about meeting its price target. It will not tolerate deviations in EITHER direction for long:
"…we would not willingly see a prolonged period in which inflation persistently runs below our objective or above our objective and that remains true. So that hasn't changed at all in terms of the committee's tolerance for permanent deviations from our objective."
This was Yellen's response to Liesman asking about the Fed's tolerance for higher-than-target inflation.
I feel irony in my skepticism about a Fed ignoring a budding inflation threat: this is the core scenario that has kept me long-term in the gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) trades. My thesis/assumption back in 2009/2010 was that the Federal Reserve would be extremely reluctant to tighten policy even as the economy strengthened out of fear that rate hikes would quickly kill the economy. By the time the Fed was ready to hike rates, the "inflation genie" would already be out the bottle. At that time, I had not generated the chart juxtaposing initial claims and the fed funds rate at that time, but now having this view firms my opinion. Granted, I am not nearly as rabid about this view, especially since I have come to appreciate the deep entrenchment of the lingering post-recession deflationist psychology in the economy.
So, even as gold and silver surged the day after the Fed's decision, I contained my excitement. I was even quite bemused and amused by the readiness of gold-haters (I am thinking of one particularly prolific and bearish money manager on Twitter with 74.2K followers…) to jump on that pop as confirmation that the Fed is indeed behind the curve. One only need to take a step back at a chart and see not only is this kind of one-day spike nothing new, but also it does absolutely nothing to change the overall character of the chart. I show a weekly chart for extra emphasis; note that there was no follow-through on Friday.
Gold pops post-Fed but the most I can say so far is that 2013 is looking more and more like a major bottom
My main encouragement from the gold chart is that with time it seems the brutal selling in 2013 is turning into lasting bottom. I came into 2014 assuming that even lower prices were coming; I was even preparing to take advantage of the lower prices to add to core long-term holdings. While little has fundamentally changed for gold, silver is in even worse shape…
Silver is still struggling to lift off its recent lows
Source for charts: FreeStockCharts.com
So, I am heartened by the sudden re-interest in gold and silver, but I am very skeptical that this episode is the long-awaited lift-off. I actually think the Fed is right to look through the current "warming" in inflation readings, and I think it will find vindication just as the Bank of England did during a similar episode under former Governor Mervyn King.
To me, the data do not support the notion that broad-based inflation is taking hold in the economy. We do not even have wage pressures, not to mention all the slack that remains in the economy as evidenced in part by extremely low levels of housing production. I will not even be surprised if late 2015 comes and goes without a single rate hike. Indeed, Yellen informed the crowd that there is a lot of uncertainty in monetary policy:
"…as I try to emphasize in my opening statement, there is uncertainty about monetary policy. The appropriate path of policy, the timing in pace of, interest rate increases, ought to and I believe will respond to unfolding economic developments. If those were to prove faster than the committee expects, it would be logical to expect a more rapid increase in the fed funds rate. But the opposite also holds true. If we don't see the improvement that's projected in the baseline outlook, that the opposite would be true and the pace of the timing pace of interest rate increases would be later and more gradual."
I can only imagine the heights of frustration if the latter comes to pass…
Be careful out there!
Disclosure: The author is long GLD, SLV. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: In forex, I am long USD/CAD, short euro, net short the Australian dollar, long the British pound.