The December Rate Increase In Retrospect: Was The Rush Really Necessary?

by: Paul Ticu

Summary

QE is over - and volatility is back.

The stronger dollar combined with market volatility puts the recovery at risk.

Developed markets are experiencing the same problems as Japan. Time for three arrows?

Last year, this article argued that the Fed had two policy tools at its disposal: (1) increasing interest rates and (2) increasing volatility using appropriate language in FOMC statements.

Given persistently low inflation, and fragile growth it seemed - at that time prudent to recommend leaving rates unchanged, and signal the removal of the "Fed Put," which would have normalized the volatility regime - and removed some of the asset price inflation.

Yet, the Fed - and markets - were keen to see the death of QE and the departure from the "zero bound" in rates, which apparently is the economic equivalent of the event horizon - the point of no return - in a black hole (Japan deja-vu?).

Recall that the Fed has a dual mandate: helping growth when the economic engine stutters and keeping inflation within limits. From this perspective, increasing rates makes sense only if economic growth is healthy, and inflation is increasing well beyond its 2% target. Neither of these two conditions were met in December, yet somehow, FOMC officials felt the need to increase rates.

The first chart shows 5 year break-even inflation, 10 year break-even inflation, and the 5 year inflation expectation in five years; the message is clear: there is no risk of inflation - if anything there is a risk of deflation.

Add to this the (existing and future) deflationary pressure from the drop in oil prices. Assuming that the effect of the oil price takes a while to work itself through the economy, the 2014 drop is being felt now, while the most recent oil price crash will have been incorporate one year from now (let's say it takes one year). This means that the deflationary pressure is here to stay at least for another year.

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So much about inflation - but what about growth? The second chart shows real U.S. GDP growth: it is modest, and given that this timid economic expansion has been one of the longest in history the threat of some economic contraction becomes all too real.

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And looking at the manufacturing PMI is concerning as it could herald the end of the economic expansion.

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The December rate hike was a mistake, as it introduced not only volatility in the market, but a whole series of headwinds within the context of a relatively weak recovery. Most notably, the rate hike is the main culprit behind the stronger dollar and will weigh on corporate earnings.

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QE and the "Fed Put" were the main causes behind the artificially low volatility regime, acting de facto as insurance against a market crash and therefore cutting the left tail of the "market" P&L distribution out of existence.The removal of the Fed Put leads to a normalization of the volatility regime, which means that market swings will happen more often and with greater magnitude.

The Fed raised rates, the dollar strengthened, yet interest rates are lower, as risk-averse investors are willing to pay the government to keep their money safe. An extreme example of this phenomenon is Switzerland where 10-year interest rates are negative. It seems that while volatility is adjusting to the new regime (and some air is lost in risk assets), investors will continue to hide in government fixed income. Once equities correct, it will be the turn of bond markets to see some pain - although - it would be almost uneventful to have yet another year with 10-year rates finishing below 3%.

There are similarities between the U.S.and Japan. Food for thought, as the last two charts show the Nikkei vs. the S&P 500 and U.S. and Japan 10-year rates. What if the Japanese economic experience of the last two decades was not a local, idiosyncratic problem but is indicative of a general, systemic problem with developed markets?

The U.S. and Europe appear to be mimicking Japan's path. As part of this experience, Japan cut rates, and subsequently attempted to increase these a few times over the years - unsuccessfully.

The West can learn from Japan: rather than increasing rates too soon, only to cut these later on, it would be easier to leave them be until the data actually warrant interest rate increases.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.