The FOMC's Closing Window Of Rate Hike Opportunity

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Includes: DIA, IWM, QQQ, SPY
by: Adam Whitehead

Summary

There is currently utility for the Fed in creating uncertainty over the timing of the next interest rate increase.

The utility associated with rate increase uncertainty is being eroded by deteriorating global and domestic employment data.

Fiscal policy is tightening at the State and City levels creating a headwind.

The Fed is managing growth expectations by promoting a new growth forecasting tool that conveniently overstates the future picture.

Janet Yellen's "transformation" of the Fed rings a bell in relation to the Fed's perpetually expanded balance sheet.

Click to enlarge (Source: Bloomberg)

The Fed has continued the process of covering all the potential "Taper Tantrum" bases, observed in the last report, in order to maintain uncertainty about the timing of the next interest rate hike. Going into the latest FOMC meeting the Fed speakers assiduously adhered to this task. As they spoke and global economic growth and domestic employment data deteriorated, there was a growing sense that the window of opportunity for interest rate hikes is closing.

As the April FOMC meeting approached, Dallas Fed President Robert Kaplan tried to push expectations for the next rate increase out into June. His recommendation to remain both "patient" and "cautious" were based on his opinion that; "We'll know soon enough. We are not going to know by April. There is time for us to make these assessments over the next few months and we will." Kaplan would like to see more data and also if the global equity markets can regain the levels they held before the New Year sell-off.

Perma-Hawk Jeffrey Lacker remains satisfied with Yellen's handling of the rate increase process and is happy to go with flow in April and/or June. Based on the benign increase in inflation, "(his) sense is that the less leisurely but still gradual pace of target rate increases that FOMC participants submitted at year-end is still more likely to be appropriate."

The neutral Atlanta Fed President Dennis Lockhart agreed with principle of rate hikes, but then raised the bar conditionally for both April and June FOMC meetings. He would first like to see the kind of economic growth that creates escape velocity in growth performance once it has breached the 2% threshold.

St Louis Fed President James Bullard scaled back expectations for an April rate hike even further. Following the line recently adopted by the IMF at its annual meeting in Washington, he emphasized the soft Q1 economic data which underlined the need for caution and patience. Bullard's zag to the Dovish side seems data driven, especially given the warning signals appearing in the weakening employment data.

There are tangible signs that fiscal policy is tightening at both State and City level. Big corporations have been blackmailing the states and cities to giving them tax breaks and other fiscal incentives to maintain their presence. These pecuniary incentives have been used to boost the bottom lines and hence share prices, rather than to invest or increase hiring. States and cities are onto this game and have cut back these incentives by about $12 billion since 2013.

The transfer of wealth from taxpayers to corporations has thus been reduced. States and cities are therefore in better fiscal shape to deal with the blowback from corporations who retrench and relocate as they are no longer paid for their presence. This fiscal retrenchment will then manifest itself as an economic headwind. Loose monetary policy from the FOMC will then have to take up the slack.

The April meeting was rapidly becoming a non-event, therefore a noted Dove was used to give it some meaning. Boston Fed President Eric Rosengren opined that the market was being too pessimistic about the chances for rate hikes, thus providing some interest in the April meeting.

Click to enlarge

(Source: Seeking Alpha)

The last report also noted the setting up of the Oregon economist Tim Duy, to proselytize the lack of risk in the potential for the Fed to overshoot its inflation target. It was observed that Duy (and the Fed) may be hoist by the petard of Stagflation, should the pace of growth fail to keep up with the rise in inflation.

Click to enlarge

(Source: Seeking Alpha)

The Fed's ability to suddenly pay more attention to data that help it to proselytize its own agenda was also observed; in the latest fad for allegedly paying close attention to the Employment Level Part Time for Economic Reasons and the Employment to Population Ratio for Prime Age Workers. These data sets conveniently show no current risk of inflation overshooting.

In this spirit of cherry picking the data to fit the policy rather than making policy based on data, the New York Fed is on deck with a new overestimating GDP tracker. Having allayed fears of inflation overshooting, the Fed now needs markets to buy into the concept that GDP is going to be stronger than anticipated. Managing growth expectations is now part of the Fed's remit in addition to managing inflation expectations.

Evidently the Fed needs growth expectations to be commensurate with inflation expectations, in order to justify its commitment to interest rate increases however slowly and cautiously they come. There may even be a hope within the Fed that if people expect faster growth, then they will behave in a way that delivers it.

(Source: Business Insider)

The hurdle to growth expectations management is that the global and domestic economy are currently softening by the currently used measurements. The New York Fed has therefore come up with something called the "Nowcasting Report" that allegedly tracks growth expectations more accurately. After inception, the Fed will then promote the perception of growth through this behavioral finance model. Conveniently, the new model already estimates GDP to be a full 1% higher than the current Atlanta Fed estimate. The Fed has therefore injected a quantum leap into market perceptions in order to shift growth expectations from their modest baseline.

If the "Nowcasting Report" is accepted and becomes the default growth index predictor, the Fed will have mitigated the risk of Stagflation by engineering a GDP perception that is commensurate with (and even higher than) the current inflation trajectory. Professor Duy's embrace of this new index would be the icing on the cake; and also the proof of the pudding about his function suggested in these reports.

Click to enlarge

(Source: Time)

Janet Yellen and her colleagues, through guidance and data cherry picking, have been largely successful in engaging Mr. Global Market in a benign form of mutual symbiotic confirmation process that supports asset prices. Having achieved this priority, she has moved onto the second priority of engaging in a similar relationship with Mr. Main Street. A recent interview with Time magazine, signals this move to frame public opinion in the wider audience of the real economy.

The message is the same, but the buzzwords used are "risk management". These two words imply a comforting duty of care for by the Fed; and may cause some observers to assume that the overall level of economic and market risk is being reduced. Rate tightening cycles are traditionally associated with increased risk, ergo the said "Taper Tantrum"; so Yellen's semantic choice of words for guidance is inspired and deliberate.

Click to enlarge

(Source: Seeking Alpha)

Recent observations of Yellen's alleged "transforming" behavior ring a bell; and should be put into the context of the view held by this author that the Fed has no intentions or capabilities to shrink its expanded balance sheet at all.

(Source: Bloomberg)

This view has been taken up by Zoltan Pozsar of Credit Suisse. Pozsar believes that the new macrostability rules being enforced by the Fed, mandate that the levels of reserves held in the banking system must remain at elevated levels. High reserves are now not just the buffers to losses in the banking system, but have also replaced the traditional Fed Funds market as the source of balance sheet funding. The conversion of the use of reserves from "risk management" tool to funding tool therefore totally refutes Janet Yellen's folksy interview with Time Magazine. Systemic risk has now been attached to reserves rather than the banks' previous commercial funding model.

Click to enlarge

(Source: Seeking Alpha)

What this means is that in the event of said systemic crisis, the Fed can simply bail out the banking system with expanded reserves; so that the taxpayer is not called upon.

The Fed therefore has control of credit creation and also of crisis management through the common denominator of reserves. This observation supports the theory also held by this author that the Fed's real mandate is to manage asset prices. Rising asset prices in theory create the P&L that gives consumers the confidence to consume rather than to retrench.

The Fed manages economic expectations by managing asset prices. A fall in asset prices associated with tightening monetary policy, is therefore only a catalyst for the expansion of monetary policy at a later date. The Fed wraps up this process under the title of macroprudential stability. When the Fed is prudently deflating bubbles in one asset class, the liquidity is migrating into another asset class.

The Fed must now manage the next fall in asset prices skillfully so that it is framed as an excuse to expand the reserve base. The next expansion in reserves will then be the reservoir of liquidity that takes asset prices to new highs and hopefully the real economy with it.

The Fed may not however have things just the way it wants them, if Jerome Powell's analysis of the bond markets is anything to go by. In his view the plethora of new rules and proliferation of new trading technology, since the Credit Crunch, have made it more difficult to assess liquidity in US corporate bonds and Treasuries.

Clearly hiking interest rates in this new world is going to have a magnified impact on these markets. Powell was however clear that in his opinion liquidity has not dried up, but only the perception of it. Perception is reality for traders however, so the Fed needs to expand Janet Yellen's new risk management reach into this arena also. Presumably this is Powell's job.

The FOMC announcement was anticipated to be a non-event and the Fed did not disappoint. There was however an underlying sense of foreboding in the announcement that the "economy appears to have slowed". The bottom line is that the FOMC claims to be in tightening mode, but remains cautious about the risks from the global economy. The absence of a press conference by Yellen heightened the feeling of anti-climax and lack of meaningful information. The FOMC' confidence on the domestic economy remains equally and oppositely balanced by its lack of confidence on the global economy. A rate hike in June is therefore not a slam dunk certainty.

Markets will only accept a certain degree of uncertainty, before they call central bankers' bluffs by betting heavily on one outcome. The Fed may be reaching the limits of creating uncertainty in the minds of speculators, who are starting to fear the worst in terms of an economic slowdown.

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.