'New Neutral', Same Old Fed

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

Summary

The Dallas Fed suggests that the Fed should change its communication style to address the public's low attention span and poor ability to process information.

The FOMC shows little sign of changing its communication style.

The latest FOMC flip-flop has been punished rather than rewarded as on past occasions.

The one way bet on US Treasuries is a signal of something far worse in global capital markets.

(Source: Dallas Fed)

Public interest in the on-off Fed rate hike saga is naturally waning as the procrastination and stalling continues. Research suggests that global capital markets have structurally dislocated in ways that policy makers do not fully understand. The penalty for failing to pay attention may therefore be greater this time. The Fed is aware of this problem and is also studying how to communicate in a way that holds the attention of its intended audience. Unfortunately, the legacy communication regime is still in place. This not only immediately turns off most of the audience, but also creates mixed messages that confuse those who are still paying attention. Fed speakers and their observers need to focus, on what they say and see respectively.

New research from the Dallas Fed, on central bank guidance, may influence the Fed's communications strategy and tactics going forward. The analysis is based on the assumption that the public has a limited attention span and capacity to process information. The solution suggested, is for the central bank to speak less but to speak longer and more forcefully when it does.

For such a communication strategy to work, there would however have to be great consensus within the central bank on the appropriate policy which the analysis fails to point out. The new world, of central bank transparency, would soon show up instances of an attempt to speak with one voice over the dissent and dissonance beneath the surface. The onus is therefore on the Chairman/Governor to build consensus, or alternatively to speak the loudest and longest in the absence of such consensus as a last resort.

The analysis is strictly limited to the central bank's influence on individuals in the real economy as economic agents. It fails to address central bank communications to influence asset prices and capital markets, which seems to be a glaring omission in these days of QE and QQE policies. Going forward, it will be interesting to see if the Fed changes its communication strategy to reflect the suggestions from the Dallas Fed. The recent evidence suggests that nothing has changed; and in fact the Fed continues to flip-flop in response to market concerns.

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(Source: The Daily Shot)

The May Employment Situation report on the face of it did little for the rate hike supporting consensus. In light of the latest Dallas Fed findings on guidance and the need to speak less and louder, it also presented a unique challenge to Chairman Yellen. For those FOMC members, like Dallas Fed President Robert Kaplan who believe that full employment has been reached the drop in the unemployment rate provided a crutch. Cleveland Fed President Loretta Mester also sees no need to deviate from the rate hiking course based on one employment number alone.

For those FOMC members who see growing economic weakness, the headline 38,000 jobless claims print will have strengthened their conviction. On balance therefore, a June rate hike is out but a July one is still on the table; especially if the low nonfarm payroll number is shown to be an outlier.

Having done his bit to prepare markets for a rate hike in June or July, James Bullard dropped back into data dependent mode; and signaled that he will ultimately decide on the day(s) of the FOMC meetings. He also said that the employment data, whilst important will not play a major factor in his decision making process. According to him monetary policy can do little to address falling labor force participation; which therefore puts a big question mark over the employment situation reports as a guide to monetary policy decision making from his perspective. Having just said that the employment data was not a major factor, he then perjured himself by saying that he was "leaning" away from voting to tighten at the next meeting as a consequence of this number. Go figure!

In the last report, the bullish tightening thesis being inculcated by Bullard and Janet Yellen was discussed. Bullard provided greater support for this thesis, when he commented that interest rate policy divergence had been largely priced into markets in his view. He thus tried to mitigate any hint of a Taper Tantrum based on interest rate differentials widening first. Following his rationale, the next step is to look for value in American assets; whilst also pricing in a falling dollar to support this relative value.

Governor Lael Brainard spoke forcefully and now, with the benefit of some hindsight, very presciently about the threat from any Brexit fallout; as she attempted to delay the rate hike decision until July. Brainard has become the focal point for the interface of Fed policy and the wider global economy. Earlier in the year, this forceful rhetoric persuaded Chairman Yellen to hold back on further rate hikes. In addition to the Brexit risk, Brainard then opined the weakness evinced by the latest employment situation report as another cause for pausing further over the timing of the next rate hikes.

Atlanta Fed President Lockhart then repeated verbatim Brainard's Brexit and employment data concerns mitigating in favor him voting to hike in July rather than June.

Now that both the domestic and global risk had been officially tabled by FOMC members, it had to be fully debated at the meeting. Brainard has therefore shown that there is still a tendency for FOMC members to use the public arena to put things on the FOMC agenda, rather than to use it as a pure medium of guidance. This hints at some further conflict and potential dissent to come between FOMC members.

The element of post-employment report doubt was also evident in Boston Fed President Eric Rosengren's mind. Having just transmuted from Dove to Hawk, he found himself compromised by the latest employment report; enough to call for a deeper analysis of more data to investigate whether this was an isolated number or part of a weakening trend.

(Source: The Wall Street Examiner)

The commercial credit cycle is leading the real economy down. The real economy is not so far behind though.

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(Source: Bloomberg)

The NABE's economists expect economic growth to be at its slowest since 2012, so Brainard's domestic call was well based and required significant attention at upcoming FOMC meeting.

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(Source: Business Insider)

Perhaps more worrying is the latest analysis by Deutsche Bank's Joe Lavorgna, which shows that the American credit cycle is peaking.

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(Source: Business Insider)

The business cycle looks to have started to slow in 2015, based on non-IT related capital investment. The various forms of QE and the Twist etc seem to have extended the business cycle, from its initial slowdown in 2012 to the end of 2015. After 2015, corporate America just gave up.

(Source: Business Insider)

This picture is also supported by the tax receipts data. According to this data, the economy peaked in 2013, then tried and failed to recover in 2015. The Fed now risks tipping the economy into a deeper correction by tightening; just as it did with its late cycle tightening prior to the Credit Crunch.

Those who are buying into the bull tightening story, believe that the Fed will soon acknowledge the error of its ways and start talking (and acting!) expansively as the new Presidential administration gets to work. The bull tightening story believers are taking a very aggressive viewpoint and paying up for equity market entry at this point in time. Clearly they feel that the next combined monetary and fiscal expansion is going to make the Fed's QE process since 2008 look like chump change. The latest FOMC meeting and Chairman Yellen's press conference have challenged their assumptions and made them look premature in their timing.

(Source: Bloomberg)

When it was finally Chairman Yellen's turn to speak loudly, after the latest FOMC meeting and decision, her thunder had been stolen (as usual) by her colleagues. The best that she could do therefore was to draw a ring around all the points made about the mitigating circumstances against tightening in June and then reiterate that the intention and capability is to tighten when the opportunity arises.

In light of the decision to stay on hold and the gloomy economy forecasts and predictions for the number of future rate hikes, the line that she drew was very thick and meaningful. Whilst acknowledging the positive growth signs that keep the FOMC in a posture that anticipates rate hikes, she made it abundantly clear that the potential for future growth and inflation is extremely subdued. Her flagging of Brexit risk, as a serious factor influencing the FOMC decision making process, also had the impact of projecting it into the realms of exogenous systemic global shocks that are game changers. Mr Market swiftly termed Yellen's narrative the "New Neutral". Whilst the FOMC therefore would like to tighten more aggressively, the opportunities to do so are on the diminishing to non-existent scale of probabilities.

(Source: Business Insider)

The problem for Yellen and her colleagues was immediately evident in the reaction of Mr Market. In the past, when she has flip-flopped, risk assets have rallied in the view that the Fed would soon be forced to ease again. The latest flip-flop was somewhere between an afterthought and total capitulation. The Dot Plots showed that every Fed official expects at least one more 0.25% rate hike this year. Additionally, one plotter projected that it will not be appropriate for the Fed to raise interest rates in 2017 or 2018. Furthermore, one plotter declined to give a projection for where interest rates are likely to be over the longer run; in a kind of protest-slash-admission of defeat. The FOMC is evidently embarrassed by its inability to look into the future, but not enough to admit that it has totally got it wrong again.

The market reaction to the flip-flop was less than kind and forgiving. This time the FOMC is being punished for its equivocation and procrastination. The new verdict being delivered is that the Fed has lost the initiative and is now a hostage to global fortune and price action. Mr Market will want to see a significant slide in the value of risk assets, before he is going to buy the dip in anticipation of the next phase of monetary policy expansion. Global headwinds will have to get discounted first though.

Observers therefore concluded that they are right and the FOMC is wrong; so that tightening may be delayed indefinitely. The bull tightening scenario which was observed to be getting discounted in the last report was therefore slaughtered; based on the assumption that the tightening will never come because the economy is too weak to take it.

(Source: Bloomberg)

The long-end of the US Treasury curve has become a one way bet on falling yields. The weakening domestic and global economic data, plus headwinds from the China, the Eurozone and the Brexit have caused a flight to safety. This flow has been amplified by the global hunt for yield in the universe of growing negative bond yields. If the Fed tightens, this flow will get exacerbated by those discounting the negative growth impact of the tightening. Then there is the bid from those anticipating the end of the Fed tightening and the ensuing monetary expansion.

Faced with these risks, traders have become complacent and now do not envisage any reduction in Treasury holdings by the Fed. Indeed, the Fed is expected to roll over its maturing bond portfolio. The removal of the anticipated spike in yields from the Fed exit of bond holding is also being discounted out of the Treasury curve; thus moving the cover lower. The relative value in the long end is therefore based on the anti-value in everything else.

(Source: Bloomberg)

Academia is beginning to get to grips with a phenomenon which has emerged since the central bank responses to the crisis; that turns Efficient Markets Theory upside down and all the investor behavior that is predicated upon it. The structure of global capital markets has changed, through a combination of new regulation and central bank market intervention, so that traditional cross currency arbitrage opportunities do not get arbitraged out. The cross currency basis no longer exists continuously. Sometimes it is there and sometimes it is not. The ability to predict when it will appear and disappear is currently beyond market making professionals.

The breakdown of this basis suggests a fundamental tear in the fabric of global capital markets, that is traditionally woven through the process known as covered interest parity. The ability of banks to provide liquidity and act as shock absorbers has been significantly eroded. Central banks should be acting as shock absorbers, but in fact they are destroying the robustness of the capital markets through monetary policy action and macroprudential regulation. The central banks have now disintermediated the commercial banks. Unfortunately, the central banks do not have their own inter-central bank brokers to act as the interface between their respective monetary policy agendas. With no interface they just crash into each other and create volatility.

(Source: The Daily Shot)

What is absent from the analysis is the discussion of the tear being wrought in the asset management industry by central bank policy action. A cursory look at most investment managers' mandates, both passive and active, will show that capital preservation is at the top of the list. Risk adjusted return then follows. Capital preservation in world of negative interest rates will only be possible if asset managers actually physically hold cash.

Risk adjusted return in a negative interest rate environment is an impossibility; since the investor is actually paying for the opportunity to take risk rather than being compensated for taking it. Paying an asset manager fees to hold cash is absurd, paying a performance fee for negative risk adjusted return even more so; therefore the industry is now facing a sunset as negative interest rates pervade the fixed income universe. Investor return is almost totally a function of capital gain in such an environment. Rather than force long term capital into the real economy, to create growth, it has been forced to become a portfolio of short term speculative trading strategies. With no asset management industry, the ability for capital markets to form and then allocate capital to the real economy is similarly threatened.

(Source: Seeking Alpha)

The US bond market is not immune from the negative interest rate creep, despite this not being official Fed policy. As investors look either for yield or for capital preservation, the US bond market flashes a strengthening buy signal as the lights go out for positive yields in other global bond markets. US bond yields are therefore converging on their global peers, rather than driving them as they have done in the past. Negative yields are therefore inevitable in the US bond markets, if they persist in global bond markets; it is only a matter of time.

With no asset management industry, the ability for capital markets to form and then allocate capital to the real economy is similarly threatened.

The tear in the capital markets fabric is thus getting wider, which implies that global capital market interconnectivity is breaking down. Coordinating central bank monetary policy is therefore much harder under these conditions. Central banks have crowded out the traditional private sources of capital. Private capital is now moving into cash to preserve itself against deflation and negative interest rates.

Central banks have become the main sources of capital for their domestic economies, in the absence of said private capital, so that their abilities to coordinate globally have been diminished even if they wished to. This difficulty is exacerbated when the respective monetary policies are diverging; as they are now between the Fed and its global peers. The Fed has already run into the difficulties presented by this situation on previous tightening attempts aka Taper Tantrums.

It is currently agonizing over whether to potentially put a bigger tear in the market fabric by continuing to tighten. Perhaps fortuitously for the Fed, the US economy is rapidly converging lower on its global partners. The global real economy basis is therefore enforcing itself upon the capital markets basis. The consequence of this is a return to synchronized global economic cycles, which means that the Fed swiftly converges back towards the looser global monetary policy stance.

On a more amusing note, despite its inability to hit its KPI's aka the Dual Mandate, the Fed now rewards itself in a manner reminiscent of the corpulent behavior found on Wall Street and C-Suite Main Street.

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The jaw-dropping pay increases for some Fed governors of 4% on average in the last year, following 6.6% in 2014, shows the Fed's conviction that inflation is bouncing back; or perhaps the Fed's contribution to moving the inflation needle! Having endured a compensation freeze in 2011, 2012 and 2013 the Fed has wasted little time making up for lost ground. Presumably the Fed will have to adhere to the line that full employment and inflation have set in, for fear of perjuring itself with its own compensation schemes. Pay increases, for the real economy's failure to hit mandate guidelines and targets, will be the kind of thing that the "Audit the Fed" movement swiftly seizes upon to advance the demise of the Fed's independence.

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.