Fed Rate Hike December 2015: It's Still A Bad Idea

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Includes: DRR, FXE, ULE
by: Grant Ferowich

Summary

Draghi is really smart.

The reward/risk structure for raising rates in the US is not there.

The labor market still has a ways to go with wages.

If the Fed agrees with me and holds ZIRP, against market expectations, then buy ULE and FXE and sell DRR.

In my last article, I assumed the ECB was going to expand their bond buying initiative. Instead, Draghi announced an extension of the program, not an increase in the program's magnitude. The euro bounced up from the 1.05 mark.

Next, the US jobs report came out, showing November employment gains were 5% higher than analysts' expectations. The markets saw this as sufficient reason to promise a December rate hike when the Fed convenes this month.

A rate hike would not be a great Christmas present for the US economy (the Fed's first responsibility), for emerging economies who have to pay back US debt, or for our trading partners such as Europe.

Labor Market Issues

First, while unemployment has reached what many economists think is the natural rate of unemployment, 5%, wage growth has been poor. This comes as no surprise. We've had a slack labor market for 7 years now. Year-over-year nominal wage growth has been entrenched below 2.5%.

(Source: Bureau of Labor Statistics, Economic Policy Institute)

Why is this a problem? Economic recoveries post recession are supposed to be fast. How do we know our current recovery is slow? It's going slower than the recovery after the Great Depression.

The positive news is that the total unemployed population fell 3.9 million in the US. Still, YOY reentrants (people who were previously unemployed and not seeking work who now are seeking work) are down 14.9%. There are some reasons to be optimistic about the US labor market, but we're not exactly looking at the peak of a labor market boom. Which is what Yellen and the Fed should be looking at before a rate lift-off.

Inflation Hawks?

For years people have screamed inflation. For years we've seen data that shows this hasn't been the case.

(Source: St. Louis Fed)

Inflation is lower than the 2% target despite monetary expansion. What gives?

A central bank nominal interest rate increase might raise actual and expected inflation. This would be the exact opposite of what is intended. Extended periods of low nominal interest rates, along with central bank promises to keep them low actually have the effect of bringing about lower inflation.

So, with employment improving, but still a ways to go, it seems the argument for higher rates is to avoid inflationary pressures. The problem is that: 1) these pressures haven't been evident in 7 years of ZIRP; and 2) this might actually have the exact opposite effect.

So basically, my argument goes like this: A) If you end ZIRP, you could get higher inflation. Ending ZIRP also does not work to the benefit of improving wages. B) Continuing ZIRP doesn't have either of these risks. So C), it's a bad idea to raise rates in December.

Euro Worries

Perhaps in a binge of foresight, Draghi anticipated a December lift-off across the pond. Expanding QE at the ECB would then decimate the euro, possibly shooting it below parity. Instead, by only lengthening the current program, he forces Yellen and the Fed to play their hand first.

Draghi is smart enough to know that cutting rates further in the EMU devalues the euro; add this to a rate increase across the pond. This is a recipe for disaster for the value of the euro.

While Germany may enjoy boosted exports as a result of the devalued euro, fears of inflation lurk in Deutschland as well. They do not want further easy money central bank policy more than is necessary.

Final Commentary

Whether the Fed jumps rates will depend how risk-averse they are. Jumping rates does not have clear benefits, aside from whetting the market's appetite. It's a much safer play to wait until 2016 to jolt up the nominal interest rate. I'm providing a contrarian opinion that the Fed will not budge on interest rates until 2016. The rewards relative to the risks are just not there. The euro still may drop to parity with the dollar, but not in 2015. As a result, buy the ProShares Ultra Euro ETF (NYSEARCA:ULE) and the CurrencyShares Euro Trust ETF (NYSEARCA:FXE) and sell the Market Vectors Double Short Euro ETN (NYSEARCA:DRR).

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.