Normalization Context: Divergent Opinion Is The Source Of Fed Convergence

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Includes: SLX, SPY, USO, UUP
by: Adam Whitehead

Summary

Market opinion on the path for US interest rates is widely divergent from the FOMC's projections.

The divergence between the FOMC and the forward curve fits the FOMC's guidance on the gradual normalization process.

After the first FOMC interest rates increase attention has switched to the health of the US economy.

The weak oil price and recession in the energy sector is a source of conflicting economic signals.

The tightening of financial stability policy implies that the normalization process will be short and shallow.

(Source: Bloomberg -link)

Much attention has been paid to the diverging monetary policies between the Fed and its global peers. Divergence has now manifested itself between the Fed and the capital markets. The Fed's "Dot Plot" forecasts, for the Fed Funds rate, are far more bearish than the forecasts implied in the forward curve. The last report observed the complacency developing in markets over the Fed's normalization path. The wider the divergence between the FOMC and the markets, the greater is the conviction held by the markets that they are right and that the Fed is wrong. In practice, the Fed is served by this strong conviction in the markets; because it implies that the normalization process will be much shorter than the Fed has initially suggested.

The "Dot Plots" are therefore some kind of worst case scenario outlier, from which the FOMC can then converge onto the less scary forward curve. Even the Richmond Fed Hawk President Jeffrey Lacker takes a benign view of this worst case scenario. In his opinion the "Dot Plots" projected four interest rate increases over 2016, signal a very gradualist approach to the normalization that he is comfortable with. This point was underlined by Fed Governor Jerome Powell, who said that he is confidently looking forward to job growth strength as his main KPI for raising interest rates next year. Dennis Lockhart then explained exactly how the normalization trajectory appears to him. This will not necessarily be a tightening at each FOMC meeting, but more likely at every other one.

The current divergence of opinion is therefore the FOMC's source of the interest rate convergence. As long as the Fed is in convergence mode, there should be no reason to fear the normalization. Currently the weakening global and domestic economic data support the FOMC's convergence thesis. Christine Lagarde made her market call for 2016, in order to put greater pressure on the FOMC to end the gradual normalisation process as soon as possible.

According to Lagarde's worldview, global growth will slow in 2016. This weaker growth story, plus the Fed's normalization, will create the kind of volatility that puts the pressure on the FOMC to comply with her demand. Investors should therefore embrace the duration bet and then sit back and roll down the yield curve to earn their return in 2016. Presumably this is how US fixed income portfolio managers will position for next year.

The last report entitled, "Projecting A Global Macroeconomic 'Transition Phase' Into The Geopolitical Void", observed the way that the Fed was tightening financial stability policy simultaneously with the normalization. This strategy is assumed to be aimed at convincing observers that the Fed is managing asset bubbles created by QE, in order to avoid addressing them by hiking interest rates. The Fed therefore hopes to avoid aggressive tightening of monetary policy, during the normalization process, by convincing observers that asset bubbles have been contained.

The strategy of tightening financial stability policy has not been limited only to the Fed; and is also to be found at the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC). The Fed, FDIC and OCC have jointly issued a warning to the commercial banks, advising them to tighten up their current slackening commercial real estate lending standards.

This strategy, of combined financial stability and monetary policy tightening, is already taking its toll. America led the world in corporate bond defaults in 2015. A very clear bubble, that has not been deflated in a controlled manner, is to be found in the energy company high yield bond market. The Fed's track record, on creating and managing bubbles, does not seem to have improved despite attempts to portray it as a success.

The Fed may actually achieve its target of a short shallow normalization process, but not as it intends. This tactical achievement may be a function of violent uncontrolled asset bubble deflations, throughout the normalization period, rather than skilful macroprudential management. Those looking to buy dips in 2016, will therefore be rewarded for their patience and lack of faith in the Fed's ability to execute the normalization with perfect timing and skill.

(Source: Business Insider - link)

The Fed may be forced to step back in and stimulate the economy faster than is assumed. Forensic evidence from the latest post mortem on the QE corpse has found that the majority of the benefits went to Wall Street. Low interest rates and abundant liquidity were supposed to increase capital investment. Many companies just used the liquidity and low borrowing costs to finance share buybacks. The companies that did expand capex were software companies, which clearly indicates a repeat of the "dot.com bubble" experience which also manifested itself on Wall Street.

One thing that the Fed must be watching closely is the oil price. Whilst its fall is a general economic tailwind for the US consumer, the aggregate impact on business is less easy to discern. The oil industry value chain is a major driver of the US economy. The recession in the oil sector is not only limited to the oil services companies and oil transports/pipelines however.

(Source: Bloomberg - link)

The weakness goes all the way to the steel industry, which supplies the steel that the global oil industry is built from. The weakness in steel then knocks on to other sectors that feed and service it. Since Wall Street ultimately finances all these connections, the contagion then feeds into the US economy as a whole through the constrained balance sheets of the commercial banks. The US economy may be driven by services, so that it can withstand these headwinds, but its overall health has been impaired. The weak steel price has often been sighted as a barometer for the economic health of China. It is fair to say that it is also a barometer of the health of the US economy.

(Source: Bloomberg - link)

Oil is also a driver of the economy of many states, North Dakota being a clear example. There is now a risk that the oil producing states join Puerto Rico in bankruptcy. They will certainly have to apply fiscal austerity measures. The current recession in the oil sector is therefore a significant headwind for the US economy. The balance between the consumer tailwind and the industrial headwind, created by the weak oil price, is going to be a source of great confusion for the Fed. It is also going to be a source of the caution at the FOMC in relation to the normalization process.

These observations suggests that "Real Main Street" could find nothing worth investing in, because it could not feel any aggregate demand pulling on its products and services outputs. "Virtual Main Street", in the form of social media and cloud computing services, experienced a boom that will now get tested for bubble status during the Fed's normalization phase. The Fed's next attempt at monetary stimulus may therefore have to be more narrowly focused on real consumption and investment, rather than financial asset prices.

There is also a geopolitical headache for the Fed, related to the falling oil price. Since the Saudis just announced no change in their production strategy and the Iranians then responded by saying that their production costs are low enough to take the Saudis on, things can only get worse for the oil price and hence the Fed. Since IS is now on the run in both Syria and Iraq, oil production from these territories can also increase.

Ironically the proxy war between Saudi Arabia and Iran has become bearish for oil prices, since both combatants are fighting each other with production capacity expansion. As the level of conflict gets worse, the probability for oil prices to fall further increases. Presumably, the Obama administration will tolerate the collateral negative blowback to the US oil producing states. This is the acceptable cost for the weakening of the conflict's regional combatants, in addition to Russia by nature of its reliance on oil production. Russia in particular has become a cause for concern at the Pentagon.

(Source: US ONI -link)

A recent US ONI report opined that the Russian navy will soon be able to deny American fleet access to the Baltic and Black Sea regions. As the Obama administration signalled with IS, the best way to weaken an enemy is to weaken its finances. A weaker oil price therefore weakens Russia strategically. The cost is that US domestic oil production and hence energy security is compromised. Some oil experts however predict that the steep decline curves on US Shale production are just about to kick in, so that domestic energy security is a mirage that is just about to vanish in any case. If the US economy intends to rely upon oil going forward, it will therefore have to go out and get it again. Weaker opponents and allies on the global oil patch are therefore an important precursor for the next global grab for oil. Since the US oil producing states are Republican in leaning in any case, the sacrifice for the incumbent administration is more than acceptable as next the Presidential elections approach.

(Source: Bloomberg - link)

Now that the fact of the first FOMC interest rate increase has overtaken the rumour, on which the US Dollar has been bought, focus is switching back to the health of the US economy. All is not as well as was assumed by the Dollar bulls. Dollar strength has therefore run ahead of the FOMC normalization reality. The strong Dollar has done considerable tightening on behalf of the FOMC already. This endorses the Fed's signals that the normalization will gradual and punctuated with periods of assessment. There is therefore room for the spot US Dollar to converge lower on the reality of the normalization process rather than the divergent perception that has been priced into it.

The last report observed how the banks were hoping to push through a festive easing of capital adequacy requirements in an attempt to mitigate the Fed's combined tightening of monetary and financial stability policy. The banks failed abjectly in this move. Instead they have been forced to give lawmakers what amounts to a $7 billion Christmas present to spend on various pre-Presidential Election sweeteners for voters.

The icing on the Christmas cake was the lawmakers "earmarking" of the dividends, that the Fed pays to Reserve Bank members, for the purpose of infrastructure spending. QE is finally finding its way to Main Street from Wall Street. If banks now want to earn income going forward, they must do it the old way of making risk adjusted loans. This traditional old school of banking is however something that they have lost the skills of doing during the easy money days of QE. It is also something that will cost them dearly in terms of balance sheet risk capital going forwards.

No doubt a new wave of mergers is coming in the US commercial banking sector, in order to achieve scale and margin pricing power. It may also be the only way to overcome the expensive burden of capital adequacy requirements. Cannibalising a competitor's capital base, is a lower fruit than actually going out and diluting ones earnings per share by raising more equity.

The Fed is evidently feeling sorry for the banks, after their savaging by Congress. The Fed is no doubt also being as circumspect with its tightening of financial stability policy, as it is with its normalization of interest rates. The Fed evinced this circumspection by signalling that the process of financial stability policy tightening will be protracted and interactive.

Banks have been asked to comment on the Fed's proposals to tighten capital adequacy standards. They have until February 19th 2016 to erect their defences. As a carrot, the Fed is offering to set the countercyclical capital buffer at zero for now, potentially increasing to 2.5% of risk weighted assets in times of economic stress that may impair the balance sheets of the banks. The stick that goes with this juicy carrot, is the threat to impose punitive measures on the dividends and executive compensation of banks who fail to meet the Fed's capital adequacy guidelines.

(Source: Bloomberg - link)

Shadow banking is an area that the Fed and the banks can enjoy some symbiosis in going forward. Shadow banking is something that the banks need and the Fed needs to regulate. It is therefore an area of common ground that will bring both parties to focus clearly on the issue of capital adequacy.

No doubt the Fed will approve of the banks embrace of shadow banking as a means of earning some wider margins going forward. In a recent speech entitled "Financial Stability and Shadow Banks: What We Don't Know Could Hurt Us" Stanley Fischer opined the concerns that the Fed has about the opaque unregulated shadow banking sector. JP Morgan is now leading this charge into online lending with its involvement in On Deck Capital. As Federal Reserve Banks stampede into this sector, the Fed will have a bridgehead from which to bring much needed oversight and regulation to this next lending bubble.

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.