The recent G20 Chengdu meeting was an opportunity to look, for any divergence in attitudes towards the Brexit vote, from a domestic US and G20 perspective. What emerges from this observation is a conclusion that global and US domestic interests have been portrayed as aligned. They are in fact diverging and may soon diverge even further. The FOMC remains committed to a divergent path.
Dallas Fed President Robert Kaplan confirmed the groupthink aka consensus, discussed in the last report, presently entrenched at the Fed in his latest speech. In his opinion: "What they may disagree on in the margin is timing and tactics" and " I think you see a lot more consistency among Fed presidents in what they say, than inconsistencies." The consensus that he sees is an agreement that the next step is a tightening one; but that the process must remain gradual because of external global risks. This view is supported by Philadelphia Fed President Patrick T Harker, who sees another two rate hikes this year once the tightening process resumes. This groupthink was reinforced rather than challenged by the Brexit vote. The Fed is now signaling that, whilst it remains worried by global uncertainty, it takes a sanguine view of the immediate Brexit risk to the US economy.
James Bullard's latest comments made it clear that he is happy to stay on hold at the next meeting. Bullard noted that some observers feel the central bank should take a wait-and-see approach, following the U.K.'s decision to leave the European Union. "I'd be OK with that," he said in reaction this inference.
Kansas Fed President Esther George has distinguished herself from the groupthink on the FOMC, by indicating that she is ready to consider immediate interest rate hikes again. She sees the Brexit impact as "mild". Her independent thought process is admirable, however one is left wondering if she fully understands the implications of her narrow domestic focus. George sees the lack of domestic weakness from the global headwinds as the reason to continue to hike. A rate hike may however induce further global weakness that then attracts more capital into the US economy that stimulates it even further.
The FOMC would then face the dilemma of a tightening, for domestic reasons, that made the global situation worse and drove more capital into the US economy. George's envisioned lack of domestic weakness is therefore partly a result of the attractiveness of American interest rate differentials; and not necessarily something independent from the global economy.
The best FOMC strategy may therefore be to let the US economy to absorb global capital until it is then growing fast enough to recycle this capital back to the rest of the world as it has done in the past. American interest rates would then rise naturally in order to attract the capital back. The issue of George versus the groupthinkers simply serves to illustrate the problems created by central bankers who think that they know what is best and refuse to let markets decide how to allocate capital. Both George and the groupthinkers just can't leave things alone.
George herself seems to be acutely aware of this dilemma; and may in fact be preparing for an agonizing flip-flop into the pool of groupthinkers. She recently commented that she is now paying very close attention to capital flows into the US dollar. In her view, capital flight into the US dollar could influence growth. She did not elaborate on whether this stimulates growth, or if it weakens growth by choking off demand for exports. Her equivocation suggests that she is uncertain; which may prompt her to join the groupthinkers on pause.
Atlanta Fed President Dennis Lockhart has adopted a qualitative discounting mechanism for the known-unknown Brexit risk. By his own estimation: "I (Lockhart) have no basis - statistical or anecdotal - for assuming any significant change in economic momentum." Because he cannot quantify it however, this does not mean that he totally discounts it as being negligible. Qualitatively, he believes that its effects are: "negligible near-term effect; a risk factor over the medium term; higher uncertainty that could amount to a persistent economic headwind." Lockhart is therefore open to persuasion by the incoming data. It can be inferred that he is willing to put interest rate hikes on hold until the data persuades him otherwise, because he recommends remaining "cautious and patient".
Far more interesting to this author, than Esther George's dissent or Lockhart's qualitative discount factor, is the lonely crusade being waged by Cleveland Fed President Loretta Mester against the groupthinking consensus on the FOMC. Unfortunately, Mester is currently getting the wrong headlines for affirming her consideration of Helicopter Money if conventional monetary policy fails. Given the appearance of Helicopter Ben in Japan, to bless the next monetary and fiscal expansion in there, observers are putting two and two together prematurely for the FOMC.
Mester has in fact been warning of what the demise of unconventional monetary policy will look like, unless a conventional monetary policy tightening occurs soon. Framing her as an advocate of Helicopter Money in America at this point in time is therefore unfair. Despite media ignorance of Mester's true message, there is evidence that it has been taken on board by her colleagues. Robert Kaplan recently opined that: "Rates this low create distortions" and "my fear is there are distortions you can see and distortions you can only see after the fact." Unfortunately however, the groupthinking consensus is more afraid of triggering a collapse in markets my tightening in the current uncertain environment. Their unwillingness to concede that their caution is creating an even greater distortion, thereby guarantees said even larger distortion which is only seen after the fact by default.
(Source: Business Insider)
In the last report Mester's salient warning, that failure to tighten would create the asset bubble that would finally destroy the Fed's credibility when it bursts, was noted in her change in communication. Her view is similar but less theatrical to that of investor Tad Rivelle. In his opinion central banks are distorting the signals that the market is attempting to make about future expectations and the true, underlying price of assets. The resulting misallocation of capital creates the Zombie conditions, which Rivelle calls Dragons, that destroy economic activity and crash asset prices. Building on this theme, Mester has since gone on to opine that she strongly disagrees with the FOMC's implicit adoption of a financial stability mandate by failing to tighten. She then argued well, that monetary policy should only be used as a last resort if other financial stability tools have failed.
It is worth noting that even Stanley Fischer admits that the Fed is way behind its global central banking peers when it comes to financial stability tools; for the precise reason that this is not in its official mandate. Until this mandate is officially given, the Fed can continue to make things up as it goes along and use monetary policy as its preferred tool by default. Mester is thus way ahead of her time. The only criticism of her is that she is now mixing her message.
By calling for an interest rate hike, rather than suggesting some new financial stability tools be employed, she is both signaling that this is the Fed's third mandate and then confirming that it its by using an interest rate change as a taboo financial stability tool. This simply illustrates how the current problem of low inflation and subtrend growth are in and of themselves a financial stability problem. Presumably, hyperinflation and hypereconomic activity are financial stability issues in the obverses sense. It is unlikely that Mester would suggest cutting interest rates in this case though, so her rhetoric seems asymmetrically inconsistent. Mester like all her colleagues has become conflicted by the weak economic data that has plagued the QE process and the alleged recovery.
(Source: Seeking Alpha)
A previous report discussed the Dallas Fed's new suggestions in relation to optimizing the impact of communication policy, in the face of an audience with a low attention span. The FOMC was instructed to speak less frequently, yet with a longer duration and more gravitas when it does. Retired Fed President Narayana Kocherlakota has picked up on this theme and is now promoting it with specific focus on Chairman Yellen. He believes that the cacophony of Fed speakers is unrepresentative of Fed policy; so that only an increased commentary from Yellen can redress the false perceptions of the numerous voices.
Kocherlakota is particularly concerned by the lack of authoritative opinion on the current dislocations in the global economy, surrounding the Brexit, that are creating a cognitively dissonant voice from the Fed speakers who refer to them. In his opinion, Yellen needs to speak more. Putting the two cents of the Dallas Fed research together with Kocherlakota's two cents, it is clear that there is a growing institutional feeling within the Fed that its communication policy is inadequate to deal with the current global environment. It is also clear that the Chairman's voice is going to be amplified over that of her colleagues. By default therefore, there is going to be a further concentration of power within the all-powerful Chair.
The optimization of communication policy appears to be a clear theme running through the Fed at the moment. The San Francisco Fed recently released its own research into guidance at the zero bound. It found that whilst the ability to influence short term interest rates has now been lost, at the zero bound, there is still scope to influence long term interest rates. Combining all the latest findings, by the various direct and affiliated Fed researchers, on guidance Chairman Yellen is now expected to influence long term interest rates with her words going forwards. In the global NIRP/ZIRP world, as capital flows converge US yields on the negative global mean, her ability to influence long term interest rates may soon be diminished however. If she thinks that she has got a new policy tool through guidance, she also needs to understand that it is a wasting asset that she needs to use soon before it disappears.
(Source: Business Insider)
The rapidly deteriorating picture in the credit markets is starting to supersede all the global macro headline risks that the Fed is so uncertain about. The latest data from S&P shows 100 corporate defaults this year versus 62 at the same point in 2015. The US has the highest number with 67, which is greater than the global total for last year at this point. This sets up a great bull-versus-bear argument, which has a wider context for the Fed.
(Source: The Wall Street Examiner)
The argument gets even more interesting now that S&P earnings are decelerating.
A bear will argue that the default trajectory is headed back to where it was in 2009. A bull will argue that the interest rate environment is supportive; and that the Fed will not tighten to tip the economy into the recession that will destroy asset prices. In fact, the bull will argue that the Fed is already too tight, especially in relation to global risks. The jury is out and the markets now have a healthy debate to discount in terms of price action. There is no arguing that the global credit cycle is flipping into contraction mode however. One could say that the willingness to hold negative yielding sovereign debt is symptomatic of this observation.
The last report concluded that US assets would be the beneficiary of capital flows, as a result of the fact that perceived economic and political uncertainty is lower in America; whilst it offers the only decent yield premium available by a developed economy in the new NIRP/ZIRP world. This thesis is strongly challenged by the recent corporate default data( above) on the face of it. In response to this, it can be argued that the rising default rate in the US is a known-unknown. The global uncertainties, such as the Brexit and its fallout are much more difficult to track and anticipate. The flight to quality therefore continues to be towards the US, especially as it offers a yield pickup to reflect the weakening corporate default situation.
Confirmation of this perverse thesis is to be found in the perverse drivers of US equity outperformance. Defensive utility stocks are leading the charge, to the consternation and surprise of the analyst community. Looked at through the frame of global NIRP/ZIRP this performance makes sense. Treasuries are rich, as Goldman has said, which has led to the hunt for yield in defensive equities which have bond-like cash flow features.
The current US equity rally is therefore perversely risk-off in nature, but qualified by the fact that one has to pay up not to take risk any more in the NIRP/ZIRP world. Jeffrey Gundlach has taken a contrarian view ,of what he terms the "mass psychosis" in relation to the global lack of yield opportunities, by shorting equities and cutting the duration of his bond investments. There is quite a difference of opinion, which always makes for a good market, in US Treasuries. PIMCO is persuaded by the attractions of Treasuries in the NIRP/ZIRP world, whilst Gundlach and Bill Gross see this period as an anomaly that will swiftly return to normal with negative consequences for bond investors.
Bank of America's latest credit strategy view also supports the thesis in relation to flows into US corporate bonds. The positive domestic economic picture and the global hunt for yield are the main drivers of the flow into high grade corporates. This does not come without its own set of risks though. Since US corporate debt is cheaper to issue than equity, there is a growing risk that US corporates are becoming over-leveraged. The rising default rate and negative earnings growth mentioned above amplify this leverage risk. It doesn't mean that the party is over however, since the risk averse will then pile out of these risk assets into US Treasuries. This will drive Treasury yields even lower, which then underpins the US risk assets that have been vacated. It is difficult to avoid this one-way-traffic argument for US assets and the US dollar. Morgan Stanley already sees such flows, pushing the yield on the US 10-Year to 1%.
(Source: The Daily Shot)
The corollary argument is provided by US mutual fund flows, which show net outflows from Europe this year. Given the weak global picture, the majority of these flows will have gone back to the US. American investors have capitulated on Europe this year, after having believed that Mario Draghi would successfully do whatever it takes in 2015. This painful memory will no doubt have been made worse by the recent Brexit headlines. Having recently been burned it is unlikely that American investors will be rushing back to Europe. American investor perceptions therefore reinforce the flow of funds into US assets thesis.
St Louis Fed President James Bullard's analysis of the flattening US yield curve also supports the global risk avoiding flow of funds thesis. Bullard said that the flattening US yield curve in a low interest rate environment signals risk avoidance. Low risk is perceived in US risky long duration assets. His analysis did however fall short of explaining that the hunt for yield nudges capital flows out along the yield curve to take this duration bet. Bullard's objective appears to be to prevent speculation through duration buying that the US economy is weakening, so that the FOMC will soon be easing again. He thus framed the flattening as a search for a global safe haven, rather than a duration bet on the Fed easing.
The IMF has done its bit to help the risk avoiding global flow of funds thesis. According to the IMF, the Brexit will have little impact on the US economy. Capital flows from the UK to the US are thus sustained. Capital flows from the Eurozone to the US are also sustained, because the Eurozone is relatively more at risk from the Brexit than the US. The FOMC also has more scope to tighten since the US economy is allegedly least affected by the Brexit; which should therefore attract more capital on the interest rate differential argument. The IMF addressed this issue, by calling on the Fed not to increase interest rates in light of the weak global conditions.
The growing divergence between Christine Lagarde's new softer IMF and the increasingly hardline short-timer Obama administration, also helps to drive the global flow of funds into the US. Lagarde's latest call for an urgent globally coordinated stimulus fell on deaf ears at the US Treasury, where Secretary Lew sees no current urgency. Presumably Lagarde is part of the cadre of thought leaders, including Ben Bernanke, who have recently been nudging Helicopter Money into public view. Evidently the Obama administration is more focused on support for Hillary Clinton as it immediate priority. The innate Socialist objectives of Helicopter Money would no doubt play into the hands of the Trump campaign; so it has been tactfully avoided by the Obama administration. The global economy is thus going to have to muddle along in the meantime, which is US dollar- and US asset-positive.
The worldview reported from the vantage point of a recent McKinsey global survey, found the recurrent theme that will drive global fund flows to safety in US assets. The populist themes that are creating global instability like the Brexit and advancing the cause of Donald Trump in America are prevalent in the study. The theme of wealth distribution, via a Helicopter Money policy response, to overcome the populist reaction is also served by the study's findings; which is perhaps the real key signal in the document for policy makers.
Fannie Mae and Freddie Mac both seem to have got the measure of things very well. Fannie Mae sees very limited domestic impact from the Brexit; and whatever limited impact will be net positive for the US economy. In its latest Outlook Freddie believes that the Brexit will raise global risks while keeping domestic mortgage rates near historic lows. That, in turn, will raise mortgage originations. First capital flies to the US and second it stimulates the economy. Applying Freddie's view, if the FOMC tightens before or after the stimulus is felt it will attract more global capital which exacerbates the dilemma over tightening even further. Ironically the Brexit is a US stimulus in the opinion of the GSE's.
Dallas Fed President Robert Kaplan recently framed the flow of funds thesis, in a manner previously noted in relation to Esther George. He also gave a clue as to how he will vote when he becomes and FOMC member in 2017. Thus far he sees growth as the priority. In view of this he maintains a very relaxed approach to raising interest rates, especially based on the current global headwinds circling the US economy. He opined that the Fed is "very sensitive" to the level of the US dollar, despite the fact that manufacturing exports account for a diminishing share of GDP compared with services. This sensitivity implies that the Fed is already anticipating a strengthening US dollar; and will therefore mitigate this effective monetary tightening by being easier on the interest rate side.
The emerging picture is one of a relatively more attractive US economy within a global economy that is growing sub-trend. Policy maker attempts to address the sub-par growth issue provide a supportive monetary and fiscal policy backdrop. Furthermore, central banks are now in the process of being used to monetise the fiscal deficits that are preventing a stronger fiscal policy stimulus. JP Morgan has pioneered some analysis of this muddling along thesis. Economic decoupling, especially between emerging and developed economies, has increased the volatility of economic growth between nations. This decoupling can also be seen politically in the rise of populism and the decline of globalization.
This emerging-versus-developed market volatility however appears to be the sign of an imbalance adjustment process taking place between these nations within the global economy. This adjustment process therefore lowers the overall level of global growth volatility. Additionally and perhaps more importantly, the developed nation central banks are smoothing the impacts of this global adjustment process even further. Decoupling, imbalance adjustment and central bank policy are conspiring to create an investment environment that is far less challenging when viewed against previous adjustment periods in history. Central banks are smoothing the adjustment process. Investors living in the moment are struggling with the concept of taking on more risk in this environment. Those like JP Morgan, with a historic perspective, find it easier to rationalize. This environment perversely makes risk even cheaper in historic terms because investors are avoiding it, whilst central bankers are deliberately making it cheaper. America is one such beneficiary of this relative risk avoidance process. Because the ECB, BOJ (and shortly the Bank of England) are making the greatest contribution to the process at this point in time, American assets are relatively cheaper. The fact that they have a yield pickup when global investors are willing to accept negative yields to avoid risk is a bonus and a massive driver.
The view of JP Morgan seems to curiously compliment the latest pronouncements about the global economy from the IMF. IMF Chief Economist Maurice Obstfeld recently cancelled the IMF's global growth pickup forecast, because of the lack of visibility created by uncertain Brexit outcomes. Obstfeld also opined that current FX market volatility is not disorderly; and is in fact welcome to allow for global growth imbalance adjustment. This view of the FX market is also held by Treasury Secretary Lew. It would appear that there is a global worldview being sponsored out of Washington and New York; that is trying to frame market perceptions to accept FX market volatility as bullish for the global economy and risk assets. Believers will then not perceive capital markets as being rigged by central banks, because the volatility in FX markets is accepted as being part of a market based solution to global growth problems.
This manipulation of perceived reality was very much in evidence at the recent G20 meeting in Chengdu. The manipulation of the perceived reality at the summit focused on the Brexit and its global impact. UK Chancellor Philip Hammond began the negative framing of the Brexit process with his worldview that the impact will last for about another two years. This vision went unchallenged and was accepted by all attendees, even though his guesstimate was not accompanied by any data or assumptions. The two-year timeframe thus becomes official G20 dogma, which allows for a further period of monetary and fiscal stimulus to be unloaded by the nations present.
(Source: Business Insider)
The final G20 communiqe omitted a specific commitment to a coordinated global economic stimulus to the recent Brexit shock event, despite the IMF's pleas to enact one immediately. G20 is keeping its powder dry, because it can't find a consensus on how to coordinate a response. The resulting uncoordinated national responses therefore risk undermining those in other G20 nations. Perhaps on balance however, if all nations are in stimulus mode, the net result will be a global stimulus despite competing friction.
The communique did have a palpable acknowledgement of the need to be more inclusive when stimulating economies, in view of the rise of populism. This acknowledgement however received far less attention than Donald Trump's almost simultaneous commitment to take America out of the WTO if he becomes president. The word inclusive suggests some kind of wealth redistribution and possibly even Helicopter Money. With the lack of data post-Brexit, to catalyse policy decision making and coordination, the event had a hollow unfulfilled air about it.
The G20 response to the rise of populism is thus far only words; as it has not collectively reached agreement on how to address the rise of protectionism and populism that threatens G20's free trading ideal. It was replaced by a smaller commitment to intervene if the global situation gets worse. The G20 approach is consistent with a global economy that is allegedly adjusting under its own correction mechanisms. It is also consistent with an attempt to frame perceptions into this way of thinking, despite all the attempts by central banks to fight a slowdown and falling inflation which are all part of the same adjustment process.
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