The Federal Reserve released the minutes from their September meeting on Wednesday, October 12, 2016. The meeting was different than recent FOMC meeting as there were three voting members of the committee that dissented from the majority opinion to leave the Fed Funds rate unchanged. Therefore, expectations were high for a hawkish report with some definitive information leading to what some senior Fed officials had called an "imminent" rate hike. Even the Chairperson of the Fed, Janet Yellen, told markets that conditions were supportive of the next move by the Fed but at their September meeting, the central bank decided to leave rates unchanged and wait for more data.
The minutes of the September meeting came as a surprise to me, and while the Fed still plans to hike rates at some time in the future, the date changed from "imminent" to "relatively soon." In Fed Speak, there is a significant difference between the two terms.
Words but not action by the Fed
The minutes indicated that it was a close call at the September meeting but the consensus decision was to wait for more data as "slack" remains in the labor force and the FOMC decided that the best approach at that time was a cautious one.
The three dissenters argued that waiting too long could threaten economic expansion and could cause the labor market to tighten. However, all members agreed that the rate of inflation remains below the central bank's target. Perhaps the most compelling reason given by the dissenting members was that the Fed is suffering from a credibility problem. After promising at last December's meeting 3-4 rate hikes in 2016, the Fed Funds rate has yet to move by even one basis point.
While there has been a lot of periodic hawkish language out of the Fed in 2016, words not action are the hallmark of the central bank, and that has destroyed their credibility in markets.
25 basis points are already in the market
Interest rate markets have prepared for a 25 basis point rate hike at the December meeting, but they had also prepared for the hawkish language that they believe would pepper the September minutes. Perhaps the most significant signal from those minutes was no reference to the December meeting nor was there any language other than a rate hike will come "relatively soon."
Equities have been faltering over recent sessions as the market expects a rate hike before New Year's Eve. The dollar is moving higher, in fact, this week it rose above a technical resistance point at 97.61 to increase to the highest level since March when the market still thought that the Fed might tighten more than once in 2016.
As the weekly chart of the U.S. dollar index highlights, the greenback broke out of a seven-month pattern of consolidation on Tuesday, the day before the release of the Fed minutes. Additionally, the price of gold, other precious metals, and some interest-sensitive commodities have taken the Fed at their word and have corrected lower over recent weeks. The markets are all set for the second hike, all of the data was there for the central bank to make a move in September but they decided to wait, and the reasoning was solid.
It makes sense that the Fed did not hike rates at the September meeting as the most contentious Presidential election in modern history will take place on November 8. However, there was no mention of the election in the minutes and at recent testimony before Congress; Chairperson Yellen rejected accusations that the Fed had been taking a political stance when the central bank decided to wait to raise the Fed Funds rate until after the November contest. The Fed is supposed to be an apolitical body, and the Chairperson advocated for just that, even when it appeared to some they should have hiked in September. Meanwhile, the dissenting members of the FOMC expressed the view that the central bank could find themselves well behind the inflation curve.
December gun to their heads
The central bank will meet in November, but it is not until December that they will once again consider increasing the Fed Funds rate from 25-50 basis points to the 50-75 level. That meeting will be the very last chance for the central bank to act in 2016, if they do not it is likely that markets will explode as perception will turn into reality and 2016 will be another year of central bank accommodation in the United States. In many ways, the voting members will have a credibility gun against their heads at the December FOMC
meeting. Meanwhile, they may be facing another problem at the end of the year that is just starting to smolder now, and that issue could tie their hands and not allow them to keep their promise to markets.
The dollar is a lurking problem
Higher interest rates in the U.S. should be very bullish for the dollar given the interest rate differentials between the U.S. currency and others around the world. Even before any Fed action, the dollar pays a small interest rate while both euro and yen rates remain in negative territory.
With the technical breakout in the dollar this week, the Fed will face the potential of a raging greenback if they increase rates. A higher dollar is not going to help U.S. economic growth as it will make American goods less competitive on foreign markets and will choke corporate profits of those businesses that depend on international trade.
Therefore, if the dollar remains at the top end of the trading range, the Fed could take a chance and hike rates. However, if the dollar rallies to the 100 level or higher on the Dollar Index futures contract by the December meeting, the Fed could find its hands tied, they could find it impossible to increase rates that would fuel further gains in the U.S. currency causing an economic slowdown.
The big problem for the Fed is that they have waited too long. There were plenty of opportunities in 2016 to increase rates and keep their promise to markets, but they acted out of fear rather than rational logic. They worried about Asian contagion and Brexit even though economic data supported a rate higher than one-quarter to one-half of one percent. After all, with U.S. economic growth at around 2%, there was plenty of room for a 25 basis point symbolic move. Fear dominated the Fed's deliberations, and an over-cautious approach has resulted in a no-win situation for the central bank. The long-bond is ahead of the Fed meaning that the free market is dictating interest rates and the Fed's monetary policy will be following rather than leading.
The long bond tells us the Fed is behind the curve
The central bank triggered the selling in the long-bond that picked up speed with the summer comments at Jackson Hole by many of the senior officials. As weekly chart of the 30-year bond displays, the long bond began its descent in July falling from 177 11/32 to new lows of 163 19/32 this week. The U.S. Treasury Bond has been on a one-way path, lower regardless of Fed inaction at the September meeting. Over past months and years, the bond suffered corrections during its long ascent that began way back in 1994, but this may be the first time that it has decided to ignore monetary policy. An infamous hedge fund operator famously said last year that the risk of buying government bonds had risen to such a high level that a long position amounted to "picking up pennies in front of a steamroller."
The bottom line is that long-term interest rates have begun to increase and the Fed is now behind the curve. These fixed-income instruments have smelled the wafting inflationary pressures in the markets, but the central bank continues to ignore them, waiting instead for more data to make a decision on the next rate hike.
The Fed now finds itself far behind the curve, and if they wind up in a corner at the December meeting of the FOMC because the dollar is exploding higher, the chances are they will not increase rates at all this year. If that turns out to the case, watch out. Capital will flood into an overvalued stock market creating a massive and unsustainable equity bubble. The price of other hard assets like gold, silver, and other commodities as well as real estate will explode higher, and the ability to fight inflationary pressures will become a treacherous road for a central bank that will turn into firefighters rather than scared economists. The current Fed is not prepared nor are they equipped to deal with the problems they have created. The U.S. economy is now in a state where monetary policy has become a toothless tiger.
No matter who wins the upcoming election that has turned into a three-ring circus, the Fed will sit on the sidelines and watch as the data tells them what the three dissenters already know. They missed the opportunity to increase rates earlier this year as fear rather than logic caused inaction.
As far as the minutes of the September meeting released yesterday are concerned, "relatively soon" just does not cut the mustard anymore. There is lots of volatility heading our way, fasten your seatbelts and take protection it is going to be a wild ride that will not end anytime soon.
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