Will The Fed Keep Its (Dot Plotted) New Year's Resolution? Don't Bet On It

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Summary

It's difficult to remember a time when there was so much uncertainty about both the economy and policy heading into a new year.

And that's just the domestic side of things. Throw in elections in Europe and China's ongoing struggle to execute a "controlled" currency devaluation and you've got a real headache.

Against this backdrop, it's far easier to see the Fed erring on the side of caution as opposed to worrying too much about falling "behind the curve.".

On the biggest issue of 2016 - political surprises - I hope we don't have too many replays. On a positive final note, I do believe it will be an excellent year for macro trading, and your Christmas reading of research notes won't be immediately invalidated this time around.

That's from former FX trader and Bloomberg contributor Mark Cudmore, whose daily missives are among the first things I read each morning.

One thing to note right off the bat with regard to the quote excerpted above is that it's a but contradictory. If it's going to be an "excellent year for macro trading," then one would think that they'll be "political surprises" aplenty. As The Economist writes in a recent piece on the death of the "2 and 20" hedge fund fee structure, "renewed political uncertainty and ensuing volatility bode well in particular for 'macro' hedge funds that trade across a broad range of bonds, currencies, and equities."

While macro funds on the whole didn't fare particularly well versus the broad market in 2016, some individual names put up big numbers around the year's most unexpected political events. Here's The Economist again:

Crispin Odey, for instance, a "macro" hedge-fund manager and prominent Brexiteer, boasted of the £220m ($297) windfall his fund made from the British referendum. And some big funds did perform markedly better in the weeks around the unexpected election of Donald Trump. The flagship fund at Brevan Howard, a large hedge-fund manager, gained 5.6% from the beginning of November to the 18th of that month; Rubicon, another macro fund, was up by 10% in the week of the American election alone.

But we'll leave that seeming discrepancy aside and focus on the contention that what you read from the sellside over the holiday won't turn out to be entirely irrelevant in the new year. Cudmore seems to be taking a fairly optimistic approach to 2017. For instance, he suggests that fears of China's demise are greatly exaggerated as are rumors of EM's imminent collapse. As noted above, he also seems to be betting that the political landscape won't experience tremors similar to those that shook the world in 2016. In other words, he seems to be assuming that the status quo - both in terms of politics and in terms of markets - will reassert itself.

One thing Cudmore isn't so upbeat about however, is the Fed and the prospects for three rate hikes over the course of the new year. Here's what he says (emphasis mine):

As for U.S. rate hikes, it's been ripe territory for constant disappointment for several years. With the dollar providing a chunk of tightening already, and the risk that Trump protectionist policies de-rail growth, the FOMC is still looking optimistic with its 3 hikes for next year.

Yes Mark, they certainly are. Have a look, for instance, at Goldman's Financial Conditions Index which clearly shows that a rather rapid tightening is under way, similar to that which took hold in late 2015 and early 2016:

(Chart: Goldman)

And that will go double should the political situation not turn out to be as benign as Cudmore hopes.

For the time being, equities' (NYSEARCA:SPY) exuberance and exaltation of Trump will serve as a kind of counterbalance to the tightening effect exerted by a stronger dollar (NYSEARCA:UUP) and rising yields (NYSEARCA:TLT). The question, however, is how much longer stocks can continue to carry the torch given historically high multiples and the very real possibility that analysts have become overly optimistic in their EPS forecast revisions.

More specifically, note that Trump's fiscal stimulus plans aren't expected to have a particularly outsized effect on growth in 2017 (see table below). That is, the bulk of the benefit comes in 2018 and 2019. That begs the following question: What happens if we are indeed at the end of the cycle and the economy takes a turn for the worst before the end of the new year? Further, what would happen if that were to coincide with political turmoil tied to elections in Europe?

(Table: SocGen)

As I outlined earlier this week, it's not exactly clear what the dynamic will be between the Fed and the Trump administration. On the one hand, Trump has in the past criticized the FOMC for keeping rates too low for too long. Now, it looks as though one of the Fed's primary objectives will be to ensure that the economy doesn't overheat as fiscal stimulus hopes meet full employment. Will the new President blame the Fed for slowing down the economy if they do indeed hike three times in 2017? Consider the following bullets from Deutsche Bank (emphasis mine):

  • Tightening monetary policy, higher breakevens, and declining central bank purchases relative to net supply should all contribute to significant bearish steepening during 2017.
  • Current border tax proposals could largely amount to a shift of the aggregate supply curve. The broken clocks which have somehow been right less than twice a day for six years will finally have their day in the sun as wages and prices rise.
  • It is this inflation that we see as the catalyst for substitution of capital for labor - the long-awaited acceleration of investment that could produce more rapid productivity growth.
  • The Fed, however, could derail the process if it reacts too strongly, too rapidly to higher inflation, weakening domestic demand and causing sufficient dollar appreciation to constitute a headwind for exports.
  • There is a procedural "brake" to Fed hawkishness, which is the expiration of Fed governors' terms, including the chair and vice-chair in 2018.

So that would seem to suggest that the Fed will need to be cautious and avoid adopting an overly hawkish approach. In that regard, we may not have much to worry about. Why? Because as SocGen notes, there's a dovish shift taking place in 2017. Here's more:

Below, we show two tables comprising FOMC voters in 2016 and 2017. We rank them from the most dovish ("1") to the most hawkish ("5"). Note that these assessments are entirely subjective and reflect our opinion of each voter's policy leanings from their public speeches, interviews, and comments.

As the tables show, there is a leftward shift in the voters towards the dovish side. Evans replaces Bullard as one of the most dovish members, and we also include Kashkari in that camp. Kashkari noted in September that "There's doesn't appear to be a huge urgency to do anything," given that core inflation was "stuck" at 1.6%, and in mid-November he said that the Fed should be willing to tolerate inflation up to 2.5%.

Meanwhile, in addition to Fischer and Powell, we have added Kaplan to the neutral camp. In a late November speech, he noted that he advocated that the Fed take action to remove "some" amounts of accommodation, but in the same speech, he also stated that given the challenges posed by broad secular drivers, he has "been suggesting that removal of accommodation should be done gradually and patiently."

With respect to Harker, we have placed him as a "4," or on the hawkish side of the ledger. As far back as late May, he indicated that he could "easily see the possibility of two or three rate hikes over the remainder of the year." In a late September interview, Harker noted that he was "somewhat concerned" about falling behind the curve, and he was "in the camp of normalizing sooner, rather than later." He also supported a rate hike at the September meeting.

The FOMC will lean more dovish next year, one unknown is the potential for the addition of up to two hawkish Fed governors. The Fed typically operates with seven governors but has been operating with five for some time, as a Republican Congress refused to consider two nominees from President Obama. President-elect Trump will have the opportunity to fill those two vacant seats, and all indications are that his appointees will lean hawkish, perhaps arguing for faster removal of policy accommodation, as well as a reduction in the size of the Fed's balance sheet.

In other words: who knows? What we do know is what happened in 2016. Here's SocGen one more time:

The Fed spent most of the year revising down its rate projections (the so-called dots), coming into the year anticipating four hikes, only to see those projections upended by market and economic events. Volatile financial markets (partly related to China's exchange rate policy and Brexit vote), falling commodity prices, falling inflation expectations coupled with temporary weakness in the US labour market report were the key factors behind the Fed's dovish stance during 1H16.

Now I don't know about you, but I'm not sure that any of those concerns has dissipated meaningfully.

In fact, I'd be overwhelmingly inclined to say that if anything, we should be more worried about China and European politics now than we were in H1 of 2016. If Trump decides to go it alone and impose tariffs on Beijing, that could very well force China into free floating the RMB by year end. If that decision were made hastily and dropped on the market overnight (like the August 2015 deval was), the fallout would likely be significant.

As for Europe, Brexit was bad enough. Can you imagine if the populist push manages to upend French and German politics? One has to think the terror attack in Berlin this week makes it all the more likely that the nationalistic fervor that's swept the bloc will only grow as we head into elections next year.

And then there is of course the possibility that emerging markets (NYSEARCA:EEM) finally break under the weight of the soaring dollar. For those interested, here's a graphic that shows which countries would be most affected:

(Map and tables: Stratfor)

To me, all of this suggests that the Fed simply cannot afford to get too aggressive in the year ahead.

For their part, SocGen agrees:

We continue to look for two hikes next year given the significant amount of uncertainty, particularly on fiscal policy.

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.