Carnage First Or Last?

by: Adam Whitehead

The FOMC is affirming Mr. Market’s elevated expectations for rising interest rates and vice versa in a dangerous feedback loop.

The economic data for Q4/2016 show stagflation conditions emerging whilst the latest jobs data shows salaries lagging these price increases.

Declining productivity is being driven by rising costs not associated with worker salaries.

President Trump’s assault on regulations may be an assault on the productivity costs not associated with worker salaries.

The composition of the Fed’s balance sheet creates an innate tightening bias that complicates the rate increase and balance sheet reduction process.

(Source: Bloomberg)

The last report discussed the elevated probability of FOMC overkill with rising interest rates, based on a sample of comments from Fed speakers looking ahead into 2017. San Francisco Fed President John Williams neatly summarized the consensus for three rate hikes. Former Fed Governor Laurence Meyer recently added some helpful granularity to this analysis by identifying where he thinks that Janet Yellen stands. By attributing detailed comments by FOMC speakers to Dot Plots and then using the process of elimination, he was able to identify that both the more opaque speakers Janet Yellen and New York Fed President Bill Dudley are three rate hike Dot Plot forecasters after all. Since both these individuals are very powerful in setting and leading the FOMC policy agenda, their position puts the FOMC in the overkill risk probability zone at this point in the year.

Whilst taking note of this overkill signal, it should also be born in mind that the last report found a significant divergence between "staffers" and "rate setters." The "staffers" who create the forecasts have been far less bullish on growth and inflation than the "rate setters." Whilst noting Meyer's useful analysis, it should be tempered by the fact that this bias amongst "rate setters" could allow them to override the inputs of their "staffer" colleagues. Whilst the Dot Plots may, therefore, appear to signal potential overkill, this may not actually be the outcome that the "rate setters" deliver.

Dudley himself attempted to muddy the waters in this game of cat and mouse by responding to Meyer's findings with his comment that "the risk that the Fed will snuff out the expansion anytime soon seems quite low because inflation is simply not a problem." His comment illustrates that he is also aware that probability of Fed overkill is elevated in market observers' eyes, and thus seeks to disrupt this perception. His attempts at disruption however did not extend to stating where exactly he is on the Dot Plot chart with a clear articulation of how many rate hikes he foresees this year.

Janet Yellen's first of two recent speeches seemed to confirm Meyer's thesis and hence the fact that she is a potential overkiller even if only a gradual one. She sees the economy nearing full employment and inflation close to target, so that the Fed's job will soon be done. Interestingly, she is less fearful of the global headwinds than would be expected given all the headlines and tweets of late. Just to drive the point home, she then reiterated that, whilst her approach to rate increases is gradual, her priority is to avoid falling behind the curve in terms of letting inflation get away from her.

Philadelphia Fed President Patrick T Harker recently identified himself as a conditional overkiller, when he stated that his baseline is three rate hikes this year. His conditions are that the economy continues to show growth and inflation increasing in line or stronger than their current showings. His concern over the dwindling labour force participation rate may make him a fully-fledged overkiller, however, if it leads to stronger wage push inflation growth and falling productivity.

Richmond Fed President Jeffrey Lacker intends to take his overkill rhetoric with him into retirement later this year. Raising the level of his invective he recently called for an acceleration in the rate hike process as inflation runs away from the Fed.

Fed Governor Lael Brainard recently articulated where she stands on the chart. In the absence of productivity gains, either through deliberate policy-maker action or private sector execution, she would accelerate the rate hike process in the face of fiscal stimulus. She is therefore potentially an overkiller, as is Dallas Fed President Robert Kaplan. Kaplan reiterated his previous comment that the patient gradualist approach to rate hikes is his chosen route.

It should be noted that St. Louis Fed President James Bullard is not in this overkill risk group. In a recent speech he chose to focus on the countercyclical impact, of President Trump's expected restrictive trade policy, rather than his widely anticipated pro-cyclical fiscal policy. Bullard is also prepared to accept that new regulations brought in by President Trump may lead to a gain in both growth and productivity, which would then temper the need for higher interest rates. In any case, Bullard does not see the fiscal stimulus making any impact until 2018/19 so he would not move to anticipate it right now. By signaling this reticence Bullard may be addressing the elephant in the room, noted in the last report, of the economic headwind presented by the rise in bond yields. The summation of his views, therefore, keeps his default baseline scenario at one interest rate rise and done in 2017. Back in the December 31st report, Bullard had been seen drifting away from this baseline. It is now clear that he has seen something that has caused him to go back to his original one rate hike and done baseline.


The risk of overkill by the Fed depends on how much growth and productivity the Trump fiscal stimulus policy creates. The greater the degree of correlation and outright levels of both, the less inclined the Fed will be to overreact. As a positive augury, Steve Bannon and Paul Ryan are closing their ideological gaps and coalescing around a fiscal reform plan that may well soothe the fears of the Fed.

(Source: Bloomberg)

So far the yield curve has been flattening, but not in the way that Ben Bernanke was seen to have advised the FOMC to manipulate it through with words in a previous report. Bernanke had called for a bull market flattening, through tough anti-inflation talk combined with soft forecasting Dot Plots. The FOMC has not followed, and it is now threatening tough action with its tough talk and tougher Dot Plots. The FOMC is following Mr. Market who is telling it, through the curves of inflation expectations, that rising shorter term inflation expectations must be dealt with immediately to avoid it falling behind the curve. Speculation about the Fed ending its reinvestment of MBS proceeds this year, in prelude to exiting this balance sheet asset altogether, has already begun. Mr. Market is telling the Fed that it should be in economic overkill mode and the Fed is affirming this view. Both have adopted a negative view of the inflation implications of President Trump's economic policies.

Undaunted by and perhaps trying to influence Mr. Market, now that he has understood that the Fed follows him rather than influences him, Ben Bernanke adopted a different tactic to create the yield curve bull flattener. This time he specifically addressed the timing of the reduction in the size of the Fed's balance sheet, by opining that this should not be reduced until short-term interest rates are "meaningfully higher." Intuitively Bernanke understands that Mr. Market will discount the impact of "meaningfully higher" short-term interest rates as recession signal. Said recession signal will then put a duration bid in for the long end of the yield curve that will allow the Fed to exit smoothly. One cannot also help thinking (and presumably Bernanke also thinks) that such a duration bid will convince the Fed to follow Mr. Market and actually do some duration buying of its own to stimulate the economy rather than selling into it!

As President Trump vowed to end the "carnage" in the American polity, his website was busy updating his policy agenda in real time, whilst Mr. Market was busy simultaneously factoring in the "carnage" that this would bring to the capital markets by way of rising inflation and interest rates. The president is committed to a 4% GDP target and the dismantling of trade deals in order to drive this target through pure domestic growth based on the reduction of anti-business rules and regulations. Mr. Market has chosen to focus on the growth target and the decrease in free trade, which he believes will elevate the level of inflation risk. He has also chosen to focus on the FOMC's accelerated response to address this inflation risk, by flattening the yield curve. The Fed has not attempted to disabuse him of this hasty jumping to conclusions. President Trump's adherence to his targets will thus create friction between his administration and the Fed, until such time as the economic weakness signaled by the flattening of the yield curve arrives in time to allow the Fed to enable the fiscal stimulus. In all, the noise surrounding the Muslim ban executive order, little attention was paid to another order which mandates that for every new Federal business regulation to be made two must be scrapped in its place. No doubt the president will soon be directing the Fed to pay attention to this swift move to address the productivity issue when it is setting monetary policy. He may argue that he is delivering on the productivity side, so that the Fed must reciprocate through not tightening monetary policy aggressively if at all.

(Source: Bloomberg)

A thesis being developed in this series of reports is that the US economy is entering into a near-term soft patch, brought about by the combination of global uncertainty and the headwind of rising US interest rates on both the domestic economy and US exports through a stronger US dollar. This thesis has then extended into a discussion of the elevated probability of Fed overkill with tighter policy by falling into the trap of following the yield curve with higher interest rates. The latest GDP data shows evidence of this economic softness and the elevated probability of Fed overkill had arrived in Q2/2016.

(Source: Econoday)

The latest Q4/2016 productivity data is another red flag. Productivity was stagnating in the quarter, which casts an ominous shadow over Q1/2017 and Trump's expected policy stimulus. Going into his stimulus, declining productivity is already prompting the FOMC to trend on the side of more aggressive tightening.

(Source: Seeking Alpha)

The latest Q4/2016 economic data also showed a sticky inflation picture, which maybe attributable to the strength in oil prices. The scenario presented by the GDP and inflation data creates a picture of an economy on the brink of an episode of stagflationary conditions. A stagflation call was noted from some analysts back in the November 21st 2016 report. This call seems to have been prescient. In the absence of any productivity gains, the Fed may feel obliged to nip the inflation in the bud by being more aggressive with its tightening moves. Despite the apparent economic softness, the elevated probability of Fed overkill was raised in Q4/2016.

(Source: Econoday)

The rising labour cost picture was however not born out in the latest Employment Situation report, which shows wages cooling. There must therefore be a component to labour costs that is, not just salary related, driving them higher and forcing employers to economize by cutting wage levels. President Trump will no doubt opine that this missing cost component is regulation cost and he may be right. Doubtless he will use this line of reasoning to slash regulations going forward. The Fed may thus see what it needs in terms of falling labour costs boosting productivity. Trump's stimulus plan will, therefore, have to demonstrate clear policy initiatives to boost productivity immediately; otherwise the FOMC will have to overreact to catch up with the falling productivity trend following on from Q4/2016.

(Source: Bloomberg)

Positive economic sentiment also seems to be running way ahead of the incoming data, although admittedly this data lags and may be currently missing the impact of this positive sentiment. Evidently the Fed is still strongly influenced by this forward-looking sentiment and is worried about falling behind the curve. It should be understood that potential Fed overkill thesis is expected to be taken by President Trump as a green light to overstimulate the economy. The Fed currently seems inclined to fight him on this, based on the lack of evidence of productivity gains. It is, therefore, likely that the yield curve will begin to flatten in anticipation of further economic softness as the Fed overreacts.

President Trump will inevitably have his day, on which the Fed is called to account and forced to get with his programme of fiscal stimulus. Patrick McHenry, Vice Chairman of the House Financial Services Committee, put the Fed on notice that this day is coming soon. McHenry lambasted Chairman Yellen for participating in opaque meetings and global policy initiatives with foreign central bankers which go unreported to Congress. He said: "It is incumbent upon all regulators to support the U.S. economy, and scrutinize, international agreements that are killing American jobs. Accordingly, the Federal Reserve must cease all attempts to negotiate binding standards burdening American business until President Trump has had an opportunity to nominate and appoint officials that prioritize America's best interests." This day of reckoning may involve the replacement of Janet Yellen; however, Secretary Mnuchin has intimated that he would not like to see an embarrassing transition of Fed leadership if he can help it.

The latest FOMC decision to leave rates unchanged and the vagueness about the next rate increase was predicated on the divergent opinion about the impact and timing of President Trump's fiscal stimulus. The January Employment Situation report, which followed this decision, vindicated the FOMC. Q4/2016 raised concerns that the FOMC is falling behind the curve and raised the probability that it may have to then overreact and overkill the economy. The January employment data has reduced this overkill risk a little. The risk, however, still remains if President Trump's policies do not get production costs down to levels at which the lower level of wages stimulate employment growth. If these production costs get passed on to consumers, whose salaries are lagging the Fed may have no choice other than to overkill the economy.

At this stage in the game, with little Trump influenced data to go on, the FOMC remains in gradual rather than overkill mode. Mr. Market is focusing his attention more on a footnote in Chairman Yellen's recent communication, rather than the outright FOMC decision. This footnote explained that due to the change in composition of the Fed's balance sheet, the average maturity of its holdings is falling swiftly. Currently this is around the six-year level. The impact of these bonds maturing is to tighten liquidity faster, which some estimate to have the same effect as two rate hikes in 2017. The Fed thus has a default tightening bias by nature of the structure of its balance sheet. The risk of overkill has thus risen by nature of the combination of this maturity schedule and the FOMC's current rate hike bias. Ben Bernanke has already given guidance on how to manage the situation; by waiting to begin selling balance sheet assets until the combination of this maturity schedule and rate increase has run its course. Matters have not been helped by President Trump's foray into the global capital markets and the headwinds emanating out of the European election calendar in 2017. His latest onslaught on Dodd-Frank also raises the issue of a new liquidity induced bubble in asset prices that the Fed will need to contend with. For the Fed to finesse its exit under these conditions, without triggering a capital markets disruption, will involve almost perfect communication and execution. The probability of imperfect communication and execution is higher at this point in time, despite the gradual care and attention being paid by the FOMC. There are just too many moving parts and incoming data.

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.