When Is A 'Taper Tantrum' Not A Tantrum? Discuss

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by: Adam Whitehead

Summary

A Taper Tantrum has begun and may go viral as the global central bank QE exit is anticipated and discounted.

The Tantrum is driven by perceptions of interest rate increases and balance sheet reduction as potential policy “overkill” versus the weak underlying inflation trend.

The US Dollar’s emerging petrocurrency behavior is something that the Fed has yet to factor in to its models.

Chairman Yellen frames the Fed’s new mission as sustaining the economic recovery that the previous emergency stimulus mission has created.

Jerome Powell is emerging as a key Fed figure based on his macro-prudential credentials and his rapport with the Republicans.

(Source: Bloomberg)

So far into its interest rate increase process, the Fed had neatly evaded the traditional Taper Tantrum. The lack of volatility was evidence of the Fed's evasion skills, combined with able assists from the global central banking fraternity's general inertia to remove post-crisis emergency liquidity. It would however not be a real tightening phase without the customary wobble, so one was logically to be expected. When it came, it was triggered in large part by the actions of President Trump rather than any real worry about the Fed's intended course of action.

In an attempt to strip out and mitigate any tantrum compounding effect from its monetary policy actions, Fed Vice Chairman Stanley Fischer tried to frame market perceptions with his soothing rhetoric. According to him, this is not 2013 again and there is no tantrum at this point in time; nor will one occur as the Fed continues to raise interest rates and shrink its balance sheet. Moving from the capital markets to the real economy, Fischer also tried to head off anticipation of the Taper Tantrum by opining that global economies are in much better shape to withstand the scaling back of emergency liquidity. When pressed on what his view specifically implies for the number of rate hikes this year, he responded that he expects two more. The economic softness that the US economy has witnessed in Q1 thus appears to be a transient aberration to him, that will not persist for the rest of the year.

A rational question to ask Fischer, yet one that remains absent in the press, is whether the global economy has become accustomed to and leveraged to the abundant cheap central bank liquidity. Applying this reasoning, the allegory of the global economy is that of Wile Coyote chasing the economic growth Roadrunner over the cliff and frantically running in thin air supported by QE wings. The removal of QE would then in theory see him crash to the ground. This question will be answered unequivocally, if and when the global central bank exit from QE begins in earnest.

A global media campaign is now underway, instigated by the global central banks, to prepare market psychology for the potential domino effect as the ECB and even the BOJ follow the Fed in the removal of QE. The latest rhetorical gimmick employed is to use the relatively benign impact of the Chinese scaling back their ownership of US Treasuries as a precedent and template for a positive halo effect from perceptions of the ending of global QE. The problem with this strategy, is that US economic data is showing signs of softening just as President Trump is encountering political hurdles to his much-anticipated fiscal stimulus. The grand QE exit may therefore be stillborn already.

The Fed must also decide if the geopolitical headwinds are strong enough to alter its intended course of interest rate increases for the remainder of the year. The initial signal from the FOMC so far, is that it believes that it can press on with withdrawing liquidity despite these global headwinds. President Trump's continued pivot away from open hostility towards cohabitation with Chairman Yellen is also being factored into the dynamic. His recent verbal attempt to get the US Dollar lower coincided with his softening commentary on Yellen's ability and potential reappointment. His improving opinion of Yellen seemed to be a default bi-product of his preference for lower interest rates. Her reappointment may thus be conditional upon the maintenance of a term structure of interest rates which is not radically different from the current one when it is time for the appointment decision to be made.

The last report noted the word "overkill" being used by St Louis Fed President James Bullard in relation to the current tightening phase. This overzealous behavioral theme was then recently extended as New York Fed President Bill Dudley delivered an early April Fool, when he speculated that balance sheet reduction could actually begin this year.

(Source: Bloomberg)

After the recent apocryphal warning by Steve Eiseman about the potential credit crunch in the auto-loan sector, market perceptions then began to extrapolate this to the broader economy. US auto manufacturers seem to be feeling a confluence of negative forces; from a shift in taste away from sedans to SUV's combined with slumping used-car values and the pullback in subprime auto lending.

(Source: Econoday)

The greatest challenge to assumptions about the FOMC's interest rate hiking trajectory came with the recent publication of the March Consumer Price Index data. Whilst the fall in oil prices, feeding through to gasoline prices, was a major vector consumer prices-ex energy remain in the negative column so far this year. The last report discussed a school of thought, emanating out of the San Francisco Fed, which believes that the Fed is acting pro-actively in anticipation of future inflation growth. This school of thought thus states that the Fed is not behind the curve. The latest CPI data pushes the FOMC to a position ahead of the curve, which may cause it to pause over its next expected interest rate increase. US Monetary conditions versus current inflation and also future inflation expectations are now restrictive.

(Source: Econoday)

The March 16th report in this series noted that America was importing inflation and exporting disinflation. This net margin contraction was equated with an economic headwind to the US economy. A strong US Dollar was seen as being a significant driver of this margin contracting trend. It was suggested that the continuation of this trend, under conditions of a weakening US Dollar, would signal an even greater headwind for the US economy. Given the slowing of inflation and the President Trump's recent attempts to verbally weaken the US Dollar, it will be interesting to see if this headwind now gets stronger in a declining US Dollar environment.

This behavior of import and export inflation was also associated with the emerging behavior of the US Dollar as a Petrocurrency. A reversal in oil prices and the US Dollar going forward would further strengthen this thesis. It would also make life difficult for the Fed, as the response to rising inflation from a weakening Dollar would have to be viewed against the overall economic headwind of a falling oil price on the US Petro-economy. In view of all these weak mixed signals, it will not be a surprise to see the FOMC acting with extreme caution.

(Source: Econoday)

The March 16th report also noted the unbalanced nature of the economic expansion to date. This was referenced by the Bank for International Settlement's (NASDAQ:BIS) finding that developed nations have become too reliant upon indebted consumers and the observation that US consumption is becoming unsustainable. The recent March Retail Sales data, combined with the massive revision lower of the February data, signals that the US consumer is rolling over. Declining US consumption is reinforcing the negative scenario emerging in the inflation data also.

The recent publication of the last FOMC minutes, highlighted the agonizing over when and how to shrink the Fed's balance sheet and the impact that this may have. The minutes showed that some outright balance sheet shrinkage may begin later this year, initially by the ending of the reinvestment of income earned on current holdings. What came through in the minutes was a significant consensus view, that whilst inflation is increasing it is still some way off target. The big fear for the Fed is that the combination of balance sheet shrinkage and rate increases is viewed as "overkill".

Going forward, rhetoric will be used to frame the perception of balance sheet reduction as "not tightening". Thus far, it is most certainly viewed as tightening. The FOMC may then be forced to shuffle rate increase and balance sheet reduction operations consecutively to overcome this negative perception. If the FOMC is forced to do this however, it will have bought into the perception that balance sheet reduction is a de facto tightening. In such an environment, the median forecast of three rate hikes for the year may suddenly look like overkill if it is combined with balance sheet reduction. Interestingly, James Bullard himself favours some balance sheet shrinkage; which is why he is cautious about hiking interest rates. Clearly, he is worried that balance sheet shrinkage will be viewed as the implicit tightening of monetary policy that it effectively creates.

Chairman Yellen kicked off the attempt to positively frame the "not tightening". Allegedly, the Fed has now switched its mission from emergency stimulus to sustaining said stimulus. Notably absent was any real framing of the current conditions as warranting a tightening of monetary policy. Her automotive analogous explanation stated that: "Before, we had to press down on the gas pedal trying to give the economy all of the oomph that we possibly could" and now she is attempting to "give it some gas, but not so much that we're pushing down hard on the accelerator." This analysis should play well with President Trump's economic view and hence for her own reappointment.

Yellen's analysis was then supported by Dallas Fed President Robert Kaplan who opined that, whilst some slack remains in the labour market, progress is being made in returning to full employment and target inflation.

Kansas City Fed President Esther George believes that the FOMC should press on, despite the Q1 economic softness and the "fits and starts" in which the economy is behaving. George's "fits and starts" may be another person's Taper Tantrum. She is however less gung-ho than she used to be, since she concedes that the scaling back of the Fed's balance sheet should be "gradual and smooth" over an extended period of time. Evidently the "fits and starts" associated with balance sheet reduction give her less confidence, which then translates into the "gradual and smooth" exit strategy. This process does not mean however that the Fed should halt or stall the process in light of soft data. In her opinion, the exit should be consistent and run on auto-pilot at each following meeting. Whilst the benefit of clear communication is evident in this approach, this comes at the great cost of flexibility; so that the Fed must get its timing exactly right when the decision to incrementally reduce the balance sheet is made.

Boston Fed President Eric Rosengren's view resonates slightly, but also differs by degree, with that of Esther George. He believes that balance sheet reduction should occur soon. In addition, this process should be so incremental that it does not impair the Fed's ability to move interest rates up or down. Rosengren, would thus like to retain some degree of flexibility over monetary whilst committing to uninterrupted incremental balance sheet reduction.

The emerging picture, is that the Fed intends to press on with its interest rate rise and balance sheet reduction timetable, come what may from President Trump's impact on the global and domestic economy. Kansas City Fed President Esther George underlined this intention and capability when she recently classified this agenda as "necessary". This dedication whilst admirable and confidence inspiring, is however starting to look dissonant from the weakening domestic economic outlook. The Fed's success is conditional upon this current economic soft patch being transient.

(Source: Gallup)

The last report noted that President Trump is stacking his credibility chips on tax reform, as he U-turns on many of his campaign promises and flip-flops on his alleged hard line on trade issues. Unfortunately just as these chips are being stacked on tax reform, unfortunately Treasury Secretary Mnuchin has signalled that delivery of this policy initiative has been pushed back into August. He may as well have said Q3. The disappointment in yet another failure to deliver on a promise was palpable and added to the growing Taper Tantrum feeling and its expression in risk asset prices.

President Trump was however swift to respond to this setback, with his customary show of delivering a short term stop-gap presidential orders that are short on details and long on headlines. This latest tactical release informed that a tax plan would be delivered in short order. Sources close to the President then leaked that said plan would be lacking in specifics and will just outline priorities. The promises made on the campaign and during the inaugurations, continue to degenerate into procrastination that lacks detail. The President is already beginning to live on borrowed time. Expectations of a June interest rate increase are thus being scaled back and may now get scaled back even further.

(Source: Seeking Alpha)

Back in the January article of this series, it was suggested that Jerome Powell would be a key individual going forward in the evolving relationship between the Fed and the Trump administration. His concern over asset bubbles and his willingness to burst them, in order to sustain a healthier dynamic approach to investing and creating real economic value, was noted as a template for his colleagues to follow. Recently, as focus turns to the vacancies at the Fed which will soon be filled by President Trump, attention has been concentrated on how Powell behaves. Whilst he is not yet being handicapped as potential Fed Chairman material, should Yellen leave, his influence is expected to grow, since he has built some invaluable bridges to the Republican agenda during his career to date. As the Republicans roll back Dodd-Frank his macro-prudential perspective and mandate will become more important as a key policy tool for the Fed, especially if economic softening hampers its ability to normalize interest rates and shrink its balance sheet commensurately with its current plans.

The power of Powell's advocacy and his rising status were recently on show, when he presented his case for the Fed to remain independent and for its structure to remain sacrosanct. His thesis is based upon the emphasis of the importance of avoiding a concentration of power over US monetary policy and the financial system, allied with the need to address both national and regional economic interests in a balanced manner. Identifying the expected reform of the Dodd-Frank Act, he opined that whilst the governance structure of the Federal Reserve is an evolutionary process, the independence of the central bank is paramount. He then went on to establish the baseline negotiating position of the Fed, which presumably he will be the principal negotiator from with the Trump administration. As a concession to the new administration he would accept raising the market size threshold for institutions to comply with the most arduous rules that have been in effect since the 2008 crisis. He would also ease the burden on bank company boards; so that directors become less like compliance officers with personnel liability for their actions and more like traditional overseers. He is thus in favor of injecting some of the animal spirits and light-touch regulation which initiated and contributed to the last financial crisis. For now however, he and the Fed are not yet ready to compromise on what he calls the "Core Reforms" that came into effect after the Credit Crunch to deal with the problems that these animal spirits created.

The Fed is now in an environment in which it must carefully negotiate its balance sheet reduction and evolving relationship with the Trump administration. Having signaled its intentions and capabilities to proceed on both fronts it has lost a degree of flexibility, in order to project certainty into market perceptions of the QE exit process. Thus far the Taper Tantrum has been a wobble, but there is a long way to go before year end.

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.