A Contradiction That The Fed Desires

by: Adam Whitehead


The “Mnuchin Rule” is being broken.

The social security deficit is unsustainable.

G7 signaled a new low water mark in Euro-American relations from which things will get worse.

The Fed Doves have signaled their intentions and capabilities to shift inflation expectations higher.

Duration buyers of US assets are making the Fed’s “Goldilocks Economy” story come true.

Running into the next FOMC meeting, the Fed finds itself in the fortunate position of being contradicted by market perceptions in a way that supports its monetary policy strategy. The rise in negative perceptions of President Trump's fiscal policy initiatives further supports the contradictory view of the Fed which plays into its hands.

(Source: Seeking Alpha)

In the last report, the "Four Arrows of Trumponomics" were identified as:

· regulation,

· tax,

· trade and

· energy policy.

The "Elephant" known as currency policy was also observed as a potential nuclear option, to be deployed as deliberate weakening of the US dollar, in the circumstances where the "four arrows" missed their target. Going forward, the flight of these "arrows" and the tracks of the "Elephant" will be followed to provide inputs to the global macro story that is being influenced by America.

The last report observed the sleight of hand employed by Secretary Mnuchin in relation to the "regulatory and tax arrows" to disguise a rolling back of banking regulations as a reward for the Wall Street cohort that has captured the Trump administration behind the stated objective of reducing the Federal budget. The subterfuge now appears to be extending to his own verbal disguise known as the "Mnuchin Rule." This rule apparently guarantees a fiscal break for the middle class taxpayer. Currently, Secretary Mnuchin appears to be breaching this rule, by refusing to guarantee a pledge that the President will not sign a tax bill that will make the highest earners the biggest winners. The picture of an administration that championed the little guy in order to win the election, only to reward its own wealthier supporters, remains intact.

The need to stabilize the budget and social security deficits is critical, given that economic growth is not creating the tax revenues to address the situation. Furthermore, the low level of inflation is not serving to push up prices and wages sufficiently to yield increased sales and payroll taxes that can also be used to pay down deficits. President Trump's new deficit neutral fiscal stimulus will therefore come under close scrutiny from a genuine economic perspective, as well as in relation to the partisan optics that his administration is increasingly perceived through. The last report noted the raging debate over why inflation and wages remain so low despite the advanced stage of the economic recovery. The San Francisco Fed has even hinted that there may be a structural change in the labour market, which is substituting higher qualified yet lower earning job candidates, for their more highly paid peers, in a great compression of salaries.

(Source: Gallup)

Both Minnesota Fed President Neel Kashkari and Fed Governor Lael Brainard have advocated that the Fed should pay more attention to this structural change in the labour market, to inform about the real employment situation and hence the more nuanced application of monetary policy going forward. This suggestion was found to be seductive by Boston Fed President Eric Rosengren, Chicago Fed President Charles Evans and also St. Louis Fed President James Bullard. Consistent with this granular analysis is a new report by Gallup, which shows an interesting inter-generational signal about social security. In general, younger workers expect to rely more on social security in retirement than their older colleagues.

These young people are in effect being increasingly excluded from the real economy and the financial market economy; many of them racking up huge student debts which they cannot repay in the process. This cohort will also be expected to defend America, whilst at the same time being denied privileged access to the rewards for their service. This situation speaks to the great compression through substitution that is challenging the great economic minds of our day. It also speaks to America's next economic crisis. If the system seems mildly inequitable today, it is destined to become egregious in within a decade.

(Source: Bloomberg)

The World Economic Forum recently reported that the US retirements savings shortfall is growing at $3 trillion a year. This is part of the growing trend of retirement savings deficits that are afflicting much of the developed world and the key emerging nations of China and India. Cutting the social security support net will simply further disenfranchise this cohort of young Americans that is supposed to be doing the economic heavy lifting and defending. As American workers are expected to save more, their ability to consume more and drive the economic growth that underlies their savings will evaporate. The form of populism associated with this cohort will increasingly find voice, as time and nature take its toll on the older cohorts. President Obama was able to tap into this group for his first term, but then increasingly fell out of touch as economic conditions worsened for them.

Populist demagogues of the future may wish to connect with this emerging cohort, in advance of the Grim Reaper connecting with their older relatives. The recent performance of the Labour Party in the UK general election, based on record voter turnout from young people, illustrates just how potent this youthful demagoguery can be. The Federal Reserve is evidently one step ahead of said Populist demagogues; or at least Neel Kashkari and Lael Brainard are which makes them both Fed Chairmen material in a youth-driven economic future.

The inability of the young to find economic enfranchisement precludes them from carrying the burden of paying the growing fiscal liabilities of the nation in the future. If the assets of the older generations are viewed as the liabilities of the indebted younger generations, it can be seen that the latter will default to the former in the future also. For now, the Federal Reserve's balance sheet is mitigating these intergenerational risks. The Fed may, therefore, never be able to fully shrink its balance sheet as this inter-generational asset liability mismatch compounds over time.

Through Fed balance sheet expansion, both Bernanke and Yellen have ameliorated the drain on current fiscal resources by boosting the value of the savings of the older generation. This has been done at the expense of disenfranchising the young, however, since they have not participated in the great asset inflation. The can has been kicked down the road, but the road is not a very long one. The growing inter-generational inequality is just one sub-set, of an increasing division in economic health, that QE appears to have exacerbated in America.

(Source: Bloomberg)

The last report observed the Fed agonizing over why inflation, especially in wages, is muted even as the nation allegedly hits full-employment. Whilst the Fed is agonizing, it is ignoring the fact that its QE policy has missed the main body of Americans that it was supposed to support. Recent figures from Gallup show Middle Class Americans falling behind on the metric of equity ownership and the wealth effect of capital gains enabled by QE. The Middle Class for whatever reason simply hasn't owned enough equities to keep up with the great enrichment that QE has provided. This spectacular QE miss of the Middle Class may have contributed significantly to President Trump's victory. Unwisely, Secretary Mnuchin's recent apparent abandonment of the Middle Class may prove to be a significant miss also. If the rumour is true that Goldman (GS) guy and Trump adviser Gary Cohn will be the next Federal Reserve Chairman the blowback from the Middle Class could get even worse.

The Fed's exit strategy from QE, announced by New York Fed President Dudley, was noted in the last report as being equity market friendly. A substantial proportion of QE will be left in place and then higher interest will be paid upon it in the form of interest on excess reserves. In addition to being left behind by nature of not owning enough equities, to participate in the equity-friendly exit the Middle Class will then be faced with higher interest rates to push the leveraged ownership of assets even further beyond its members. The Middle Class thus got hit during QE and will be hit again during its scaling back. The Fed will, therefore, drive further inequality through its QE exit strategy after creating it with its QE entry strategy.

Signs of attrition in the level of household debt levels are also causing concerns in some quarters. Generally speaking, deleverage since the credit crunch has put households in a much better place to service their debts. The consumer has been driving the economic recovery and this drive has been debt-financed. With consumer debt levels at record levels and little if any signs of wage increases, however, the ability of the consumer to continue with the economic heavy lifting is challenged.

(Source: Seeking Alpha)

Readers of this series of reports will remember that the Trump agenda was identified with the attempt to engineer regime change in Europe. This agenda can be seen as part of the "trade arrow" of Trumponomics. To make this connection, one must understand with no common free trade agreement between them, the EU and America have little in terms of economic interest to align them or to mutually defend.

Since his election, President Trump has continued to de-prioritize a free trade deal with Europe, whilst he has simultaneously tried his own hand at influencing the election process in European nations. The European establishment has responded to this "trade arrow" forcefully. As President Trump recently body-checked and arm-wrestled his way through the recent G7 meeting, it was evident that relations between America and Europe have hit an all-time low from which they will fall even further in the near future.

The NATO founding principle of mutual defence was effectively terminated without specific conditions by President Trump when he refused to commit to Article Five of the Treaty. President Macron signalled the new status quo with a defiant handshake and Chancellor Merkel announced the bad news in a beer tent. EU President Paolo Gentiloni then confirmed that their position is widely held by fellow EU nations.

The people of Europe, Manchester and London in particular, were the first signs of collateral damage. As General Mattis was announcing that the American initiative of the war against Isis is entering the annihilation phase, US homeland security rules were simultaneously being tightened further to limit the expected blowback on American soil. The immediate blowback is being felt in Europe where indigenous Muslim communities that are home to extremists provide the useful idiots to enable it. The War on Terror has the common factor of Russia and its attempted influence of American and European elections, which will be the catalyst for the further deterioration in global foreign relations. Recent stories that President Trump has shared intelligence with Russia will have alarmed European leaders and choked off the flow of sensitive information that they traditionally share with America.

President Obama by and large sub-contracted out Middle East diplomacy and war making to the European nations with former Middle Eastern mandates. President Trump would seem to be more interested in combining his own initiatives with the former Ottoman and Imperial Russian mandates in the region. President Macron noted the similarities in leadership style between President Trump and the Presidents of Russia and Turkey. Since the EU is antipathetic towards both Turkey and Russia, relations with America by default must decline. In the new age of the great leader, despite the attempts of the Democrats and the FBI to disrupt President Trump and President Putin reaching an agreement on global spheres of influence, Europe finds itself short of a President. It is, therefore, moving as fast as it can towards the deeper political and economic integration that will deliver a President, before it is destroyed by Populism.

Having remarked that German carmakers and Germans in general are "very bad" at the recent summit, President Trump signaled that the next step in his campaign against Europe will directly involve trade. At this point one can expect that the value of the US dollar, or rather its over-value from an American perspective, will become a further cause for deterioration in global trade relations. America has already walked away from the Trans-Pacific Partnership (TPP) and signaled a major rethink on Nafta, so a collapse of relations with Europe is logically to be expected; at which point a fundamental re-evaluation of the US dollar must be undertaken.

(Source: Princeton)

Hitting the ground running on his return home, after his bruising European encounter, President Trump then fired off the "energy arrow" by announcing that America will withdraw from the Paris Climate Change Agreement. This further drives a wedge between America and its European allies. When fired together with the "trade arrow" the impact can be devastating for Europeans. A general escalation of American direct involvement in combat in the Middle, North East and Africa regions will create instability that increases refugee and migrant flows to Europe. Global warming in these regions is already a significant driver of these migration flows and the source of regional conflicts over limited water resources. American foreign policy should be seen as cover for the "trade and energy arrows." These policies are now aligned together in direct conflict with the European Union's own foreign policy.

(Source: Bloomberg)

As the geopolitical situation unravels and developed countries struggle to find any hints of inflation, despite continued economic growth and unemployment rates converging on classical definitions of full employment, market sentiment about the timing of the FOMC's next interest rate increase after June's done deal is starting to become vague. This vagueness still accommodates the FOMC's signal of one more rate hike after June, but as time erodes this assumed next hike must by default start to be questioned.

The Fed's latest Beige Book for April has introduced some more certainty; however, this is negative in economic guidance terms. The report dropped the classification of activity back to "modest-to-moderate" from "improving." In addition, the descriptors "flattening out" and "slowing" increased their frequency in the word-count that is followed by analysts. Q2 has not started with any signs of improvement at the Fed's regional viewpoint. Q1 is thus starting to look like the beginning of a weakening trend rather than the transient phase which Yellen described it as.

As if to confirm these divergent expectations of FOMC policy, Fed Governor Lael Brainard slipped back gracefully further towards her original Dovish dissenting position. The cause for this slippage is her growing perception that what Yellen called a "transient" Q1 soft patch in inflation may actually be the beginning of a declining trend.

(Source: The Daily Shot)

The view taken in the last report, of the process for the shrinkage of the Fed's balance sheet outlined by New York Fed President Bill Dudley, was that it represents a slowdown in the pace of monetary expansion rather than a reversal. Commentary about this process, by St. Louis Fed President James Bullard puts this view into further context. It is his opinion that the impact on long-term interest rates from the process of balance sheet reduction will be minimal. His conclusion is based on the view that inflation is still chronically undershooting for an economy that is alleged to be so strong. Based on this view, he also believes that the Fed is being too aggressive on its rate increase guidance and that the bond market's growing loss of faith in the Fed's guidance is correct.

It should be remembered that Bullard is a one rate hike this year and done adherent, so he is obliged to play down any signal for higher interest rates implied in the forward curve. Notwithstanding his innate bias and assuming that he is aware of Dudley's plans for balance sheet reduction, Bullard has signaled that he is not expecting significant balance sheet reduction. In addition to being a one rate hike adherent, he has also identified himself as someone who does not foresee a significant shrinkage in the Fed's balance sheet. He is however still willing to accept that some balance sheet reduction must occur, albeit it at snail's pace. Presumably, he does not see any scope to create an interest rate cushion whatsoever, to deal with future economic softness through monetary policy easing, so he has opted to keep the economic patient on a mildly reduced monetary steroid diet as the prophylactic alternative.

San Francisco Fed President John Williams kicked off the latest round of expectations framing running into the June FOMC meeting. He said nothing to dispel the expectations for a rate hike at the next meeting followed by one more some-time in the second half of the year. The real issue now is what the Fed does in 2018, since this year's rate increases and balance sheet tapering have been widely anticipated. Williams is attempting to inculcate the vision of a "Goldilocks Economy" into the mind of the market. A gradual approach to normalization is commensurate with such a view. Should the Fed in general be successful in framing this view of its policy, there will be very little in the form of a volatility and fear in capital markets which will ultimately affirm this view and enable this gradual behavior.

Williams bravely addressed the issue created by Bill Dudley's balance sheet shrinkage that is not really a shrinkage at all signal. He chose to address the issue through the duration rather than magnitude of the Fed's unwinding steps. According to his calculations, the Fed's balance sheet will only be reduced significantly after five years. This five-year duration will therefore encompass Dudley's view for some QE being left in the system as an insurance policy on which higher interest rates will be paid before it is finally removed. Evidently, the Fed intends to pay a lot of interest on excess reserves over a five-year time span in order to leave a large permanent monetary stimulus behind once it leaves. Williams' five-year exit strategy is also consistent with his strategy identified in the last report, to get market observers to believe in and also to discount what he lovingly termed the "Goldilocks Economy". Such an embrace by the markets would lead to the classical self-confirming bias, that the Fed hopes will be viewed as affirmation that it has done its job perfectly and also that QE is a friend and not a foe that can be accepted as a tried and tested Fed monetary policy tool. A bull market in equities, with no Taper Tantrum, that lasts for five years will presumably be the collateral evidence that Williams hopes will sell his thesis.

Fed Governor Jerome Powell has been noted in these reports for having a greater practical rapport with the Trump administration than his colleagues. His latest shift towards the more Dovish approach to rate increases and balance sheet reduction is therefore noteworthy, in that it presents a policy framework that will be more acceptable to the Trump administration. Consistent with his latest Dovish pivot, he recently stated that he is still well prepared for rate increases and balance sheet reduction; but noted that this process will have to be put into the context of a continued undershooting of inflation. His view of the inflation target as "symmetrical" strongly resonates with the recent views of Dove-turned-Hawk-turned-Dove-again Charles Evans on the subject. It is also consistent with the new dogma known as "flexible price level targeting" being promoted by John Williams.

Above all, Powell's views on the prospect for Fed balance sheet shrinkage, endorse the guidance from both Bill Dudley and John Williams. He doesn't see the balance sheet shrinking below $2.5 to $ 3 trillion and also confirms the five-year duration of this expanded legacy estimated by Williams. If the Doves have Powell on-board, the framing of perceptions of the "Goldilocks Economy" will be much easier to achieve. In relation to said "Goldilocks Economy," Powell opined that current market perceptions of balance sheet discussion so far "augur well for an orderly phase-out of reinvestments," which suggests that he is already on-board.

The exit from QE has thus been handicapped at a five-year baseline estimate. Such a leisurely process will significantly avoid a Taper Tantrum and any economic headwinds associated with it. Presumably it is intended to extend the current business cycle. Looking rationally at what Williams is suggesting, one has to assume that he is not in fact a believer that the economy is at full employment. He must, therefore, believe that the economy has structurally changed to one which has a bias towards disinflation. Williams must also take a dim view of the potential for the Trump stimulus to get legislated in full. Looking on the bright side, however, five more years of leisurely balance sheet reduction will project US equity markets to lofty valuations! The bid for the US dollar implied by Williams's view must by default be a tepid one also.

Williams's comments about the timing of the shrinkage of the Fed's balance sheet must also be understood in the context of something he explained to what is ominously called the Shadow Open Market Committee about a new policy tool. Williams advocates what he calls "flexible price-level targeting." In practice this means that the Fed either overreacts or underreacts, by setting a new future annual price level, depending on what it did the previous year. Whilst he was careful to state that years of undershooting does not imply a significantly higher target level going forward, the implicit assumption is that a new higher price-level will be adopted by default. If Williams is successful in selling this "flexible price-level targeting" to his colleagues in principle, it is easy to see this as part of an initiative to finally shake falling inflation expectations out of their negative spiral. Taking five years to shrink the Fed's balance sheet, in addition to turbo-charging liquidity by paying higher interest on reserves that are painfully slowly unwound over this period, is also an attempt to materially shake inflation expectations.

Readers may remember in the last report Chicago Fed President Charles Evans suggested that a new inflation target should be viewed as a midpoint around which to fluctuate rather than the current ceiling which it is viewed as. There is a pattern developing amongst the Doves here. Evidently, it is the Doves intention and capability to firmly shift inflation expectations higher over the next five years. Such a stated objective is Dollar Negative and will require a higher yield premium to compensate holders of dollar-based assets.

Dallas Fed President Robert Kaplan then continued to square the circle as Williams had done in order to make his appearance of equivocation appear consistent with Williams's "Goldilocks Economy" frame of reference. In doing so, Kaplan also confirmed the veracity in Bill Dudley's balance sheet exit plan, whilst putting a value on the rump of the QE balance sheet that will remain in place. Kaplan sees two more rate hikes this year BUT not because the economy is strong. He is not very clear, however, on why there should be two more rate hikes if the economy is not so strong. One must assume that the rise in interest rates, that he foresees, is associated with the rump of the Fed's balance sheet that will remain in place; and the attempts to boost Fed Funds in circulation by paying higher interest rates on excess reserves therefore. Said excess reserves will equate to $2 trillion, which is Kaplan's estimate of how much of the expanded balance sheet will remain in place.

Kaplan's economic thesis, for the huge chunk of the balance sheet that is not removed and the need to proceed slowly on raising interest rates, is based on two GDP drivers which are not normally associated with higher interest rates. He has totally ratcheted down or discounted the Trump stimulus and now sees GDP at 2%. This is based on his view that the labour-force is neither increasing productivity nor growing demographically. Full employment in his view is, therefore, an artefact that he associates with a weak underlying workforce and GDP picture rather than a capacity constraint issue in an overheating economy. He even went on to suggest that this weak workforce environment will persist for a decade.

Kaplan's porridge is evidently lukewarm and getting colder! Parsing his view from a speculator's perspective, ample liquidity and easy monetary conditions, combined with a stagnant laborforce, should see a continued boost in technology stocks; since this is the only sector to provide the business solution that the workers are incapable of doing. Since Williams sees five years of incremental balance sheet shrinkage and Kaplan sees a decade of workforce stagnation, with $2 trillion of Fed balance sheet as a permanent legacy, this bull trend in technology still has a long way to go. Just to provide food for the technology bulls, Kaplan even gave a market view on equities ostensibly to avert any kind of Taper Tantrum getting in the way of progress. He would like to see some kind of correction to shake out the weak hands holding stock, so that the uptrend will be stronger and longer in duration. This correction he called for, dutifully then appeared in the "FANG" basket that is driving technology stock valuations. Thus far, in relation to the "Goldilocks Economy" and even equity valuations speculators are reading off the same page as the Fed.

(Source: Bloomberg)

Mr. Market whilst ostensibly challenging the Fed's guidance on further interest rate increases this year, is unwittingly playing into the hands of the "Goldilocks Economy" spin-doctors at the Fed. Following the unspectacular May Employment Situation report and lower revisions of the two previous months, Mr. Market strongly doubts the FOMC's thesis for further rate increases this year. The duration bid for US Treasuries, that is commensurate with this doubt, is however also an affirmation of the "Goldilocks Economy" thesis that the Fed requires for its five-year extended play version of the normalization. Confirmation bias and groupthink can emerge from even the most well intentioned of Bond Vigilantes who believe that they are actually disagreeing with the Fed. Foreign-based US duration investors may be wise to leave the party a little earlier than their US co-investors; and their exit should cause the US duration investors to rethink their convictions.

As the US dollar starts to discount the extended Fed normalization period by falling in value, at some point foreign holders of US assets will require a risk premium. If the Trump administration has not made serious progress on cutting the fiscal deficit and if the Fed is serious about cutting its balance sheet, then foreign holders of US assets will be required in the future. Foreign investors will require a higher yield premium to remain docile holders. If they revolt, then one should expect the Fed to come back and oblige by expanding its balance sheet again. Such a move by the Fed will not support the US dollar, however.

(Source: Bloomberg)

The fundamental prospects for a weaker US dollar going forward were discussed in the last report. A recent research note from Goldman provides a timely suggestion that this weak US dollar thesis is gaining traction. Goldman is worried that rising wages will erode the productivity gap and crush S&P earnings. Intuitively one would assume that rising wages and falling productivity should lead to higher interest rates and a higher US dollar. This ignores the fact that falling corporate profitability is a headwind for the US economy.

(Source: The Daily Shot)

A falling US dollar would be the lowest fruit on the policy making branch to address this problem. A falling US dollar could also come with rising US interest rates, as global investors demand a rising risk premium to compensate for a weakening currency.

When the FOMC meets and pats itself on the back, for its success in manipulating perceptions of the "Goldilocks Economy," it would do well to understand exactly whose perceptions and positive feedback it is influencing. As discussed previously, young and middle class Americans are not the asset owning classes sending this positive feedback message. Clearly, it is in the interest of the asset owning classes to provide the positive feedback which leads to their portfolios being given a further boost through the cautious exit from QE. As the recent slide in NASDAQ shows, these people can get ahead of themselves and the message that they feedback to the Fed can lead to unstable asset bubbles.

A weaker US dollar is also something that would boost US equity portfolios and would thus deliver further positive feedback and the justification for higher US interest rates. Belief in the "Goldilocks Economy" would also create a ceiling over just how high interest rates would need to rise to compensate for the weaker dollar also. So far Mr. Market and the Fed are on the same page and the bears haven't showed up. The narrative says that they won't show up for another five years too!

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.