The Fed Tries To Avoid Reaping What It Has Sown

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by: Adam Whitehead

Summary

The Fed views the bubble risk of maintaining QE to be larger than the risk of exiting QE in a disinflationary environment.

John Williams signals that the exit from QE will be “transient”.

The QE exit thesis is a global imperative.

The global QE exit is being coordinated and the marketreaction is being manipulated.

The January 2016 datum provides a model of how things may play out this time around.

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In the absence of inflation and with the alleged full employment point being weakly framed, by the circa 130,000-ish sub-optimal monthly payrolls numbers, the Fed seems intent upon pursuing a gradual QE exit despite its better judgment. Could there be a bigger risk of hanging round that is prompting the Fed’s hurried “gradual” departure? The Bank for International Settlements (BIS) certainly thinks so!

The Fed’s recent yet widely anticipated interest rate rise, was framed in a context of benign forecasts for inflation and growth out into 2018. Further context was added by the signal that balance sheet reduction will also begin this year. In her testimony, Janet Yellen was clear that the recent softness of inflation is another one of her famous “transient” artifacts driven by the low oil price. Said oil price continues to trend lower, so this is starting to become a permanent rather than a “transient” phenomenon.

Chairman Yellen apparently remains an adherent of the power of the Phillips Curve to trigger some wage inflation soon, as unemployment continues to fall. Her signal that the slow pace of rate hikes will continue this year, even with balance sheet reduction, indicates her belief in creating a tighter monetary policy cushion before this wage inflation appears. She thus believes herself and the Fed to be ahead of an inflation curve, that has not shown up yet. What this means to her is that there will be no need to react aggressively if and when this inflation shows up, because she has already taken out some insurance. Interest rates will thus not have to rise as high and the balance sheet shrinkage can do the rest of the inflation fighting. This all sounds great, as long as the expected inflation shows up. If not, it will start to look as though she has totally got it wrong; and is making the situation worse by tightening monetary policy into a disinflationary environment. Looking on the bright side, she may have created some kind of interest rate cushion to ease policy from going forward if required to do so.

The most interesting development at the last FOMC meeting was the dissent of Minnesota Fed President Neel Kashkari, standing in direct opposition to Yellen and supported by the incoming inflation data. In his view the Fed should be waiting to see if the Q1 inflationary soft patch is “transient” or not. Based on his view, one can say that the Fed is well ahead of the inflation curve. In other words, it is currently tightening rather than normalizing monetary policy.

Kashkari hinted that his dissent found sympathy amongst other FOMC members. Dallas Fed President Robert Kaplan appears to be one such sympathizer. His comments, following the recent Fed decision, show that he is carefully trying to balance the need to exit QE against the nagging fact that inflation does not justify it. Going forward, he will need some major convincing and/or stronger inflation data to make him vote for further interest rate increases. If the decision is taken to shrink the Fed’s balance sheet, in the absence of said inflation data, Kaplan would then by default be even less likely to vote for further interest rate increases.

Sensing controversy on the horizon, New York President Bill Dudley became the first FOMC member to overtly support Yellen’s view. He defaulted to the Phillips Curve and the fact that the US economy is near to full employment by its definition as the basis for his support. The controversy still began to ripple out from the rock that Kashkari dropped in the consensus pool irrespective of how Dudley sought to calm the waters.

(Source: Seeking Alpha)

Following Dudley, San Francisco President John Williams also spoke in support of Yellen’s thesis. There was a strong hint of the “Goldilocks Economy” scenario in his characterization of monetary policy moving forward, when he said that: “Gradually raising interest rates to bring monetary policy back to normal helps us keep the economy growing at a rate that can be sustained for a longer time.” In the absence of the desired continuation of the rally in oil prices, to make Yellen’s “transient” inflation dip story come true, Williams hunted round for new transient factors; and came up with mobile phone charges as the culprit for the disinflationary effect that will apparently soon reverse.

Cleveland Fed President Loretta Mester tried a bit of double-bluff to overcome the doubts surrounding the rationale behind the continued normalization in the face of inflation undershooting. Whilst noting that based on current inflation data, there is no "immediate need" to raise interest rates, she was able to make the case that they should rise again soon. Opining the Fed’s omniscience, she argued that the slow appearance of inflation has been factored-in to the FOMC’s gradual steps to raise interest rates. The Fed is therefore neither behind nor ahead of the curve. Once again, there were hints of “Goldilocks Economy” in her rhetoric.

Chicago Fed President Charles Evans, an original monetary policy Dove, has never appeared to seem confident with his embrace of the consensus leading to interest rate increases and the scaling back of the Fed’s balance sheet. Further signs of this unease were visible in his latest comments on the subject matter of inflation undershooting. He chose the recent headlines, involving Amazon’s disinflationary disruption of the food sector, to air his concerns about the disinflationary impact of technology on the economy. This disruption is evidently shaking his conviction about what he learned as a student. In his own words: “I can’t say that the Phillips Curve isn’t going to lead to higher inflation, but I worry that it’s very flat and it’s not going to.”

Evans is clearly susceptible to the theory that the shift in the Phillips Curve is a secular one, which will therefore delay any cyclical upswing in inflation. He may even be willing to be convinced that the Phillips Curve has become an anachronism. Whilst he challenges his assumptions, his commitment to stick with the gradual normalization of monetary policy may weaken.

Dallas Fed President Robert Kaplan, still expects inflation to pick up but has become much more inflation data dependent about the next interest rate increase. He is now keeping an open mind about a further rate increase this year, which marks a less aggressive stance than his previous almost formality assumption that there will be another one this year.

(Source: Mortgage News Daily)

Boston Fed President Eric Rosengren will not easily give up on higher interest rates and balance sheet reduction, just because the Phillips Curve is not working as usual. He urged for his colleagues to see the wider context of macro-stability in relation to monetary policy. The current monetary policy environment has supported risk asset values, which its continuation could extend to bubble valuations. Any bursting of this bubble, triggering an economic contraction cannot currently be met with further monetary policy stimulus, because no cushion has yet been created through normalization. On the basis of the need to create a countercyclical monetary policy cushion therefore, Rosengren deems it prudent to continue with the normalization process. He may have a point. Fannie Mae has noted lending standards weakening since mid-2016, as a direct consequence of poor housing affordability and low inventory available. Lenders are betting on the rise in house prices to cover their risks of taking a lower deposit...sound familiar?

Rosengren’s thinking seems to resonate with Stanley Fischer’s. Following Rosengren and before Yellen, he pointed to higher asset prices as well as increased vulnerabilities for both household and corporate borrowers as threats to complacency when gauging the safety of the global financial system. The inference was that the Fed will take lofty risk asset prices into account when framing monetary policy decisions. Loftier valuations then will lead towards a tighter policy bias.

Rosengren and Fischer’s thinking also seems to resonate strongly with that of Janet Yellen. In her most recent speech, Yellen clearly took aim at asset bubbles which she referred to as “rich”; especially the one under construction in financial stocks that has received further inflating by the Trump administration’s plans to roll back regulation.

Just in case anyone was missing the point, San Francisco Fed President John Williams labored it in simple terms. Without mincing words, Williams made the valuation call that: "The stock market seems to be running pretty much on fumes ... It's something that clearly is a risk to the U.S. economy, some correction there -- it's something we have to be prepared for to respond to if it does happen." What was most interesting was his signal that the Fed will have to respond to the market correction that it has created.

(Source: BIS)

The Fed’s resonance pattern of thinking has become a global trend, with the final plot of the Bank for International Settlements on the trend-line. In its latest Annual Report, the BIS warned the developed central banking fraternity that they have created a debt bubble that needs deflating. Global debt to GDP levels today are some 40 percent higher than they were on the eve of the 2008-2009 crisis. All that the central banks have done is to inflate this bubble. They have not created strong economic growth, to pay down the debt, nor have they created strong inflation to inflate it away. In addition, they have also become systemically important institutions that now present a risk to the global economy, by nature of the size of their balance sheets. Central bankers are in the process as setting QE in the panoply of false gods and other accepted monetary policy tools, that can be applied in times of recession, just as the evidence mounts that it has potentially created a bigger threat.

Global economies have become geared to lower interest rates, so there is no way that they could withstand a period of significantly higher interest rates. Central banks are thus faced with the task of pretending to cut back QE in the name of deflating the asset bubble that threatens the global economy. The duration bid, from the slow-witted holders of fixed income, has signaled to the central bankers that they can get away with the great exit from QE unscathed. Despite the absence of inflation and strong economic growth, these central banks will scale back the QE process gradually, behind the cover story of the “Goldilocks Economy”; only to return at some later date (as John Williams has promised) when this narrative becomes a recession story requiring their monetary policy intervention.

First however, they need to coordinate their global exit at a time when neither growth nor inflation provide an optimal exit environment. If they get it wrong, their credibility based upon their embrace and application of QE as a policy tool will be destroyed …… at which point real Populism rather than what is currently purported to be so may manifest itself.

The stakes are high, but the central banks are skilled operators. They may however also need to be lucky. So far, luck is with them, in the form of the duration bid for fixed income and the suspicious “fat Goldfinger” that triggered a sell-off in the metal just before the coordinated central bank jawboning began. There is nothing like a rally in Treasuries and sell-off in Gold, to go with a Fed inspired risk off moment, in order to numb the senses of investors to the bigger game being played. In the world of “Fake News” rigged markets should be accepted as commonplace also.

Fed Chairman Yellen began this global coordination process with Mario Draghi, who spoke at the ECB Annual Forum on the same day that she was jawboning in London. Draghi emphasized that ECB QE will drag on, even though its days are numbered, because of attendant global threats. Chairman Yellen in particular seemed to tempt fate, in more ways than one, with her bold assertion about the probability of another financial crisis and her own mortality. In her opinion, there will not be another financial crisis in her lifetime.

(Source: Seeking Alpha)

It is instructive to contrast Chairman Yellen’s bold assertion, with the more equivocal view taken by the loquacious and skilled oration of Stanley Fischer on the same subject. Fischer said that: “There is no doubt the soundness and resilience of our financial system has improved since the 2007-09 crisis. However, it would be foolish to think we have eliminated all risks.” Whilst supporting Yellen (just) in spirit, he opened the way for a more significant flushing out of the weak speculative hands that currently hold richly valued risk assets; in order to ultimately make the extended rally more durable and long-lived. In doing so, he also makes himself look wiser and more experienced than Yellen; never a bad thing when it is rumored that the Fed Chairman will get fired and she has tempted fate with some ill-conceived statement on her mortality!

Yellen’s intention was to provide further cover, behind which the Fed can retreat QE to some extent before coming back strong with another round of it. To cheat death, metaphorically and economically, she must now continue to scale back QE gradually so as not to trigger a spike higher in bond yields and/or a spike lower in risk asset prices. The ECB and also possibly the BOJ, will need to oblige with some residual QE whilst the Fed gradually leads the charge to the exit. Once it has got outside the building, it can then make noises about coming back into to save the ECB and BOJ, with some easy money, whilst they are trying to wiggle through the closing exit door.

Since he does not vote this year, St Louis Fed President James Bullard’s view provides an objective perspective on the dialogue between his voting colleagues. His baseline scenario of one rate hike and done remains in place but his position on balance sheet reduction has moved to support its start later this year. Bullard is thus able to serve his thesis that inflation undershooting remains an issue, by keeping rates unchanged even at the risk making the situation worse by withdrawing Fed liquidity.

In his first serious comment, since becoming the new Atlanta Fed President, Raphael Bostic hinted that he will be bringing some Behavioral Finance theory to the debate to deal with the dogma that is cognitively biasing his colleagues. On the subject of economic confidence, he opined that consumers are not behaving as their confident opinions say that they should be. This disconnect may appear to frame what some may view as an economic slowdown in the future. Unfortunately he could not or is unable to shed light on the fact that consumers are in fact behaving as their negative inflation expectations predict that they should behave. Go figure!

(Source: Bloomberg)

The bond market doesn’t wish to get involved in the Fed’s debate over inflation; it has already decided that disinflation is a real long-term threat that the Fed will exacerbate if it continues to shrink its balance sheet and tighten. The duration bid is therefore back on. It may not be long until this yield curve flattening is viewed negatively for the US economy in general. Coming late to the party, the IMF recently lowered its US economic growth expectations for both this year and next year. The failure of President Trump’s ability to get traction on his policies was sighted as key driver of the revisions. Whilst the IMF is way behind other pundits with its view, it may well mark the historic turning- point at which this view becomes consensus rather than early move outlier. In this case, the Fed’s QE exit has already become circumscribed and markets are now awaiting the arrival of weaker growth and inflation data to start discounting the end of the Fed’s QE exit.

It is interesting to note that markets have egregiously started to reach into the future for the next wave monetary easing, even though the current phase has not ended.

The last report observed President Trump’s onslaught on banking regulation, leading to the specific pecuniary reward for the narrow interests of the Wall Street lobby that has captured a piece of the Trump administration. Janet Yellen, as outlined previously, recently identified and admonished said interests. Goldman Sachs has estimated that the banks affected will enjoy a $96 billion windfall freeing up of excess capital. President Trump has opined that this will find its way into the economy and infrastructure. The recent data show that borrowers are stretched and the credit cycle is in fact rolling over. The banks are thus more likely to use this windfall to reward executives, buy back stock and pay higher dividends. especially if the Fed has engineered a correction in stocks that enables this kind of financial gymnastics.

Private capital unfettered by government regulation, is inherently conservative and rewards itself rather than makes public sector infrastructure bets. Fed Governor Jerome Powell and the OCC, recently put speculators on watch that momentum in bank stocks is going to get a catalyst from the imminent rolling back of the rules. Referring to bank capital adequacy, he signaled that the supplementary leverage ratio (SLR) governing what enhanced capital systemically important banks must reserve will be reduced. To create a beneficial justification to explain the ensuing boom, in bank balance sheet leverage and bank share prices, he opined that the current punitive ratio may be undermining banks’ commitments to central clearing which is frustrating the efficient operation of capital markets.

Powell’s timing, in delivering the good news for bank stocks, was curiously coincidental with the latest Fed stress test results; which gave a clean bill of health even under the worst-case-scenario to thirty four of America’s global systemically important financial institutions. With the prospect of higher margins, through a combination of higher interest rates and reduced capital adequacy requirements, these stocks have been given a clean bill of health to power ahead once the Fed has created fundamental value in them by engineering a broad market sell-off.

(Source: Seeking Alpha)

Looking back through the prism of these reports, history is rhyming again and there is a model available to see how we got through it last time. Using the January 24th 2016 report as a guide, one can foresee a Taper Tantrum of sorts coincident with a sideways movement in risk asset prices. What came next was the promise of more liquidity and then the assent on the summit of risk asset prices. This time it’s different, as they always say and also with some conviction because we now have President Trump, but ex-President Trump it all looks remarkably familiar. Take away his stimulus plans and it looks even more so.

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.