Interest rates are still accommodative, but we're gradually moving to a place where they will be neutral…We may go past neutral, but we're a long way from neutral at this point [emphasis added], probably."
- Federal Reserve Chairperson Jerome Powell (10/3/2018 Q&A Session with PBS' Judy Woodruff)
We realize that this is the second blog article we've published on the Federal Reserve in recent months (see Goldilocks Enters the Breach) as the Fed feels more emboldened to normalize U.S. monetary policy from its post-2008 Financial Crisis levels. This path towards normalization includes Fed officials projecting a path of future hikes to its benchmark short-term interest rate, which when adjusted for 2.00-2.25% core inflation, will enter positive territory for the first time since the Financial Crisis, assuming another rate hike in December as widely expected (Figure 1). The Fed also continues to slowly pare back its balance sheet which now stands at $3.977 trillion, down 6.4% when quantitative tightening began last year.
Figure 1 - Markets Expect Fed Funds Target Around 2.75% by Year-End and Only 3% by End of 2019
And yet we feel compelled to publish a follow up piece to 'Goldilocks Enters the Breach' given the visceral reaction (for many, a 5% sell-off in the S&P 500 does feel visceral) to Powell's comments by both global equity and fixed income investors as they incorporate a scenario that could see interest rates pushed well past 'normal', which is a level apparently far from where current rates stand based on Powell's comments. Although several market observers attribute this month's negative equity returns to technical-selling pressures stemming from short-term algorithmic trading models such as CTAs and risk-parity as well as ongoing concerns over China slowdown in the wake of U.S. trade tariffs, longer-term investors can be rightly concerned about whether the post-2008 global economy can withstand high inflation-adjusted interest rates.
And, yes, we're being facetious with this blog article title (no, Powell is not literally strangling the market although this month's sell-off has that feel) as the title reflects upon the perceived policy shift from the Greenspan Put to the Fed Strangle, using options parlance, that we wrote about in our 2nd Quarter 2018 Market Commentary. Here is what we wrote:
In addition to the financial tightening that the rate hikes are starting to produce, the Fed's reactionary function to market-disrupting events can be viewed more as a Fed 'strangle', rather than a Fed 'put'. Credit goes to Stifel Financial macro strategist, Barry Bannister, for coining the 'strangle' concept which posits that the Fed has, theoretically, sold both a put and a call option but with much wider strike prices around current market levels versus what may have been observed with prior Fed regimes. Wider strike prices imply a lower probability of those put and call options from being exercised.
Under Fed Chairperson Jerome Powell, the imputed strike price on the Fed put is at a much lower level versus prior Fed regimes which were more sensitive to deflationary spirals brought on by the onset of volatile markets post the 2009 Great Recession. In other words, the Powell Fed is less likely to step in to support the markets during a price swoon, and the sell-off would need to be much deeper to compel the Fed to react.
In contrast, the high imputed strike price on the Fed call makes the call option less likely to be exercised as the Fed's monetary policy seems to be more sensitive to market imbalances brought on by runaway asset prices or excessive risk-taking. As long as the U.S. economy continues to grow at peak employment levels with inflationary threats just around the corner, the Powell Fed can maintain the policy strangle while pursuing a rate normalization schedule that brings short-term rates in line with the theoretical neutral real rate of interest."
So, in Trumpian fashion, Powell went 'YUGE' when he conveyed a much higher Fed funds rate in the PBS interview. Although the Fed has never officially endorsed the Fed Put (and certainly not the Fed Strangle), Powell's comments seem to imply a much wider strike price band on the strangle than what the market is expecting. In other words, the Fed is giving itself wide berth on how intentional it will be in pursuing its goal to normalize monetary policy, regardless of how much market pain is inflicted, and it will only 'pause' if it becomes clear that the market volatility is pointing towards real economic weakness.
Now, subsequent Fed official comments (St. Louis Fed President James Bullard, Vice Chairman of the Board Randal Quarles) suggest that the Fed should pursue a more gradual approach to the one implied by Powell and that the Fed should pause if there are signs of a slowing economy and inflationary pressures. So, in one sense, the Fed could be pursuing an " Art of the Deal" strategy where Powell outlines one extreme position in order to give the Fed enough maneuvering to pursue its preferred rate hike path. Perhaps, we're reading too much "4D Chess" into the Fed thought process, but it wouldn't surprise us if the Fed is trying to build up a larger buffer between its policy-setting objectives and the complaints from President Trump.
Revisiting The Real Rate Debate
So, what would "far from neutral" look like? One economist, Brian Wesbury of First Trust, who has been more accurate than others in observations about the current economic cycle, believes that nominal U.S. GDP growth should serve as the neutral rate target, especially with the economy having benefitted from 5+ years of zero rate accommodation. U.S nominal GDP grew 5.4% year-over-year based on the 2Q2018 release (Figure 1) and could further rise based on the momentum of U.S. fiscal stimulus stemming from Republican tax cuts and government spending, notwithstanding Trump's trade tariffs. Wesbury is projecting at least four rate hikes in 2019 (implying 3.75% Fed Funds Rate), which is well above consensus expectations as well as the Fed's own dot plot projections (Figure 2).
Figure 1: U.S. Nominal GDP Continues to Advance at a Healthy Clip
Figure 2 - Federal Dot Plot Projections Puts Median Fed Funds Rate around 3.00-3.25% by Year-End 2019, While the Markets Have Priced in 2.75-3.00%
As discerning as Wesbury's observations about the current versus his peers, we at 3D believe Wesbury overestimates how much of a real interest rate burden the U.S. economy, let alone the global economy, can withstand. Wesbury shares other hawkish concerns that years of overly-accommodative zero-rate policies have increased the risks that the Fed has fallen behind the inflation curve and will need to play catch up with an overly aggressive rate hike policy (more aggressive than what investors were expecting up until now). Yet, despite Wesbury's contention that the U.S. been operating as a "plow-horse economy", the world is still living with the deflationary aftermath from the 2008 crisis as well as "New Normal" secular trends of aging demographics, high debt levels, and excess capacity (although the U.S. appears to be escaping from some of these drags as the labor force expands and the U.S. growing beyond capacity).
As we've published in prior articles concerning the Fed, we believe that the Laubach-Williams neutral real rate of interest model based on sustainable GDP growth serves as a better estimate of neutral rate levels than that implied by nominal GDP growth. However, this model has lags (we only know what sustainable GDP growth looks like in hindsight) and is also dependent on the Fed's forecasts for GDP growth and inflation. Indeed, the most recent release saw a major upward adjustment to the real neutral rate estimate (r*) that suggests the U.S. economy should have been able to handle a sub-1% positive real rate over the past 10 years (Figure 3). So, the revisions at least confirm Wesbury's point that the Fed has indeed been highly accommodative by keeping its benchmark rate at negative real interest rate levels and is now having to play catch up.
Figure 3 - Well, What Do You Know? It Looks Like the Real Neutral Rate (R*) Was Estimated to Be Positive Since the Financial Crisis
Source: Federal Bank of Reserve New York
So, the L/W model implies the U.S. economy can handle real interest rate levels around 1%; a 1% real rate would imply Fed Funds at 3.00-3.25% assuming core inflation of 2.00-2.25%. But Wesbury's forecast implies real interest rate levels well beyond what is implied by the L/W model even with the upward revisions. And we contend it remains to be seen whether the U.S. (global) economy can withstand real interest rates well north of 1% (see the Fed's r* estimate for advanced economies - hint: it's closer to 0% than 1%).
So, the key will come down to how core inflation trends over the next couple of years. Higher core inflation will give the Fed cover to pursue a more aggressive policy, while lower core inflation would give enough cover for the Fed to pause, less they be accused of overshooting (which our current President will be most opportunistic in tweeting out such accusations).
So, What About the Fed Strangle… Focus on the Fundamentals
Although we seem to disagree with Wesbury on the appropriate neutral rate level target, we both seem to agree on the premise of the Fed Strangle and why investors shouldn't be overly concerned about monetary policy in the absence of overshooting risk. Here is what Wesbury wrote about Powell in "Heartburn, Not a Heart Attack:"
Many pundits were calling for him to back off his tightening and his "hawkish" language, but he didn't take the bait. He's focused on monetary policy, and the economy and won't be pushed around by hysterics or market gyrations. The S&P 500 fell about 6% from its intraday all-time high to Friday's close. This isn't earth-shattering, and the Fed shouldn't respond. Investors need to stop obsessing about the Fed. Instead, they should focus on entrepreneurship and profits. The fundamentals are what matter (emphasis added)."
Yet, at some point, we will see the intersection of 'fundamentals' and higher interest rates as the latter ultimately affects the valuation assigned to the former in terms of what investors are willing to pay for future growth prospects. And higher interest rates may end up with a ' reflexivity' effect on consumer and business spending behavior, the latter which has accumulated a lot of debt during the current cycle. Higher real rates will eventually matter to longer-term investors and to the broader economy, so Powell may be posturing for the upper end of the strangle, but the greater likelihood is that the Fed would rather err on the side of caution than risk overshooting on rate hikes.
Disclaimer: The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes, and opinions of others are assumed to be true and accurate; however, 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above is all inclusive or complete. Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC, and the reader is reminded that all investments contain risk. The opinions offered above are as of October 22, 2018, and are subject to change as influencing factors change. More detail regarding 3D Asset Management, its products, services, personnel, fees, and investment methodologies are available in the firm's Form ADV Part 2, which is available upon request by calling (860) 291-1998, option 2, or firstname.lastname@example.org visiting 3D's website at www.3dadvisor.com.
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. I have no business relationship with any company whose stock is mentioned in this article.