Wednesday, March 18, 2015

When Doves Cry?

Charlie Bilello, Director of Research at Pension Partners, LLC, an investment adviser that manages mutual funds and separate accounts, wrote a comment, Dreaming of Doves: The Disconnect Between the Fed and Markets:
Will the Fed raise rates and if so, when will they start and how quickly will they hike?

In a world obsessed with easy money, these questions have become among the most important for global markets.

There is currently a wide disconnect on the answers, depending on whether we are looking at the Fed’s own projections or the projections implied by the market via the Fed Funds Futures.

The Fed last revealed its expectations (known as “dot plots”) in December, when they projected a year-end policy rate of 1.13% in 2015. This would imply between four and five rate hikes of 25 basis points in 2015 and the first hike to occur in June or July.

Fed Fund Futures today are far from these levels, with the market expecting a year-end policy rate of 0.56%. This implies only two to three hikes in 2015 with the first hike not occurring until September or October (click on image).


If we look out further, the expectations gap widens even more, with the market expecting only 1.96% at the end of 2017 versus the Fed’s projections of 3.63% (click on image).
Why the large disconnect and how will it be resolved?

Market participants are likely calling the Fed’s bluff here as betting on more dovishness has been the best bet every year since 2009. In 2010 and 2011 when the Fed was expected to hike rates within months, they reversed course after sharp stock market declines.

Most believe the same will happen in 2015 and with the additional pressure of global easing (over twenty central banks have eased policy in the last two months) and the rising dollar, few think the Fed will be the first to act.

Perhaps they will be correct, but I have a different view here. I believe Fed wants to start normalizing and will adjust market expectations as soon as the March 18th meeting. By removing the word “patient” and reaffirming their dot plots from December, they will send a strong message to the market that this time is indeed different and that a June/July hike is possible.

What could derail plans to raise rates in 2015? As I wrote a few months back, a large stock market correction if history is any guide. They cannot serve two masters and they have shown time and again that they will choose the short-term movement of the stock market over the real economy in making policy decisions (click on image).


But absent such a correction, the Fed is likely to move.

For as Stan Druckenmiller said on CNBC earlier this week: “If the Fed was ever going to raise rates and not have it dramatically impact financial conditions, this is a golden opportunity right here, right now. Because there’s so much foreign money that I think will be attracted to treasury rates that it will not affect the curve as it traditionally has if the Fed starts moving.”

Will Yellen take this “golden opportunity”? The market still doesn’t believe so, but then again, the market isn’t always right.
There are plenty of nervous Fed watchers out there worried that a significant tightening campaign is just getting underway. I'm glad Charles Bilello posted this comment but I thought the consensus view is the Fed will drop the word "patient" when it meets later today. At least that's what CNBC's exclusive poll is reporting.

Investors are worried about how the stock market and bond market will react if the Fed does indicate it's ready to raise rates. We'll find out soon enough but as I discussed in my last comments on unwinding the mother of all carry trades and why the bond market isn't as scary as it seems, I think many investors are getting ahead of themselves and don't realize why this time is different.

Importantly, too many investors continue to underestimate the very real possibility of global deflation, which is one reason why I actually agree with Marc Faber (rare instance that I agree with Dr. Doom!) and think the Fed won't raise rates this year because the mighty greenback keeps surging higher and the latest U.S. economic data has been lackluster at best.

Sure, the Fed will likely drop the word "patient" but until you actually see a rate increase, don't get all flustered about rate hikes. In my opinion, the Fed will be making a monumental mistake if it goes ahead and raises rates. The global economy is very weak and the euro deflation crisis is far from over.

Even Ray Dalio, founder of the world’s largest hedge fund firm, Bridgewater Associates, told investors there’s a risk that the Federal Reserve could create a market rout similar to that of 1937 if it raises interest rates too fast.

Also, keep in mind the surging greenback has already done a lot of the tightening for the Fed and the risks are the U.S. will start importing disinflation and even deflation if this trend continues. I already discussed this in my comment on the mighty greenback back in October, 2014:
What does the strong USD mean for the U.S. economy? It means oil and import prices will drop and exports will get hurt. Ironically, lower oil and import prices will reinforce deflationary headwinds, which isn't exactly what the Fed wants. But the stronger USD might also give the Fed room to push back its anticipated rate hikes. Why? Because the rise in the USD tightens up financial conditions in the U.S. economy, acting as a rate increase.

In terms of stocks, the surging greenback may be a triple whammy for U.S. earnings. Multinationals which as a group derive almost half of their revenue from international markets, will see a hit on their earnings, especially if they didn't hedge accordingly. But you should see small caps (IWM), which have been beaten down hard in September and thus far in October, rally as they're more exposed to the domestic market.

Despite the October selloff, I'm not worried of another stock market crash. I maintain that the real risk in stocks remains a melt-up, not a meltdown, but you have to pick your spots carefully or risk getting slaughtered (look at coal, gold, commodity stocks that were obliterated in 2014). This is why a lot of active managers underperforming this market will continue to do so as we head into year-end. There are a lot of things that could derail this endless rally but there is still plenty of liquidity to drive all risk assets much, much higher.

Having said this, we are at an important crossroad here. The euro deflation crisis is threatening the global economy. If the ECB doesn't act fast, it will get worse, and likely spill over to the rest of the world. Then you will see more quantitative easing from all central banks as they try (in vain) to fight the coming deflation spiral.
I still think there is plenty of liquidity to drive U.S. stocks much higher which is why in my Outlook 2015, I recommended investors to overweight small caps (IWM), technology (QQQ or XLK) and biotech shares (IBB or XBI) but keep steering clear of energy (XLE), materials (XLB) and commodities (GSG). 

Now, I realize there is an argument to be made that the U.S. led the global economy down and it will lead the global economy out of this slump. While this has been the case in the past, I'm highly skeptical that this will be the case going forward.

Why? In my last comment on the scary bond market, I stated five structural factors exacerbating and bolstering global deflation:
  • Aging demographics
  • The global jobs crisis
  • High public and private debt in developed economies
  • Rising inequality throughout the world
  • The looming retirement crisis which will ensure more pension poverty down the road
You can add technological advances to this list but the point I'm trying to make is the Fed and other central banks can only buy time, they can't change the structure of our fragile economies. 

This is why I keep saying "enjoy the liquidity party while it lasts" -- and it will last a lot longer than Stanley Druckenmiller and other skeptics think -- but at one point, liquidity will not be enough to drive risk assets higher. That will be a very scary moment for financial markets but we're not there yet.

On that note, I leave you with an interview with Chris Watling, chief executive of Longview Economics, who tells CNBC why he is starting to "think like a bear" as the market environment starts to change. Watling thinks we're entering into the last 18 months of the global economic cycle, but warns of a challenging year ahead.

He may be right but all I can tell you is it isn't the time for doves to start crying. Listen to the classic song from Prince and the Revolution and keep dancing to the music because this global liquidity party has a few more legs up before it all comes crashing down.


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