Thursday, September 24, 2015

Sea Change At The Fed?

Mary Childs of Bloomberg reports, Gross Tells Fed to `Get Off Zero Now!' as Economies Run on Empty:
Bill Gross said the Federal Reserve needs to raise interest rates as soon as possible, trading some near-term market losses for longer-term stability and a healthier financial system.

If zero interest rates become the long-term norm, economic participants will soon run on empty because their investments aren’t producing the gains or cash flow needed to finance past promises in an aging society, he wrote in an investment outlook on Wednesday for Denver-based Janus Capital Group Inc. That’s already beginning to happen as Detroit, Puerto Rico, and, he predicts, soon Chicago, struggle to meet their liabilities.

“My advice to them is this: get off zero and get off quick,” Gross urged the central bankers. He said it’s time for a “new thesis” that allows people in developed economies to save, enabling liability-based business models to survive and spurring more private investment, “which is the essence of a healthy economy. Near term pain? Yes. Long term gain? Almost certainly. Get off zero now!”

The Fed last week decided to keep its benchmark rate near zero, showing reluctance to end an era of record monetary stimulus in a time of market turmoil, rising international risks and slow inflation at home. Futures traders are betting the Fed is unlikely to act in October, as they put 43 percent odds on an increase by December and 51 percent by January, according to data compiled by Bloomberg.

‘Wreak Havoc’

Last week, Gross said the Fed was right to keep interest rates near zero at the September meeting, and that it may take years for the economy and rates to return to more normal levels. Monetary policy has exhausted its effectiveness, with asset prices distorted by years of near-zero rates, and fiscal policy will be needed to get the economy back on stronger footing, Gross said in a Sept. 18 interview with Tom Keene and Michael McKee on Bloomberg Radio.

“They did the right thing,” he said in that interview, citing current financial conditions. “When they did the wrong thing, and this is way back in terms of past history, they went below 2 percent in terms of the short-term rate. They didn’t have to do that, they didn’t have to go to zero. So now getting back up there will wreak havoc on asset markets.”

Gross, 71, joined Janus about a year ago after leaving Pacific Investment Management Co., where he once ran the world’s biggest mutual fund. He now oversees the $1.4 billion Janus Global Unconstrained Bond Fund. The fund lost 1.7 percent this year, putting it behind 76 percent of similar funds, according to data compiled by Bloomberg.

‘Revolving Spit’

Gross underscored that it’s not just insurance companies and giant pension funds that are suffering from low interest rates. Investors aren’t getting the 8 percent to 10 percent returns they counted on to pay for education, health care, retirement or vacation.

“Mainstream America with their 401(k)s are in a similar pickle,” he wrote. “They are not so much in a pickle barrel as they are on a revolving spit, being slowly cooked alive while central bankers focus on their Taylor models and fight non-existent inflation,” Gross said, referring to a rule named for Stanford University economist John Taylor.

Fellow famed bond manager Jeffrey Gundlach, co-founder of $80 billion DoubleLine Capital, sees a fifty-fifty chance the Fed will raise interest rates in December. Gundlach forecast “choppiness” in fixed-income markets, though he said yields won’t actually change much. Los Angeles-based Gundlach has been saying for months that the Fed may not be able to raise rates this year for reasons including a strong dollar.
Bill Gross is right about mainstream America where the 401(k) nightmare continues. In fact, if you ask me, it's time to declare the 401(k) experiment a failure and realize the United States of pension poverty needs to come to grips with the brutal truth on DC plans. Now more than ever, the U.S. needs to implement radically new retirement policies that enhance Social Security and are modeled after the Canada Pension Plan and the Dutch pension model.

But is Gross right about the Fed needing to move off zero rates now? Here I'm perplexed as he recently warned that the global economy is "dangerously close" to becoming a "deflationary world" and raised alarm over weakness in emerging market currencies and commodity prices.

In other words, Gross agrees with me that the Fed has a deflation problem, especially after China's Big Bang, and can ill-afford to raise rates and watch the mighty greenback surge higher stoking more fears of deflation and raising the specter that it eventually comes to America.

So why is Gross pressing the point for the Fed to move off zero now if he's warning the world is perilously close to deflation? I think he sees that zero rates have been a boon for overpaid hedge fund managers borrowing on the cheap and leveraging up their stock and bond investments as well as corporations on a buyback binge, but they haven't helped regular people struggling to find work and save for their retirement.

In other words, the Fed's zero interest rate policy (ZIRP) is exacerbating inequality which is deflationary. Worse still, by maintaining rates at zero, some argue the Fed is introducing more uncertainty into the financial system and reinforcing a deflationary mindset that can that easily devolve into a dangerous deflation trap.

While I'm sympathetic to these concerns, I agree with Jeffrey Gundlach who recently stated on CNBC the Fed shouldn't raise interest rates and if it does, it will introduce more uncertainty in the financial system. Gundlach is worried about the high-yield corporate bond market (HYG) and for good reason, he sees it as a leading indicator for risk assets and thinks it will head lower if the Fed hikes rates (click on image):


But apart from the junk bond market, I think the Fed made the right call last week because it's rightfully concerned of global economic weakness spreading to the U.S., especially now that inflation expectations are so low. As Lawrence Lewitinn of Yahoo reports, this shift from domestic to international focus represents something huge from the Fed:
The Federal Reserve hasn’t raised rates in 9 years, but its latest reasons why may indicate a shift in how the Fed makes decisions.

Last week, the Federal Open Market Committee decided to keep the federal funds rate between 0% and 0.25%. When issuing its latest statement after its meeting, the Fed said its assessment took into account unemployment and inflation, the bank’s two stated mandates. But a third factor was also mentioned: “readings on financial and international developments."

This indicates a sea change in the Fed’s policy motivations, according to Ira Jersey, senior client portfolio manager at OppenheimerFunds.

“The acknowledgement that the Federal Reserve is going to be looking at things like global deflation and a slowdown in the global economy is a big deal,” said Jersey. “U.S. data is actually holding up reasonably well. But with the market volatility and the slowdown of emerging economies, they’re really concerned about that.”

The recent shakeup in China’s markets after fears the country’s growth may slowdown took its toll on U.S. financial markets. The Shanghai Composite index has plunged 37% since its mid-June record highs while the S&P 500 is off by 6% during that same time frame. Jersey said the Fed has grown worried about the impact on the overall U.S. economy.

“Just in June, you only had two members of the Federal Open Market Committee saying that they wanted to see hikes in 2016,” he said. “Now you have four members who think that they should be hiking only in 2016 or later. It’s hard to see what’s going to change over the next couple of months that is going to convince them that it’s actually time to hike without any significantly detrimental affects on the U.S. economy or market.”

By holding off on a rate hike, the Fed also made it easier for other central banks to take on their own monetary stimulus measures, Jersey added. It may relieve some of their concerns that capital could flee out of flagging economies and into the U.S. with its relatively higher rates.

“If the ECB were considering extending their own quantitative easing program beyond 2016, this would be an opportunity for them to do that,” said Jersey. “Other central banks like the People’s Bank of China or even the Bank of Japan could also potentially come up with additional easing mechanisms without having to worry too much about their currency really devaluing a lot against the dollar.”

Lower U.S. rates also makes slightly riskier American assets more attractive by keeping the hurdle fairly low. Jersey expects that to continue.

“Once it becomes common consensus that the Fed is going to be very, very slow once they do hike sometime, ultimately equities and corporate bonds can do very well in that environment,” he said.
I agree with Jersey, there's a sea change going on at the Fed and this isn't necessarily a bad thing given the world is perilously close to global deflation. If the Fed holds off a bit longer, allowing other central banks to keep pumping liquidity into their financial system, then those betting big on a global recovery might turn out to be right (so far, it's been painful). 

Conversely, if the Fed hikes rates too soon, ignoring the dire warning of the bond king, it will be making a monumental mistake which is why Ray Dalio is worried about the next downturn and why Harvard's endowment is warning of market froth.

Below, take the time to listen to Ira Jersey, senior client portfolio manager at OppenheimerFunds, discussing a sea change in the Fed’s policy motivations.

Update: Bloomberg reports Federal Reserve Chair Janet Yellen said the U.S. central bank is on track to raise interest rates this year, even as she acknowledged that economic “surprises” could lead them to change that plan:
“Most FOMC participants, including myself, currently anticipate that achieving these conditions will likely entail an initial increase in the federal funds rate later this year, followed by a gradual pace of tightening thereafter,” Yellen said during a speech Thursday in Amherst, Massachusetts. “But if the economy surprises us, our judgments about appropriate monetary policy will change.”

Yellen, 69, spoke a week after the Federal Open Market Committee left its benchmark federal funds target near zero, saying "recent global economic and financial developments" might damp growth and inflation in the U.S. Concerns over a slowdown in China following a surprise Aug. 11 devaluation of the yuan triggered turmoil in financial markets and raised questions about the outlook for the global economy.

While “there wasn’t anything significant enough that changed in one week for her to give us a different take,” said Tom Porcelli, chief U.S. economist at RBC Capital Markets LLC in New York, Yellen “finally acknowledges that she, specifically, does believe that a rate hike is appropriate this year.”

Porcelli expects a December increase, but thinks there’s a high hurdle to moving this year.

Slower demand from China, where growth is projected to drop below 7 percent this year, has helped push down commodity prices, sapping already low inflation in the U.S. The Fed’s preferred gauge of price pressures rose 0.3 percent in the year through July and has been under its 2 percent target since April 2008.
We'll see if global economic conditions improve enough to warrant a rate hike this year. I remain skeptical but if global PMIs come in stronger than expected, the Fed will likely move.

As for Fed Chair Yellen, I hope she's feeling better on Friday as she paused a few times during her speech in Amherst, Massachusetts on Thursday (see below, h/t Zero Hedge).  The 69-year-old Fed chief got medical attention after struggling with her speech and was said to be dehydrated and exhausted after speaking for nearly an hour before a packed university auditorium.


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