Tuesday, December 15, 2015

The Federal Reserve’s Tacit Aim?

Luc Vallée, chief strategist at Laurentian Bank Securities, wrote a comment over the weekend for the Globe and Mail, The Federal Reserve’s tacit aim is to stabilize the dollar:
Here we are again, days from yet another Federal Reserve meeting to decide whether to increase U.S. interest rates for the first time in more than nine years.

This time should be the one, though. As former Fed vice-chair Alan Blinder wrote recently, “Only the stubborn remain unconvinced” that liftoff will happen next Wednesday. And I concur. Barring a disaster, Fed chair Janet Yellen would lose too much credibility if she did not deliver the long-awaited hike.

But, as some Fed officials have warned, too much attention is being paid to the timing of the first move rather than the path of subsequent rate increases. Credibility aside, there are excellent reasons for the Fed to finally want to move away from its zero-interest-rate policy (ZIRP), which was adopted after the financial crisis. And let’s face it, a mere 25-basis-point increase will not be the end of the world, but rather just the beginning of the monetary-policy normalization process.

Moreover, the neutral interest rate (the short-term policy rate consistent with stable inflation at full employment in the long run) might be lower today than it has been in the past. But, according to the Fed’s own research, the neutral rate is still likely to be around 3.75 per cent, a long way from where the Federal funds rate stands today.

Assuming that next week’s rate hike is a forgone conclusion, investors should turn their attention toward what the Fed is likely to tell us about its intentions for 2016 and beyond. Since September, 2014, it has been saying that over a 15-month horizon, the funds rate should increase by about 1.25 per cent, or 125 basis points. But the Fed has not moved since; all it has done is to roll forward these future rate increases. For instance, in September, 2014, the median of the “dots” (the policy rate forecasts of each member of the Federal Open Market Committee) called for the rate to reach 1.37 per cent – or for five rate hikes – by December, 2015. Yet, in September, 2015, one year later, the median “dot” was still pointing to the same rate of 1.37 per cent but, this time, to be delivered by December, 2016.

This 15-month forward rate forecast by the Fed is thus now much less credible. And the bond market has, unsurprisingly, adjusted its expectations to take into account the Fed’s failure to deliver on its own guidance. Bonds are now pricing increases of between 50 to 75 basis points (i.e., two or three hikes) for the whole of 2016. This is a significant divergence from the Fed’s view, which still officially anticipates that it will move by 25 basis points every two FOMC meetings (there are eight a year), while the market roughly thinks the Fed will hike similarly every four meetings.

And over a longer horizon, the expectations of future rate increases have also diminished. In September, 2014, the market may have been inclined to believe that the policy rate would move to 4 per cent after a few years, but investors on the bond market now implicitly forecast that the rate increases by the Fed beyond 2016 will be spread over a much longer period and end at a much lower rate than what the current “dots” suggest. The U.S. 10-year bond yield is 2.20 per cent and the 30-year rate (a good proxy for what the market thinks the upper limit of the neutral rate should be) stands at 2.95 per cent.

I believe that at its next meeting, the Fed will adjust to this new reality and communicate its thinking to the market in order to provide a more favourable environment to foster economic growth. This communication will be crucial, because many financial market participants still fear that once the Fed starts raising rates, there are considerable risks that it may tighten too soon and faster than warranted. One way to assuage this fear would be for the Fed to credibly signal that it recognizes the current economic recovery, domestic and global, stands on weak foundations and excessive leverage, and could relapse if pushed too hard.

Yet the United States is almost at full employment, and although inflation is below the Fed’s target of 2 per cent, there are reasons to believe this weak price environment is temporary, as energy and non-energy commodity prices are currently at cyclical lows. The timing and the rationale to raise rates are thus appropriate, especially given that monetary policy works with a lag.

What is the problem, then? One problem is that the recovery is much less firm in the rest of the world than it is in the United States, and as the Fed starts raising rates, global liquidity will begin shrinking, putting even more downward pressure on consumption and investment.

Preventively, other central banks – most notably the European Central Bank and the Bank of Japan – have launched massive asset-purchasing programs to compensate for the anticipated reduced global liquidity the Fed’s restrictive monetary policy will have once it starts raising rates. As a result of these pre-emptive expansionary policies outside the United States, the U.S. dollar appreciated significantly against the euro and the yen in the past year, although the Fed has yet to tighten. This would have been all very good had those depreciating currencies led to more growth in Europe and Japan in 2015. But, as in Canada, the positive effects of these engineered currency depreciations remain works in progress. In other words, despite all the stimulus recently provided by non-U.S. central banks, global growth is still tepid, an embarrassing outcome for policy-makers.

Conversely, the U.S. dollar’s appreciation has considerably slowed U.S. exports and growth in 2015. Fed vice-chair Stan Fischer, relying on a model developed at the Fed, acknowledged in a speech last month the negative impact an appreciating dollar has on U.S. growth. This may go a long way toward explaining why the U.S. economy’s performance was below most economists’ expectations this year. Ms. Yellen also explicitly recognized the phenomenon in a more recent speech, when she said the appreciating dollar probably cut U.S. growth by 0.5 per cent in 2015.

But, more important, Mr. Fischer argued the negative effects of the 2015 appreciation of the dollar are likely to unfold over time, and consequently could affect U.S. growth next year and beyond: “Recalling that the dollar’s actual appreciation has been about 15 per cent, … the cumulative reduction in U.S. aggregate demand from the dollar appreciation is likely to total 2.5 per cent of GDP after three years.”

From there, it is easy to conclude that the last thing we need today is a further appreciation of the U.S. dollar. U.S. growth in 2016 will be affected negatively by the dollar’s appreciation over the past 12 months, but growth could be even lower if it appreciates yet again next year. Furthermore, growth could deteriorate even further, and for several years, if the dollar were to pursue its ascension toward new highs.

Given that the American economy is one of the few engines – if not the only engine – for the global economy these days, slowing U.S. growth surely does not sound like a winning strategy for promoting world growth. It also does not look like a wise path if one wants to avoid a disorderly devaluation of the Chinese yuan in the near future, as the likelihood of such an event is more likely as the dollar strengthens and U.S. growth falters.

Reading between the lines in both Mr. Fischer’s and Ms. Yellen’s most recent speeches, as well as in European Central Bank president Mario Draghi’s underwhelming policy response to Europe’s woes last week, we can gather that central banks are most likely co-ordinating their efforts to stabilize the U.S. dollar. Implicitly, they are also contributing to stabilizing the yuan.

Where does that leave us next week after a Fed rate hike? In my opinion, the real news on Wednesday is not that the Fed is putting an end to seven years of ZIRP, but that it is reducing the speed at which it intends to raise rates going forward, tacitly aiming to stabilize the dollar.

The Fed is likely to do this by lowering the “dots” from four more increases in 2016 to just two. It may also further lower the long-run neutral rate to 3.0 per cent or less. In doing so, the Fed would credibly acknowledge that it underestimated global headwinds and the negative effects of the rising dollar on both U.S. and global growth. It would also signal that it intends to take the time needed to raise rates to the neutral rate while remaining data-dependent. This would also go a long way in calming nervous market participants and reducing uncertainty. This may even help to create a more favourable economic environment for business investment and job creation.

However, such a statement would likely complicate the Fed’s conduct. Its dual mandate today calls for stabilizing inflation and maximizing employment. It might never admit to it, but going forward, the Fed may have to actively try stabilizing the dollar.
This is a great comment from Luc Vallée, my former colleague at the Caisse who is now the chief strategist at Laurentian Bank Securities. He raises the key points that will weigh heavily on the Fed's big decision to raise rates on Wednesday (if you want to sign up to Luc's research, you can email him at ValleeL@vmbl.ca).

Jonathan Ratner of the National Post also recently reported, Why the U.S. dollar is raising alarm bells:
The threat of defaults around the world is rising as the U.S. dollar may appreciate further regardless of whether or not the U.S. Federal Reserve hikes interest rates later this month.

This comes as little surprise to those who keep an eye on the balance sheets of corporations in emerging markets, for example, since much of their debt is denominated in U.S. dollars.

“It’s hard to be bullish about the global economy these days,” said Krishen Rangasamy, an economist at National Bank Financial. “Besides China’s tricky rebalancing, which continues to have repercussions across the globe, there’s the growing threat posed by the surging U.S. dollar.”

He noted that global exposure to the U.S. dollar has never been higher, since the trade-weighted greenback has gained more than 12 per cent in 2015, which is the largest annual appreciation in more than 30 years.

Rangasamy warned that this increases the probability of corporate defaults, particularly when you consider recent data from the Bank for International Settlements. Its latest quarterly review showed that dollar-denominated debt held by non-financial entities outside the U.S. grew to US$9.8 trillion in the second quarter of 2015.

“That’s a record not just in absolute terms, but also as a percentage of GDP,” Rangasamy said in a report.

The economist also noted that at nearly 18 per cent of global GDP (excluding the U.S.), this debt level suggests the world’s exposure to the strengthening greenback is twice as large as it was 20 years ago.
I have long argued the Fed's deflation problem is being exacerbated by the mighty greenback and this has brought a sea change at the Fed forcing it to worry a lot more about global economic weakness and its effect on the U.S. dollar.

In particular, if the U.S. dollar keeps rising relative to all other currencies, U.S. import prices will keep declining and if there's another Big Bang out of China, there's a real risk that deflation will spread to America. And if that happens, it's game over; we're going to see negative interest rates in Canada, the U.S. and the rest of the world for a very, very long time.

I know, there are elite funds preparing for reflation and market oracles like Alan Greenspan and Paul Singer warning of a disaster in the U.S. bond market, but the only disaster I'm worried about is there's no end to the deflation supercycle and this will wreak havoc on the global economy for a very long time and possibly usher in negative rates around the world.

"Leo, deflation will never happen in the U.S." That's exactly what the managers of Vega Asset Management were telling me back in 2003 after I expressed concerns on their short U.S. Treasuries position (great hedge fund managers but they ended up closing their global macro fund after suffering huge losses).

I've been worried about global deflation for a very long time and have expressed my concerns to great hedge fund managers like Bridgewater's Ray Dalio. Dalio scoffed at my concerns when Gordon Fyfe and I met him ten years ago but his fund subsequently made a bundle playing the deleveraging theme.

It's crucially important for all of you to keep in mind these six structural factors which are deflationary and bond friendly:
  • The global jobs crisis: Jobs are vanishing all around the world at an alarming rate. Worse still, full-time jobs with good wages and benefits are being replaced with part-time jobs with low wages and no benefits.
  • Demographics: The aging of the population isn't pro-growth. As people get older, they live on a fixed income, consume less, and are generally more careful with their meager savings. The fact that the unemployment rate is soaring for younger workers just adds more fuel to the fire. Without a decent job, young people cannot afford to get married, buy a house and have children.
  • The global pension crisis: A common theme of this blog is how pension poverty is wreaking havoc on our economy. It's not just the demographic shift, as people retire with little or no savings, they consume less, governments collect less sales taxes and they pay out more in social welfare costs. This is why I'm such a stickler for enhanced CPP and Social Security, a universal pension which covers everyone (provided governments get the governance and risk-sharing right).
  • Rising inequality: The ultra wealthy keep getting richer and the poor keep getting poorer. Who cares? This is how it's always been and how it will always be. Unfortunately, as Warren Buffett and other enlightened billionaires have noted, the marginal utility of an extra billion to them isn't as useful as it can be to millions of others struggling under crushing poverty. Moreover, while Buffett and Gates talk up "The Giving Pledge", the truth is philanthropy won't make a dent in the trend of rising inequality which is extremely deflationary because it concentrates wealth in the hands of a few and does nothing to stimulate widespread consumption.  
  • High and unsustainable debt in the developed world: Government and household debt levels are high and unsustainable in many developed nations. This too constrains government and personal spending and is very deflationary.
  • Technology: Everyone loves shopping on-line to hunt for bargains. Technology is great in terms of keeping productivity high and prices low, but viewed over a very long period, great shifts in technology are disinflationary and some say deflationary.
In a recent comment on the Greek pension disease spreading, I harped on how rising inequality is deflationary and that while central banks' unconventional monetary policies were necessary to avoid another Great Depression, they're fueling more inequality, rewarding speculators and punishing savers and forcing pensions to take on increasingly more risks to meet their obligations. 

This too is part of the Fed's tacit aim, forcing pensions and other investors to take on a lot more risks to meet their obligations in an effort to awaken "animal spirits" and stoke inflation expectations higher. Will it work? I have my doubts but it forces all of us to play the game or risk being left out if markets go parabolic which can easily happen going into 2016.

One thing the Fed will likely ignore is the latest blow-up in the U.S. high yield market which is concentrated in the riskiest most illiquid bonds. Of course, I share the bond king's concerns and also think there are risks to raising rates in these markets but the Fed is itching to go. It has been telegraphing this move for a long time and if it doesn't raise rates, it will not be interpreted well by market participants. Some strategists think this will be a mistake but others think it's about time.   

In my opinion, the best thing the Fed can do on Wednesday is raise rates by 25 basis points and wrap it up in the most dovish wait and see tone it can possibly deliver. This will send the U.S. dollar lower and it might bring about a Santa Claus rally that a lot of funds and investors desperately need to make up for a terrible year in the stock market. 

On that note, Raymond James strategist Jeffrey Saut said Tuesday stock investors should get ready for a "rip your face off-type rally." Listen to his comments below. I agree with him, we've got the tax loss season behind us (December 15) and there will be plenty of beta chasers gunning for high beta stocks trying to make up for their losses this year. And as I stated back in October, this rally will be vicious and it will extend into the first half of 2016, so enjoy it while it lasts.

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