2016/12/16 Commentary: Fed Dread All in the Head

2016/12/12 2016/12/16 Commentary: Fed Dread All in the Head

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COMMENTARY: Friday, December 16, 2016

Fed Dread All in the Head

While Fed Chair Yellen and her cohorts put a nominally stronger spin into the FOMC statement and projections as well as her press conference discussion of the degree to which the US economy is firming a bit further, our sense is that underneath the surface they are dreading the need to revert back to a much more aggressive view of the upside US economic potential. That is in part because they were so wrong in projecting all of the higher inflation and need for higher rates exactly one year ago today. For much more on that misguided hawkish assessment see our December 16th, 2015 Commentary: Fed’s ‘Normalcy Bias’ Continues post from later than day.  

It seems the Fed has become increasingly invested in its own predictions more than real world economic evolution. This problem was discussed by the estimable Larry Summers quite a while ago prior to it contributing to both the Dot.Com Bust and the 2008-2009 dual Credit and Housing Crisis. We will revisit the full context of his mid-1991 research presentation on that below. Suffice to say for now that the problem with macroeconomic analysis is that so many of its practitioners are stuck in “stochastic” models. 

That is to say they can only shift an incremental degree from the previous assessment. This has been the case for the Fed over the past several years. Especially note how it was dragged kicking and screaming into allowing economic activity in 2016 was weaker than it had predicted. And at present it does not want to acknowledge how strongly the incoming US administration’s policies might affect upside economic performance. In that regard, the empirical indication from the US govvies is that the Fed is already behind the curve.

As we have seen in past macro cycles, if the Fed is tardy in tightening near term economic conditions the equities can thrive. This is why we now feel that the additional single 2017 rate hike (i.e. 3 instead of 2) will leave the US economy better positioned to accelerate to the upside, with that being reflected in the US equity markets. That said, there did seem to be some concerns in the US equities this modest additional FOMC tightening might be a negative factor, as was obvious from Wednesday’s selloff.

However, any consideration this very modest additional bit of Fed action might derail the overall equities rally is folly. It is just a bit less accommodation, and any ‘Fed dread’ on such a modest setback this week is ‘all in the head’ of hypersensitive participants.

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NOTE: Given the likelihood the US economy will now get the structural reform that we (along with Mario Draghi and others) have been loudly complaining was not forthcoming since our dual It’s Lack of Reform, Stupid posts in January 2015, we need to adjust our view that a potential economic and equity market failure is coming. We previously referred you back to our December 8, 2015 post for our major Extended Perspective Commentary. That reviewed a broad array of factors to consider Will 2016 be 2007 Redux? While a continued regime of higher taxes and more regulation (i.e. under Clinton) might have fomented a continued weak or even weaker US economy, the tax and regulation changes proposed by a Trump administration that will likely be approved by the heavily Republican Congress now diminish the similar fears we had to what transpired in 2007-2008.  

▪ For a far more extensive exploration of all the ways in which the incoming Trump administration that is in line with most of the Republican US Congress had already been planning over the past several years is going to stimulate the US economy, please see our Monday Commentary: Not THAT Taper & US Equities Surge post. While the headline tax rate reductions and regulatory reform are important, there are other complementary policies that will reinforce the corporate investment and hiring incentives.

Those seem to be the sorts of spurs to economic growth that the Fed cannot incorporate right now into its recently (through 2016 since the misguided December 2015 projections) less upbeat US economic outlook. And that gets us back to that excellent Larry Summers’ critique of what was wrong with econometric analysis 25 years ago which the economic analysis community refused to acknowledge. It is possible the Dot.Com Bust and the 2008-2009 dual Credit and Housing Crisis might have been avoided if the economic analysis community had adopted the more flexible, empirical approach he prescribed.

His complaint was as we have noted above regarding the Fed’s economic analysis in recent years: too stuck on justifying its previous positions and not shifting it in line with real world conditions. His summary of the primary deficiency of modern macroeconomics compared to the rigor and responsiveness of the empirical sciences was both as very straightforward and enlightened as it was scathing.

To wit, “Physicists do not compete to find more and more elaborate ways to observe falling apples. Instead they have made so much progress because theory has sought inspiration from a wide range of empirical phenomena. Macroeconomics could progress in the same way. But progress is unlikely as long as macroeconomists require the armor of a stochastic pseudo-world before doing battle with evidence from the real one.”

It seems to us that the Fed would benefit from shedding some of that ‘stochastic armor’ in from the false comfort that its previous assessments must have been as least passingly on target. It is time (in fact quite a bit past time) for the Fed to stop making the mistakes that led to the previous crises. Just to be clear, we are not predicting there is any crisis right now, or that one is even passingly looming. Rather it was misguided hidebound assessments going all the way back to Alan Greenspan right through Bernanke’s sanguine views that allowed them to develop across time. This must change.

For anyone interested in Summers’ full (rather lengthy) research presentation, it was his “The Scientific Illusion in Empirical Macroeconomics” (The Scandinavian Journal of Economics, Vol. 93, No. 2, Proceedings of a Conference on New Approaches to Empirical Macroeconomics. Jun., 1991, pp. 129-148.) It was seriously criticized by many mainstream economists both at the time and since. Maybe that much more reason to give it a read in light of the abysmal performance of so many economic analyses since that time right into the Fed’s forecasts.

Other Upbeat Factors

Without spending too much time on the background factors prior to the Evolutionary Trend View (ETV) developments in key markets, in addition to mostly improved economic data there were two key developments over the past week that warrant attention. The first was last week Thursday's Organization for Economic Cooperation and Development’s latest Composite Leading Indicators (CLI.) 

It was easy for this broader economic outlook to get lost in the shuffle with so much emphasis on ECB’s simultaneous reduction and extension “non-taper” announcement on its Quantitative Easing (QE) asset purchase program from shortly after the OECD CLI release last Thursday. For more on the “non-taper” nature of the ECB’s QE adjustment, see Monday’s post.

Yet what we know for sure is that even prior to the Trump administration plans the overall global economic outlook was improving. In fact, the latest OECD CLI release goes back to even before the US election. That is because (as we always explain) the OECD CLI is a six month forward view, yet with a two month delay to ensure the veracity of the data used for this insightful assessment. As such, it nets out to a four month forward view.

And in this case that means this was actually the six month forward view from early October… well before the US election. At times we mark-up this release to highlight certain factors. However, in this case outside of the weakness in Italy it is all positive. It is especially important that the key indication for the US was also turning up even prior to the election.

This goes back to how ironic it is that Hillary Clinton lost the election in part because people were so disappointed with the US economic weakness, even though it was already improving prior to the election. See our November 30^th Politics: Irony of Ironies post for much more on this, and how it was the exact inverse of how husband Bill managed to defeat George H.W. Bush back in 1992.

Even for Europe

We have made much of how the difference between a still stagnating Europe that lacks the sort of structural reform the US is about to achieve will drive many asset classes activity. The most obvious is the significant strength of the US dollar versus the euro that will be based to some degree on the foreign direct investment (FDI) appeal of the US, and not just the short-term interest rate differential on which many analysts focus. There is also the obvious upside leadership of the US economy that drives equities differentials.

Yet even in Europe there is some constructive news beyond the headline economic data. That is the very recent determination of the European Banking Association (EBA) that European Union banks will need to raise quite a bit less capital to meet its reserve capital standards. According to Wednesday’s Financial Times article on the subject (our marked-up version), “The amount of loss absorbing capital banks must raise to comply with the 2022 EU rules is now pitched at between €66.6bn and €298.1bn… In July, the range was given at €130bn to €790bn.”

Are they kidding? At the high end they slashed the estimated capital raise requirement by 62%, with the low end possibly being as low as €66.6 billion? This is in some small part due to capital already raised. Yet it is a boon to the struggling European banking sector. Maybe not on the order of the US Financial Accounting Standards Board ruling that US banks did not need to mark-to-market any of the illiquid toxic MBS (Mortgage Backed Securities) at the depth of the crisis in April 2009. Yet a boon to the struggling European economy, thus bolstering a key area outside the US as well as what we expect here.

The Fed

After criticizing the Fed for what we saw in the extremely bland assessment of what to look for in the US economy, it is only fair to revisit just what it said. We are skipping the content of Chair Yellen’s press conference, as this mostly defended what was only a very modest further improvement in the US economy. That is compared to our (and quite a few other analysts’) view that any significant implementation of the Trump administration plans by a compliant US Congress will foster a dramatically better US economy.

And in that regard we can review the FOMC statement its very ‘stuck’astic tendencies. It is quite a bit of what has actually become boilerplate expression of the FOMC mandate on employment and inflation. That includes the typical commitment on the assessment of “a wide range of information” both domestic and international.

Great. Yet the glaring deficiency in this is the degree to which it leaves the Fed ‘data dependent’ instead forward looking. And in our experience the changes can come very quickly once there is a return to real ‘normal’ during an economic upswing. Once the various factors (see Monday’s post) reinforce each other, employment and wages along with real ‘demand pull’ inflation (versus the Fed’s attempts at over the past several years at phony ‘monetary inflation’) can rapidly create an inflationary spiral.

Yet looking at Wednesday’s revised FOMC Projections there is little sign they are anticipating much further strength in the US economy into even 2018. That is in spite of the major structural reforms that almost assured during the early phase of the Trump administration. A brief glance at the first page of the projections shows US GDP growth slipping back to 2.0% in 2018 from 2.1% in 2017. It is also very interesting that the Fed still feels the longer run tendency is going to be 1.8% growth. This is a clear sign of how much the ostensibly very smart folks at the Fed are now fully invested in the ‘new normal’ that is about to be left in the dust of a major bout of US structural reform.  

This is where Summers’ thesis on the negative impact of all that ‘stochastic armor’ comes back into play. In addition to the dispersion graphs on page 2 reflecting stagnant GDP and inflation, the ‘dot plot’ on page 3 shows the federal funds rate still into 1.5% through 2017.

Just as the Fed appeared so far out in front of a still stagnant economic situation from mid-2015 into 2016 due to its emotional investment in its forecasts (highlighted by the December 2015 expectation of four rate hikes in 2016), it now seems it could be significantly behind a useful forward view. That would incorporate what the likely US structural reforms might mean for the US GDP, employment and inflation.

Even allowing the Fed might be attempting to tread constructively lightly on a US economy that is coming out of the most stagnant recovery on record, the likely improvements should at least be acknowledged as a potential accelerant. The broad indication that the FOMC is still going to watch a broad range of factors hardly suffices to show some insight into the fact that conditions will be changing significantly into 2017.

As Summers so presciently noted 25 years ago on an issue that has left the reputation of the economics profession in tatters over the past several decades, “…progress is unlikely as long as macroeconomists require the armor of a stochastic pseudo-world before doing battle with evidence from the real one.”

That tendency toward not being able to understand the empirical evidence outside of sometimes misguided econometric models was apparent in Greenspan not sanctioning the banks for the creation of MBS with toxic components; and in Bernanke not appreciating that a ‘bubble’ mentality was becoming ingrained when the US equities exceeded the 200 highs in late 2006. Once again we note that there does not seem to be much crisis potential at present. Yet the inability of the Fed (and most other central banks) to appreciate the empirical evidence remains troubling on the most recent Fed assessment and the lack of any anticipatory view of future conditions.

Markets

Yet as noted since Wednesday’s FOMC announcement, projections release and press conference, this is likely as good for US equities as it is negative for US govvies. Insofar as it encourages more US economic and equities strength than if the Fed were being more aggressively hawkish once again, it is likely also constructive for the US dollar even up at its current elevated levels.

So much of interest has transpired over the past week or so that we are offering this brief update as a temporary assessment while we await further developments today prior to updating the full Market Observations after today’s US Close for the weekend.

EQUITIES

▪ The December S&P 500 future push above the 2,180 area also finally overran the late-August 2,191.50 all-time lead S&P 500 future trading high three weeks ago.  The expiration of the December contract Thursday means it is important to consider the March S&P 500 future against the weekly front month levels.

Due to the recent more aggressive increases in weekly MA-41 (as it loses old low end Closes from the sharp early year selloff) extended weekly Oscillator levels now move up roughly $7 each week.  That nearest threshold last week was 2,213-18. Once that was overrun the only surprise in the December contract pushing up to the next threshold at 2,238-43 was how quickly that transpired. It speaks of strong momentum.

The Oscillator escalation into this week shifts that area up to the 2,245-50 range the December contract Closed above last Friday. As such, it is important that the March S&P 500 future is holding it out of Wednesday’s selloff into this morning. At least for now it is also holding the upward Oscillator shift to 2,252-57 next week.

Even if it should fail, the lower Oscillator threshold is up into the 2,225-20 area. Yet if the March contract holds into the weekend, then a swing up to higher Oscillator resistance that moves up to 2,287 into next week remains likely.

GOVVIES

▪ In the govvies the December T-note future below violated 128-00 support had also been ranging below next support in the 126-00 area with 124-00 next. Yet the Fed’s nominally stronger outlook accompanied by what were still subdued interest rate hike projections into 2017 (i.e. only up to 3 from 2 previous) was toxic for the govvies. It is important to revisit the historic tendency for the Fed to be led by the long-dated fixed income trend rather than lead it.  

Once the December T-note future violated 124-00 area as well the front month expiration will also play a role here. The March T-note future takes over after the December contract expiration next Tuesday. It is trading at more typical three-quarters of a point discount (24/32nds) to the December contract than the premium in the March Bund future prior to last week’s December contract expiration.

So the December T-note future below 124-00 leaves the March contract ranging down into the mid 122-00 area prior to the recovery to 123-00 area at present. That will become more critical into next Tuesday, as the far more major critical congestion from late-2013 into early-2014 (post Fed ‘taper tantrum’) in the 123-00/122-24 range. Next major supports below that are not until the 120-00 and 118-00/117-22 areas.

▪ Even the previously deferred failure of European govvies had finally dropped below key supports. That includes the December Gilt future failure back below its pre-Brexit low-124.00 resistance prior to the recent stabilization around that area, with next levels around 122.00. While the Gilt future expiration is always very late in the month, from around the time of the US T-note future expiration it is important to focus on the second month Gilt due to all of the liquidity moving over to that contract.

With the March Gilt future typically trading at almost a full point discount to the December contract, it will be very important to see if it can recover to also stabilize back up in the 124.00 area, or becomes more likely to weaken down to the 122.00 area. That is especially so with all of the recent rally highs of the March contract stalling into no better than the 124.00 area. Next lower support below 122.00 is not until the 120.00-119.00 range.

▪ Only the more resilient December Bund future had recovered well back above 160.50-.00 without ever remotely nearing next support into the 158.00 area. This all fits in the each economy’s growth prospects. For anyone involved in the Bund it was also important to refer to our extended analysis in the previous Market Observations for the implications of the premium March Bund Future pricing as we headed into its typical early quarterly expiration last Thursday (December 8^th… right into the ECB press conference.)

That meant that in spite of the short sharp ECB reduced asset purchase shock last week Thursday, it only dropped back for a quick test of that 160.50-.00 front month support prior to recovering above it once again. That has seen it recover back above the 161.50 interim congestion, even if there is more formidable resistance into the 163.20-164.00 area. All of this reflects the individual country reform and attendant economic growth prospects.

FOREIGN EXCHANGE

▪ Last but not least, foreign exchange saw the predictable further strength of the US Dollar Index after it finally overran the .9860 resistance in early November. That has seen it ratchet up above the more major 1.0000-1.0050 old highs of the rally from March and December of 2015 prior to its recent setback into that area as support. It was not much of a surprise that once the ECB signaled its continued accommodation last Thursday it recovered from that area.

While next resistances are up into the 1.04-1.05 range (with more major resistance up around the 1.10 area last seen in 2002), the weak sister EUR/USD had to be watched closely. While it has failed both 1.1000-1.0950 and 1.0850-00 supports, the post FOMC meeting failure below recent and extended historic 1.0500-1.0450 support are real support for the near term trend of the US Dollar Index as well. Also note that while there is interim support in the 1.0300 area, the major support is not until the broad berth down into the 1.0000-.9800 range that has not been retested since the way up in 2002.

▪ The other extremely weak currency is the Japanese yen, as reflected in the USD/JPY immediately remaining bid above 105.00 since the post-US election Wednesday afternoon. It subsequently duly pushed above the mid-July 107.50 trading high by the end of the US election week. That left it ready to challenge 110.00-109.50 historic congestion it has now overrun along with the more recent 111.00 congestion from back in February and March.

Of course, we need to allow that the yen is also a ‘haven’ currency, and there seems quite a bit less need for that in the wake of the current US equities rally. As noted previous, much above 111.00 there was not much until the mid-114.00 area it stalled against initially but then overran. That said, the far more major resistance remains the 116.00 area major congestion along with the February long term channel DOWN Break, with the major (all-2015) 118.00 congestion as a buffer above that which has stalled it for now.

Extended Trend Assessment is available below.

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