2017/09/20 Commentary: Fear of Fed
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Commentary: Wednesday, September 20, 2017
Fear of Fed
Yep, ‘Fed dread’ is back. And we are not talking about Janet Yellen deciding to go for a fashion change and switch her hairstyle to dreadlocks. Various market tendencies outside of a continual storm reconstruction driven bid in US equities (see Thursday, August 31st Commentary: When It Rains… and last Thursday’s Commentary: Storm Surge! posts for much more on that) reflect some concerns about the potential for the FOMC to tighten in a way that will weigh on the govvies and also affect foreign exchange. The latter has seen a modest recovery in the US Dollar Index from the violation of it major 2.5 year trading low at 91.91 on the Close two weeks ago. And concern about the FOMC’s next moves is likely behind those two market tendencies.
Yet as explored in our Thursday, July 27th Commentary: Balance Sheet Chicanery post, the latitude is narrow for the Fed to move in any meaningful way on its two primary fronts: further base rate increases (almost nonexistent at present), and balance sheet reduction that is the primary bogey man worrying the markets right now. While the latter is the more likely to possibly be definitively outlined and then discussed at today’s press conference, on all recent assessments by Fed governors and outside analysts it will be so incremental as to be more psychological than quantitatively critical.
This is also the same as noted in our Commentary: Balance Sheet Chicanery post, and we will be revisiting the reasons behind no likelihood of a rate hike and why the balance sheet reduction is psychological. Yet, let’s give due respect to that psychological component, as the govvies are prone to reacting to future influences as well as current conditions. Consider the major drubbing the US T-notes experienced after both Fed Chair Bernanke’s QE ‘taper’ comments in May 2013, and the hit they took after the last US election even though they managed to rally back in each case (much more below.)
However, prior to delving into all of that, this morning saw the release and presentation of the OECD’s latest Interim Economic Outlook. It seems to confirm that a general global growth cycle is indeed in progress in the short term. Yet it also points out the ways in which the medium term is less assured. The lack of global investment, rising trade barriers, a lack of higher wages typically accompanying a sustained recovery (also important for the Fed), need for further systemic reforms and other key factors might still restrain the recovery. That remains a key focus for the Fed as well.
Authorized Silver and Sterling Subscribers click ‘Read more…’ (below) to access the balance of the opening discussion. Non-subscribers click the top menu Subscription Echelons & Fees tab to review your options. Authorized Gold and Platinum Subscribers click ‘Read more…’ (below) to also access the Extended Trend Assessment as well.
NOTE: REVISED 2017-08-31: Like many others, we were encouraged by the likelihood the US economy would get the structural reform we (along with Mario Draghi and others) had been loudly complaining was not forthcoming since our dual It’s Lack of Reform, Stupid posts in January 2015. Since our December 8, 2015 Extended Perspective Commentary we were concerned about various factors that included continued high taxes and more regulation (i.e. under Clinton) that might have meant a continued weak, or even weaker, US economy. It was hoped Donald Trump’s election would change that. However, much like the estimable Ray Dalio (see our August 24th Commentary: Trump Troika post) and others, we are now very concerned that the US President’s diminished relationship with the Republican Congress will mean his tax reform and infrastructure spending agenda will have trouble getting passed into law. And that will quite possibly be a problem for any US economic acceleration, and high-priced US equities.
▪ And this is why it is likely premature for the Fed to get too aggressive with any removal of accommodation at this juncture. However, it is still possible, and even likely, there will be some aggressive future growth, inflation and interest rate increases in the revised projections from some of the more hawkish Fed governors today. This is why we are actually more interested in the Fed staff’s predictions that the governors.
Getting back to the now highly anticipated adjustment of the Fed’s Brobdingnagian balance sheet, we say highly anticipated after the Fed failed to be more explicit in the Wednesday July 26th statement only release. What was clear was that it was ostensibly tough talk on the balance sheet reduction rather than any further serial future interest rate hikes at this time… and for good reason. Yet the same reasons Janet Yellen had to reverse rate hike expectations in her previous Congressional testimony applies to the balance sheet reduction plans as well.
A review of that previous FOMC statement (our mildly marked up version) illustrates how the Fed has become not just ‘data dependent’… it is overtly data sensitive in a way that is almost unseemly. Yellen’s reversal of hawkish sentiment was reversed once again in the statement’s more upbeat minor change. As noted in our annotation, the first was the shift to “have been solid” from “moderated” in the June statement.
Data Still Not Great
One good US Employment report and the Fed is back to stronger language on the strength there, which flies in the face of more recent indications. On the employment front, the Nonfarm Payrolls numbers remain passably good; not great, but good. However, the seeming improvement to 0.3% monthly Hourly Earnings in the August Employment report was revised right back down to 0.1% in the September release; back at the same levels that were so disappointing back in 2015 and 2016.
And more some important recent economic releases have also been disappointing, like last Friday’s abysmal US Retail Sales (kind of works with those weaker Hourly Earnings) and Industrial Production and Capacity Utilization. While there have been other data points which were more upbeat, the net perspective must remain cautionary.
Inflation Still Not Strong
That is why the balance sheet reduction will be marginal enough to be more so symbolic than real in terms of its effect on bond market yields. That is especially so if indeed as we and others expect, the inflation pressures will not be very strong in spite of US and global employment gains. For much more on all of that please see our Thursday July 20th Commentary: ‘Normalization Bias’ NOT Back Redux post and the previous (post-Yellen testimony) Commentary: ‘Normalization Bias’ NOT Back!! post.
We encourage anyone who has not reviewed those posts and especially the very informative access to estimable outside sources to still do so. It’s very good insight on ECB psychology as well as the Fed. While those have now consistently reiterated their confidence in a global recovery, the actual pace and sustainability of that recovery in light of the OECD Interim Economic Outlook (see above) is still an issue the central banks cannot ignore.
Especially the Thursday July 20th post final opening section comments and link out to the assessment from Fulcrum Asset Management’s estimable Chairman Gavyn Davies in last Thursday’s ‘Normalization Bias’ NOT Back Redux post is telling. Along with other analysts’ critiques in the previous posts of why central banks reliance on seemingly defunct ‘Phillips curve’ relationships between employment and inflation is a real failure, he also offers a more recently developed alternative.
It is compelling on why some other central banks have had to remain very dovish, and even the Fed has had to so quickly truncate its plans for the significant further rate increases. That was signaled as recently as its June 13-14 statement, projections and press conference.
Balance Sheet ‘Chicanery’ Remains
Accusing the Fed of ‘chicanery’ regarding its looming balance sheet reduction program might seem a bit strong. Yet consider that it means (according to the Oxford English Dictionary), “The use of deception or subterfuge to achieve one's purpose.” And in this case it is as we noted at the outset of this post that the Fed is still trying to make the case that US employment is so strong that it needs to tighten.
Even as more and more observers allow that the old ‘Phillips curve’ employment-inflation relationships are so obviously breaking down, the Fed seems to be engaging in another form of its same old ‘normalization bias’ from back in 2015 and early 2016. Except now it is with ostensibly tough talk on the balance sheet reduction as a form of tightening rather than serial future interest rate hikes. That is even though the pace of those balance sheet reductions will be limited enough to raise a question over whether they will affect the bond markets enough to accomplish the Fed’s ends in other areas.
That is the problems further short-term rate increases represent for a yield curve that already remains too flat for many folks. And that means especially the major banks that are relying on an at least reasonably positive yield curve to ensure that their major balance sheets can earn a ‘risk-free’ return.
Bond Market Pricing
Going back to our observations from the July 27th Commentary: Balance Sheet Chicanery post, we know that most of our readers absolutely, positively do not need schooling in bond market pricing and yields… so treat this as a brief reminder. The degree to which bonds (especially govvies that have virtually zero default risk) price at a premium to inflation in most cases provides the ‘real yield’ (i.e. after any erosion of the bond earnings from inflation are factored into the real return.)
And to revisit one of the most extreme historic cases, this was most prominent into the early 1980’s when inflation fears were still very high and so were government (and all other) bond yields in deference to that. Adding to the pressure on prices (and upward pressure on yields) were the huge US government deficit financing needs that led to record government bond auction volumes.
Yet from approximately 1984 onward especially into 1986 those massive US T-bond and T-note auctions were very well received. While the anticipation and event of the auctions might have caused some downward pressure on the bond prices, they seemed to almost miraculously recover after each auction was complete. And in spite of the continued sizable auctions, from May 1985 into April 1986 the 30-year US Treasury Bond yield imploded from around 10.5% to 7.5%!!
Inflation Was, and Remains, the Key
What in the world had transpired to create such confidence in lower inflation that implied a still acceptable ‘real yield’ at such significantly lower nominal bond yields (and massively higher prices)? It was that phase’s implosion of sustained high Crude Oil prices. As the previous high oil prices had fostered major over-production, prices dropped sharply.
After the first OPEC oil embargo in 1973 West Texas Intermediate Crude Oil went from $20.00 per barrel to $117.00 in July 1980. After holding up at no worse than $60.00 per barrel into November 1985, by February 1986 it had dropped to roughly $30.00 per barrel. And the sustained lower inflation assumptions from an area that had massively contributed to the 1970’s ‘stagflation’ in the developed economies were enough to drop bond yields in the manner noted above.
If the already still large US government debt auctions could handle the load of the massive offerings back then, why would anyone consider that there would be real sustained pressure on govvies now? The nominal amounts the Fed balance sheet reduction will be adding to total supply is not likely to create any sustained bond market weakness unless inflation starts picking up more dramatically… in which case the bond markets would have suffered even without the Fed balance sheet reduction.
‘Normalization Bias’ Still Here
This gets us back to our assumptions on the Fed’s balance sheet reduction being more chicanery; a psychological move to appear to be removing accommodation more so than real tightening. It allows it to take a misguided nominal stance against the inflation pressures that leave it wanting to tighten without upsetting some positive aspects of the strengthening US economy; which would be the case if it were to continue raising short term interest rates.
And the nature of the problem is just what the Fed had seen in 2015 and early 2016 on any threat to raise or actual hiking of short-term rates. Those had the potential slow a US economy which it must have sensed was growing slower than it would like to have imagined in its ‘normalization bias’ tainted view. Otherwise why would it have signaled the potential for rate hikes so many times only to demure at the actual FOMC meetings?
This lack of stronger US growth, accelerated employment gains and sustained higher inflation also allowed the longer term bonds to rally (i.e. long-term yields weaken) right into the Fed’s threats to hike during that period. Also note that longer-term yields remaining low at present in spite of the recent nominal ‘Fed dread’ uptick is still part of the Fed’s problem on…
It’s the Yield Curve, Stupid!
…the still rather flat ‘yield curve’. Also going back to our observations from the July 27th Commentary: Balance Sheet Chicanery post, that is a real problem for the Fed, which extends to being a problem for banks that are pressuring it to allow the yield curve to widen. As such, it is as much the Fed’s respect for that as the sense that too many further short-term rate increases (i.e. the ‘federal funds’ rate that it directly controls) may weaken the economy.
Of course, any weakening of the US economy will also exacerbate the situation by further weakening the inflation that is remaining more subdued than the Fed would like; and well below its 2.00% Personal Consumption Expenditure target. (As is the case for other central banks, as extensively reviewed in the previous posts noted above.)
So as much as the Fed is respectful of the degree to which the US economy and inflation are not strong enough to absorb the sort of rate increases suggested at June’s FOMC meeting, it also cannot afford to flatten the yield curve with more short term rate hikes. Especially if there were any concerns about US growth that rallied the govvies (i.e. lower long term yields) into higher short term yields, that would be a problem.
Many folks have felt for some time that the lack of any real ‘risk free’ yield classically associated with government bond investment is a problem. That is true for both the average investor and major entities like insurance companies, which have longer term obligations which increase at a pace faster than the recent and current paltry bond yields.
Key Constituents
Yet focusing on one of the key central bank constituents (true globally and not just in the US), the banks benefit from a positive yield curve. Historically one of the ways that the Fed and other central banks assisted the return to economic growth out of recessions was to allow the banks (especially the major banks) to ‘regrow’ their balance sheets. That was accomplished by the banks holding reserves garnered at low short term yields, and investing them at the higher long-term ‘risk free’ government bond interest rates.
And that has become even more important after the 2008-2009 Crisis, due to especially the major banks being required to hold much larger percentage reserves against the loan books and other businesses. Especially due to all of the other pressures from post-Crisis prosecution of major banks for misdeeds during the 2005-2008 Credit and Housing Boom, the banks were holding additional reserves as a buffer against any regulatory fines.
This created some of the relatively largest major bank balance sheets in the history of finance. The individual who articulated the best path for the banks due to higher statutory reserve requirements that had to be augmented with additional protection against any regulatory fines for previous (perceived or real) misdeeds was JPMorgan-Chase Chairman and CEO Jamie Dimon. In the company’s 2015 annual report he described the policy his team had instituted as a “fortress balance sheet.” He went on to describe that as…
“…enhanced capital and liquidity, our ability to survive extreme stress of multiple types, our extensive de-risking and simplification of the business, and the building of fortress controls in meeting far more stringent regulatory standards.” Rightful and well said.
What is the importance of that for the current ‘yield curve’ discussion? Simply that the recently higher short term rates are running up against limits at which they are potentially a drag on the banks that the Fed would like to see lend more. The Fed needs to allow banks to earn a better return on their balance sheets to help them prosper… and lend.
“More Symbolic Than Real”
This is why the Fed shifting over to balance sheet reduction from short-term interest rate hikes is less of an elective move than a requirement of the situation. The Fed’s short-term rate hike program has simply ‘run out of road’ in the context of yield curve implications.
For a very well-informed view on that we turn to Mr. Bill Gross originally of PIMCO fame and now with Janus Henderson. In a very pointed CNBC interview after the Wednesday July 26th FOMC statement Gross notes that the pace of the Fed’s balance sheet reduction “…is akin to something like watching paint dry.” That is the observation at the beginning of the video clip, and he even notes that this is the same sentiment he has heard directly from some Fed officials. And today’s FOMC statement and projections and Chair Yellen’s press conference are the first opportunity to review that at length once again.
Gross goes on to note some of the same things we have been signaling regarding the Fed’s shift, especially that it wants to appear to be tightening, yet cannot afford any further short-term rate hikes at this time. We also encourage you to watch the relatively concise interview for the specifics of the potential actions under the balance sheet reduction program as signaled so far. Gross notes that this will only amount to approximately 1.0% to 2.0% annually of the Fed’s balance sheet.
That fits right into the degree to which it is (as he notes) “…more symbolic than real.” And the same is true for its likely lack of impact on longer term bond yields. As noted above, those will substantially be set at a differential to underlying inflation (that ‘real yield’ again) more so than the sheer amounts of debt securities on offer at any given point; except as a very short term influence.
As a final point on that, it was very interesting that during the Fed’s massive Quantitative Easing purchases of US treasuries and other securities the bonds tended to rally on the announcement of the next round of Fed purchases. And the rallies mostly continued right into the actual purchase program commencement, only to sell off after that. The strength of the equities on the continued Fed liquidity infusions was enough to ‘spook’ the bond markets once the purchases actually began.
In those cases the additional massive Fed buying did not have much impact on a bond market beginning to worry about inflation. So why should the bond market be concerned about the nominal Fed fixed income supply provision to the markets, except as a short term psychological drag that will be better assessed in the context of what transpires with inflation across time.
Govvies Now Critical
Last Thursday’s macro Commentary: Storm Surge! post explores the reasons the govvies are predictably backing off from recent highs in the wake of last Tuesday’s Brexit-related stronger UK inflation numbers and other strong data since then. That included other stronger than expected international economic data (especially inflation numbers) and UK employment figures as well. The key now may be whether the December T-note future (front month after today’s September contract expiration) can hold the 126-00/125-24 support, or needs to drop to lower supports. That should also be important for the Gilt and Bund that have also weakened to near their next support areas.
▪ The Extended Trend Assessment with full Market Observations that were going to be updated after Thursday’s US Close would not have been sufficient. That is due to both the US Dollar Index and especially the govvies moving back into more telling technical trend conditions, which required a further Thursday evening Commentary: Fear of Fed Redux post to cover those changes instead of just the next update of the Market Observations.
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