With many once again believing that a rate hike is just around the corner (as has been the case for the past 2 years... the same with expectations that NFPs will finally push higher any month now), here is a reminder of what happened the last time there was a concerted effort by the Fed to contract liquidity. And this is just hiking rates. Never before has the US stock market had to ween itself off $125 billion in QE-related monthly liquidity. All in all, no matter how long Bernanke tries to delay the end of QE2, the outcome will become a self-fulfilling prophecy which will slam stocks, and by the Chairman's definition, the economy, making a QE3 episode inevitable (not to mention the $2 trillion in debt each year that has to be monetized). We are on the same side of the Peter Shiff bet who has given Steve Liesman 5 to 1 odds for $10,000 that QE3 is imminent.
A Strong US Economy
February 10, 2011
By John R. Taylor, Jr. Chief Investment Officer
When it comes to the US economic outlook, we seem to be among the most pessimistic out there as our more optimistic view sees a staircase decline, with the picture deteriorating each quarter: 4%, 3%, 2%, and 1%. We are feeling a bit sheepish as last summer we had called for the economy to go into recession during this quarter. Although that was before Jackson Hole and the deal that Obama crafted with the Republicans in December, we didn't envision those further stimuli and we should have. Somewhat stubbornly, we still see these fiscal and monetary boosts losing their power as the first half comes to an end and doubt that the US consumer, capital spending or trade can pick up where Washington lets off. Those who told us that one should never bet against the US consumer have been right so far; and as credit card debt expanded in December for the first time in two years, we can see they could be right all year. The credit market seems to be sensing the same thing as it is now projecting the first Fed hike in December, with the second one next March. Our credit market cycles call for yields to rise for another few weeks and possibly into late April. If long-rates really move up, the date of the first Fed hike could get much closer.
But what happens if the Fed hikes rates? Even with a tiny hike, the good times are over. Higher short- term rates do not mean that the economy turns down — in fact, it could have a positive impact — but it will mightily disrupt the credit markets and asset markets. Just look at what happened in February 1994, when the Fed first hiked rates after the 1991 recession, several years after the economy was back on its feet. It's hard to remember how scared the US authorities were when faced with the saving and loan crises and with the lack of economic response when they dropped overnight funds from over 9% to 3%. With rates at these rock bottom levels, the Asian tigers roared and Eastern Europe and Russia were given the breathing space to become capitalist economies. This was a thrilling time to own emerging market equities, but this was not true after February 1994— and they did not bottom until the 2001 to 2003 period. Although we think of the 1990's as great equity years, stocks were down almost everywhere and in some cases dramatically in the 6 to 9 months after the February surprise. The government bond market was a total shambles and portfolios suffered their worst year since Volker had taken control in 1979. Currencies went every which-way, but those that had a need for offshore capital were crushed as inflows quickly became outflows. Several weeks after the rate hike Mexico began its slide into the currency collapse in December, and the old Communist countries saw their currencies go into a long decline, which in some cases culminated in the 1998 crisis. With the sharp reversal in liquidity, 1994 burst a lot of hopeful balloons and was a terrible year for asset managers.
With average developed market overnight rates significantly below the 1% level, a Fed hike would be a splash of very cold water, much colder than that of 17 years ago. The results should be more dramatic now. It seems clear that all equity markets in all countries will be moving lower, with those in the emerging countries faring the worst. Government markets should be moving lower, but it looks to us as though they are already anticipating this move so the shock should be much less here than in the equity markets. Countries with current account problems could be the biggest currency losers: Turkey, Australia, New Zealand, South Africa, and (of course) the US, come to mind. Last time around Mexico was the biggest loser, but Turkey dropped in half in two months. Despite all this market activity, if things are the same, it will have minimal impact on the real economy. Wall Street will be punished and the US heartland will cheer. The political fallout should be interesting.