This page has been archived and commenting is disabled.
The Fed Is Trapped: The Naked Emperor's New "Reaction Function"
When China transitioned to a new currency regime last month, what should have been immediately apparent to everyone, was that the Fed was, from there on out, cornered. Boxed in. Trapped. Screwed.
We reiterated this earlier today as the market still seems to be quite confused as to what exactly happened that caused Janet Yellen to resort to what many thought was the most unlikely option going into this week's meeting: the "dovish hold", or, as Deutsche Bank recently called it, the "clean relent."
What follows is a recap of just how we got to this point or, in other words, an explanation of how the FOMC missed its opportunity and became trapped in the wake of China's move to devalue the yuan. Following the recap, we present excerpts from Citi's take on the Fed's "new reaction function. For those familiar with the backstory and/or who have a good grasp on why it is that the Fed went the route they did, feel free to skip straight to the section from Citi and the subsequent discussion.
* * *
How did we get here?
Despite all the ballyhooing about moving to a more market-based exchange rate, the PBoC actually did the opposite on August 11. As BNP’s Mole Hau put it "whereas the daily fix was previously used to fix the spot rate, the PBoC now seemingly fixes the spot rate to determine the daily fix, [thus] the role of the market in determining the exchange rate has, if anything, been reduced in the short term." Obviously, a reduced role for the market, means a greater role for the PBoC, and that of course means intervention via FX reserve drawdowns (i.e. the liquidation of US paper). Of course no one believed that China’s deval was “one and done” which meant that the pressure on the yuan increased and before you knew it, the PBoC was intervening all over the place. By mid-September, PBoC intervention had cost some $150 billion between onshore spot interventions and offshore spot and forward meddling. The problem - as everyone began to pick up on some 10 months after we announced the death of the petrodollar - is that when EMs start liquidating their reserves, it works at cross purposes with DM QE. That is, it offsets it. Once this became suddenly apparent to everyone at the end of last month, market participants simultaneously realized - to their collective horror - that the long-running slump in commodity prices and attendant pressure on commodity currencies as well as the defense of various dollar pegs meant that, as Deutsche Bank put it, the great EM reserve accumulation had actually begun to reverse itself months ago. China’s entry into the global currency wars merely kicked it into overdrive.
What the above implies is that the Fed, were it to have hiked on Thursday, would have been tightening into a market where the liquidation of USD assets by foreign central banks was already sapping global liquidity and exerting a tightening effect of its own. In other words, the FOMC would have been tightening into a tightening.
But that’s not all. When China devalued the yuan it also confirmed what the EM world had long suspected but what EM currencies, equities, and bonds had only partially priced in. Namely that China’s economy was crashing. For quite a while, the fact that Beijing hadn’t devalued even as the yuan’s dollar peg caused the RMB’s REER to appreciate by 14% in just 12 months, was viewed by some as a sign that things in China might not be all that bad. After all, if a country with an export-driven economy can withstand a double-digit currency appreciation without a competitive devaluation even as the global currency wars are being fought all around it, then the situation can’t be too dire. Put simply, the devaluation on August 11 shattered that theory and reports that China is “secretly” targeting a much larger devaluation in order to boost export growth haven’t helped. For emerging markets, this realization was devastating. Depressed demand from China had already led to a tremendous amount of pain across emerging economies and the message the devaluation sent was that China’s economy wasn’t set to rebound any time soon, meaning global demand and trade will likely remain subdued, as will commodity prices.
That was the backdrop facing the Fed going into September’s meeting. Put simply, if the Fed hiked to maintain some semblance of credibility and to prove that it isn’t outright lying about being “data dependent” , it would have risked accelerating EM capital outflows, which would in turn prompt further FX reserve drawdowns and serve to amplify the effect of “liftoff”, in the process turning what should have been a merely “symbolic” move into something far more dangerous. Once that dynamic tipped the EM world into crisis, it would be only a matter of time before the Fed was forced to reverse course and, ultimately, to launch QE4 to offset the tightening of global liquidity it had unleashed by failing to realize that in a world operating under a massive, coordinated easing effort, the smallest policy “error” reverberates exponentially.
And then there was of course China's epic stock market meltdown which triggered a modern day Black Monday across global equity markets.
As if that wasn’t enough to think about going into this week’s meeting, the FOMC had also to consider whether not hiking would also have the effect of accelerating EM capital outflows and triggering the very same chain of events described above. The argument for that eventuality is simply that the Fed missed its window to hike and now, the market gets more nervous and more uncertain with each passing Fed meeting and so by failing once again to rip off the band-aid, the Fed has ensured that capital will continue to flow out of EMs as the market continues to anticipate what it assumes is inevitable but which, for all the reasons laid out above, may actually be impossible. As Vanguard’s senior economist Roger Aliaga-Diaz put it: "We are concerned with the Fed's acknowledgement of recent market volatility in its decision. The Fed runs the risk of being held captive to the markets as, paradoxically, much of that volatility is due to the anticipation and uncertainty around when the Fed will move."
Of course not everyone understand or took the time to consider all of this going into Thursday which is why some were confused about why it is that concerns centered around the global economy and global financial markets were sufficient to override employment gains when it came time for the Fed to make a decision. For those who are still confused, or who seek confirmation of the narrative laid out above and on numerous occasions in these pages over the past three weeks, consider the following from Citi who is out with a fresh look at the Fed’s “new reaction function."
* * *
From Citi
The Federal Open Market Committee (FOMC) decision to stay pat reveals a new monetary policy rule in place—one that amplifies the importance of international and financial market developments.
We did not believe the FOMC would take such a limited risk scenario involving China, which is not part of their baseline outlook, and delay a rate increase that arguably is warranted by domestic conditions. Indeed, we have noted that the last time international economic and market developments stopped the Fed from raising rates was in 1997-1998 when LTCM, Russia, and the Asian crisis caused disorderly markets that were global and systemic. Current volatility conditions are not at all similar to those of 1998.
The new FOMC reaction function—one that assigns greater importance to global and international financial market developments—will require some time to assess and understand.
Now what? China's growth uncertainty will not diminish quickly and the EM fallout will take time to assess. The Chinese authorities have no track record of successfully dealing with such a structural slowdown, nor a track record of not exacerbating such a well-anticipated economic weakness. Also, excess supply conditions in commodity markets depressing EM growth and US inflation likely will not dissipate quickly.
The September FOMC meeting was a real "bunker buster" insofar as it has challenged our understanding of Federal Reserve policymaking and the inputs that matter most. There is little evidence that an emerging markets-led global slowdown would be able to generate sufficient drag to warrant delaying normalization, unless it were severe and engaged the advanced economies as well. However, this risk alone should not have delayed normalization.
In light of the new Fed behavior, we tentatively have revised our forecast for the next interest rate increase to be sometime in the spring of 2016 (Figure 1). This delay would be required for market participants and the Fed to gather sufficient information to reduce the uncertainty surrounding the global growth outlook and to ease financial conditions. We believe that a gradual rate increase implied by such a cautious policy posture would bring the federal funds rate to 1 percent by end-2016, 1.5 percent by end-2017, and 2.25 percent by end-2018.
* * *
There are a few things to note here.
Citi seems to have not taken seriously the idea that a Fed hike would almost certainly serve to push EM over the edge. That is, when they say that "there is little evidence that an emerging markets-led global slowdown would be able to generate sufficient drag to warrant delaying normalization, unless it were severe and engaged the advanced economies as well," they seem to be ignoring the fact that hiking would have made just the type of slowdown they're talking about a virtual certainty which would have then fed back into DMs causing the Fed to immediately reverse course.
Second, the Fed isn't operating in a vacuum and as such, it should come as no surprise that developments in China played a prominent role in the FOMC's decision making. That said, Citi is probably correct to say that considering Beijing's track record of late, waiting on China to stabilize before hiking may be a fool's errand. Similarly, the fact that, as Citi says, "excess supply conditions in commodity markets depressing EM growth and US inflation likely will not dissipate quickly," means justifying a hike could be difficult for the foreseeable future.
The implications from all of this are that the world will now plunge further into the monetary Twilight Zone. That is, with the Fed on hold, the ECB may be forced to cut further, which, as we discussed on Thursday evening, means the Riksbank, and then the SNB will need to follow suit, diving further into NIRP as everyone scrambles to ensure that a foreign central bank's double-down-dovishness doesn't jeopardize their own domestic inflation targets.
Needless to say, the takeaway here is that the emperors (all of them) have no clothes and this is a never ending race to the NIRP bottom. For those interested in a preview of what comes next, see here (or ask Blythe Masters).
»
- 25583 reads
- Printer-friendly version
- Send to friend
- advertisements -
sooner or later you run out of other people's credit.
Fed isn't trapped. We are.
The Fed's been trapped for the last 30 years. It built the trap, got in, dragged us in and closed the door.
They will all get horribly drunk this weekend, suffer an incredible hangover and come to work Monday morning to do the same illogically stupid shit they have been doing for years .....because they know nothing else.
The world has made a mission, a life's calling, of taking each opportunity of choice to make the absolutely WORSE choice possible. We now find ourselves with few if any choices...all bad. So now we should fully expect absolutely nothing to change. There is no place to go, no alternatives for securing your wealth or even lively hood. Like a lifetime of overeating, smoking and drugging,the inevitable outcome is upon us. Choices matter little if at all.
"How did we get here?"
Once upon a time about 350 years ago, there was a man named Bauer who lived in Germany. He was a goldsmith who lent money to the government. He quickly realized that he could lend out far more gold certificates than he had gold in reserve, so he began the usurious journey which has led to the present financial catastrophe. He had five sons who he sent out across Europe to infect other nations with the fractional reserve fiat scam which proved so lucrative to his family and close friends. Suffice it to say, this plague finally arrived on the shores of America in 1913 (actually 1910 - Jeckyll Island) and metastasized itself onto this unfortunate host in the form of the Federal Reserve System.
Now it is up to the citizens of this country - and others around the world - to extract this cancer from our collective bodies.
it looks like ayn rand but without the brains.
The Fed IS the trap.
Allowing the global money supply to be created out of thin air as interest sucking debt by private individuals has got to be the stupidest thing we ever did as a species.
Other than electing (or alternatively not killing) the whore leaders owned by these same private bankers who illegally imposed this system upon us that is...
Here's the Official Bank of England video explaining the modern money creation process in the first 2 minutes. And NO Nobel prize winning economist Paul Krugman (you complete idiot) it does NOT come from a banks existing DEPOSITS...
https://www.youtube.com/watch?v=CvRAqR2pAgw
Or just read about it at the Bank yourself!
http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/...
Fed is also trapped you cant taper a ponzi scheme
Just remember...the Fed people get inflation protected pensions....and healthcare...as they promote inflation for others...
Trapped my arse...this is wealth transfer by design.
Conscious, intentional, purposeful theft by the tribe.
Grannie will figger it out, if not her then that Fischer arsehole.
GOY LIVES MATTER
"GOY LIVES MATTER"
Not if you have carefully read the Old Testament they don't. Rabbi Ovadia Yosef lays it all out for you...
“Goyim were born only to serve us. Without that, they have no place in the world – only to serve the People of Israel. That is why gentiles were created.”
http://failedmessiah.typepad.com/failed_messiahcom/2010/10/gentiles-exis...
Just in case you think this guy is a complete nut... think again. Vice President Joe Biden is one of his greatest admirers...
http://www.slate.com/articles/news_and_politics/fighting_words/2010/11/i...
The solution to the current problem is for all Muslims to renounce Mohammed and all Christians to renounce Jesus and everyone (almost) to thus becomes Jews. Then we can all go back to the good old days of owning slaves, selling our children and get back to the hard work of killing or enslaving the rest of the planets remaining 3.5 billion inhabitants to the glory of Yahweh just as the good book commanded.
Unless anyone can think of something better that is...
As Reagan said "There you go Again" when times get tough be sure to blame the Jews because you were not smart enough to compete with them for a job or to create the internet messaging that you are using the Salk vaccine that saved your kids and the Eienteinian theory of E=MC2 etc. that forms the basis of most science today. The number of medical patents that Israel and the Jewish people file everyday with only 15 million people worlwide exceeds the entire Middle East by a factor of 10x while they have 250 million people. Throughout history and from its inception by the Swedish government the Jewish people have earned 30% of all Noble Prizes in Chenistry and Physics and a slightly smaller number in the Humanities. Did I forget that the Manhatan project during world war 2 run by Jews saved the lives of hundreds of thousands Of American swervicemen mostly "Goy" GI's who would have had to invade Japan after suffering 6 million deaths at the hands of the Nazis. In our spare time we provided you with Jesus to keep you busy. Oh one more thing you will never be a Jew we screen out morons.
I'm not blaming "The Jews". Personally I agree that they are disproportionately the smartest and hardest working (or if they are really smart not hard working) people in the world as a direct result of their culture/religion. It's the rest of us that are the idiots.
In summation we should all become Jews was what I was saying. All religious biases would simply end that way. Besides... Jews would never put up with the kind of shit that the rest of the planet is putting up with. ;)
If I was forced to join one of these primative bronze age / iron age or medieval religions I would pick Judaism.
The person you should really be having a word with is that rabbi... but I see he's already dead.
The Jews as a group are to be commended for their disproportionate contributions to mathematics and science, but that still doesn't excuse the evil that some Jews are doing today and have done in the past.
And the Jews didn't give us Christ even though he was of the tribe of Judah He was conceived by God.
John 8
'They [the Jews who didn't believe him] answered and said to Him, “Abraham is our father.”
Jesus said to them, “If you were Abraham’s children, you would do the works of Abraham. But now you seek to kill Me, a Man who has told you the truth which I heard from God. Abraham did not do this. You do the deeds of your father [the devil].”'
Well, that explains a few things actually
That is one sharp blade for that hog head.
Privately owned US Federal Reserve Stockholders are now 90% focused on Politics and Growth of US Based/Anglo Banks.
- TBTJ became 30% Bigger after the Corporate Bailout for Crony Corporation and Accounting Control Fraud.
- How do you address Political Organization, force them to Change, force them to Reorganize??
- A Putsch, US Congress would have to Retake the Organization, it's Buildings, it's Equipment, it's Personnel, and it's Data and computer records... once a military style control has been achieved... Nationalization would have to be done immediately... at this point you can control the Budget... and you can fire all people and put in your own experts, Lawyers, Bankers, and Auditors
You lost me when you said the US Congress would ride in as a white night.
Well, then just forget everything I said and say nothing to no one!
"- How do you address Political Organization, force them to Change, force them to Reorganize??"
Before we can think about doing anything, who is able to pension off those 'bought n paid for' mouhtpieces in both houses of congress and the WH ?
All of them are bankrolled by the banksters. Where do you think their loyalties lay ?
The banksters who fund their re-election campaigns or the idiots who vote them into office ?
"now what" is what it has always been: print or die
Virgin Mary says major downturn to happen NEXT WEEK, while Pope is in US:
www.locutions.org
God is watching, and speaking, and helping.
'When the people find that they can vote themselves money that will herald the end of the republic.' - Ben Franklin
'When the Banks find that they can buy themselves all the money, that will herald the end of the currency, the beginning of full-on totalitarianism and a war waged against the people' - Sgt Shaftoe (There, fixed it.)
You know what, fucking day traders and speculators aside, all this uncertainty sure makes it easy to come up with draft budgets and otherwise plan for the future.
Hey Janet, you dumb, vapid twat - uncertainty is entropy - entropy costs you time and money.
Raise rates by .25 and say you'll keep them there for a year, then look at another .25 for 6 months, then another .25.
This day to day week to week volatility, all the fuckery with these markets - its all horseshit. No price is reasonably related to actual value.
A big part of that is the same fucking commodity can be 25% more in 3 days. I know 'why' but 'why' is this good for productive labor?
People trying to make a quick buck - god bless ya, but fuck you, you aren't making things better. You're fucking it up for people who like to see around the next bend.
All I can guarantee is more US deficit spending and needless wars and interventions. and a debt that will never be paid, the trick will be to see what .gov gives away, of "ours" in order to satisfy the handful of large holders of that debt.
How's late october for the start of a war, boys?
People will be tired of talking about it by 2 weeks before Xmas.
Ask a hoarder if they have ever got rid of anything.
The FED turned the 1% into uncontrollable hoarders of wealth. Sure they always were greedy, but since 2009 they have entered into the final stage of hoarding where they have endangered themselves and everyone around them.
They have sucked up everything and not allowed anyone else to share. It isna terminal sickness.
Some of them have hoarded real estate, paying any price for it, but nobody is living in the homes. Like a hoarder buying 25k tubes of toothpaste and for some reason keeps buying every tube they see. There is no way they can ever use a tenth of what they bought, and now nobody else can find toothpaste. They ask the hoarder to share, or even to sell, but the hoarder won't. Saying, "It's mine and I need it."
QE is buying ten gallons of milk because it was on sale when you can only drink two by the time it spoils.
Hey now, don't diss all hoarders. I'm a hoarder extraordinaire, and I LOVE to share my things with people who I know appreciate them. (This also 'frees up' space for more stuff, conveniently.)
It's a dynamic hoard, as opposed to the more common static hoard you usually see...
Also, no junk mail or pizza boxes, this is an upscale hoard. The 'sickness' is that there's just so goddamned MUCH of it at any given time...
But if I know someone really likes a thing, and it's not one of my faves, I LOVE presenting it to them as a gift, it makes me feel good. And since I accumulate quite a lot of stuff, I know I'll replace it with similar or better soon, so there's no danger of depleting the inventory any time in my lifetime. If I had as much cash as I have stuff, I'd hand that out just as easily.
These rich guys are more like the TV hoarders, with the piles of rotting crap and the remains of old family pets behind the refrigerator...the ones who lose it and start crying and digging things back out of the truck during the clean up. It may be great wealth, but they treat it just like the tv hoarders do.
I just wanted to clear that up, as there IS a significant group of hoarders who would NEVER act like that, like me. I hoard because I like and want to have these things...they hoard because they don't want anyone else to have it.
Though I'm sure there are a few big money hoarders who enjoy sharing their wealth and don't have the sick compulsion to keep anyone else from getting it. They're just like me, they like getting and having AND giving, and don't get all grabby and go 'Donald Duck' on it..."Mine! Mine! MINE!"
Sorry...I'm just starting to get a complex because of that goddamned tv show.
the criminal class represents the "owner"
class with varying degrees of psychometric
and psychotronic bullshit covering a fundamental
fraud. there is nothing new under the sun, man.
layers and layers of fractal carbon based fibers,
steaming in decomposition. hit the hay, what do you say?
.
NRBQ at the Paradise '82- #9- "Hit the Hay"
https://www.youtube.com/watch?v=m5GT_cCe_rI
im sick of seing this ugly jew-snout
if you put puppets in charge of fed anyway you could at least decide for some 21 years old beauty
Just observe how T-Mobile is going to provide Canada and Mexico mobile service. Verizon is targeting Cuba. Many other examples.
Trans-Pacific Partnership (TPP) | United States Trade ...
Nothing new here under the sun: Feb 23rd 2011 – Charles Hugh Smith – Trapped: The Fed Has Painted Itself Into a Corner
http://www.dailyfinance.com/2011/02/23/trapped-the-fed-has-painted-itsel...
The Fed just lost their only chance at their so-called "data dependent" flag allowing a rate hike. Future US data will not even allow them that excuse.
China will continue to experience an accelerating domestic slowdown with the tide flowing out revealing a far higher higher degree of non-performing debt than currently admitted in their massively over-touted "Great Red Capitalism" corrupt, state owned enterprise laden, centrally planned, ghost city building, bridge to nowhere malinvestment fest since 2007, all of that possibly leading to a crisis event in what they far too generously call their "banking system."
From this, EMs will continue to experience accelerating FX and commodity price crisis because of China and the slowing to stall speed or worse of the DM economies.
In other words, there will be no opportunities for perhaps years to come for the Fed to raise rates without making these things even worse. There will either be a slow but very deep decline worldwide over a period of years or, far more preferable, a fast, deep decline triggered at some point by some unknown event as the Lehman Bros. event did in 2008 which will allow a much faster recovery.
there is no unit of measure or price discovery
of any value so the entire regime can do
exactly what? think profanities and all those
terms associated with decomposition and compost.
can you smell it? what do you actually detect
with that olfactory sense; the gasses released
by bacteria decomposing and digesting, no? there
something to evaluate, digestion and decomposition.
I hope the headline is not referring to the current head of the Federal Reserve.
If so, please pass the mind's-eye-bleach.
NRBQ at the Paradise '82- #10- "Shake, Rattle and Roll"\
https://www.youtube.com/watch?v=Uodmt0gZyPk
.
"you don't do nothin' to save your doggone
soul." ...
Nice one, blindman. Great track!
somehow, your comment means the world
to me, thanks.
p
NRBQ's Terry Adams and Steve Ferguson perform Smackin' the Blues and Dutchess County Jail
https://www.youtube.com/watch?v=u-aM7Sgll9I
The Fed became banker to the world when they extended billions if not trillions in dollar facility swap lines to foreign banks during the 2008 fiasco. This just makes it official.
https://www.youtube.com/watch?v=n0NYBTkE1yQ
If you remember the movie, Old Yeller went rabid and had to be put down.
I will repeat: Fed policy will not change no matter how much 'conditions improve'. Fed policy will change only in reaction to the next crises, whenever and however that appears. We are expecting an S&P range of 1000-1500 before Fed policy changes.
We believe that a gradual rate increase implied by such a cautious policy posture would bring the federal funds rate to 1 percent by end-2016
Oh Citibank... You sweet liars.
We do not want to see Janet Yellen naked.
I would rather see a market meltdown rather than see that witch naked!
There is a rumour going round, that the Fed WILL raise rates in Decemberuary 2061.
Prepare yourselves for the imminent rate hike.
Yellen ?----Naked??---things are getting really ugly
According to Bank of America Merrill Lynch:
https://app.box.com/s/2x1jqc1901tv8v00mbqnqjfbu8rrqzzp
The HY Note
Global growth concerns spread from us to Fed
A slow moving train wreck
Today’s Fed decision was the second worst outcome for risk markets, in our view. We have written on numerous occasions that if the Fed didn’t hike rates today initially markets would rally modestly before selling off. The realization that global growth concerns are not only real, but very dangerous right now should cause a risk off environment. And with no room to cut rates, we question the Fed’s ability to manage any further slowdown through what would have to be QE4. However, we can’t see how additional quantitative easing will help, as the goals of QE have already played out: the banking system has recovered, rates are low, investors have driven debt issuance and asset prices to uncomfortable levels, and the housing market has recovered enough to not be a concern.
Furthermore, lower rates don’t help high yield at this point. Whether the 10y is at 2.20% or 2.0%, does the asset class really look all that more compelling? Not in the slightest. In fact, outside of hiking while sounding very hawkish, not hiking and sounding very dovish while expressing concern about the global economy may be the worst thing that could have happened today.
We have been saying for months that the global economy is weak and the Fed’s dovish disposition today only bolsters our view. Europe is about to enter QE2 as inflation and growth remains poor. Japan and Brazil were just downgraded. Commodities remain under pressure and we think, at some point, the narrative could turn from a supply driven story to a demand driven one. Domestically it becomes harder to argue that a strong dollar and the lack of inflation can be viewed as transitory and this headwind is continuing to hurt high yield corporates. Manufacturing is uneven, consumer spending hasn’t improved in a year, and 2014 real median income was down 6.5% versus 8 years ago (and down 7.2% from the 1999 level). Although auto sales remain strong, we would expect as much given low gas prices, an aging fleet and the fact that auto loans are one of the few places in the economy where it’s easy to obtain credit.
Additionally, high yield corporate earnings remain incredibly weak, with yoy earnings growth negative for the first time since the recession (even ex: commodities EBITDA growth is only slightly positive). Leverage is at all-time highs (again, even ex- commodities) and the High Yield index is more globally exposed than it has ever been (35% of the market generates 45% of its revenue from outside of the United States, and that doesn’t include Energy, which is globally exposed despite not realizing significant direct sales abroad).
Not only are earnings weak, but there has been next to no capex investment, debt issuance has been massive, and buybacks and dividends have driven equity valuations as CEOs and CFOs, afraid to invest in organic growth, have chosen to buy growth instead. And as a result, recovery rates are 10-15ppt below historical norms and defaults and downgrades are creeping into the market. Although we understand many will say its just commodities, is it really? What started as coal weakness 18 months ago became coal and energy weakness. But it wasn’t really just the commodity sectors, as retail was also already weak. Now it’s the commodity sectors, retail and wireline (but definitely not all of telecom). The situation almost seems unbelieveable, as everything that seems to go wrong is explained as being isolated (AMD, well, of course semiconductors are in a secular decline) and treated as a surprise (Sprint).
In our view, the makings are there for a risk off environment for some time to come. For non-commodity spreads to be 400bp tighter than in 2011 makes little sense to us. Replace Greece for a much bigger problem: China. Replace Washington dysfunction and debt downgrade with uncertainty about monetary policy and EM weakness (though we may see Washington dysfunction very soon between this fall’s budget talks and the presidential race looming). Replace US QE with European QE. Additionally, replace strong earnings growth and margin expansion in 2011 with no earnings growth, a stronger dollar, and higher leverage today. Replace decent liquidity back then with poor liquidity now. And replace the fears of a double dip recession with the potential for fears of a global recession. Though this last point has yet to play out, we think it’s only a matter of time before investors begin to feel as bearish as we do.
The Fed had an opportunity today to hike rates and begin to build a cushion should the global slowdown be so severe it can’t be ignored. Instead, they chose to wait. In our view, this has left them in a predicament as now the rumbles of never being able to increase rates will become even more exaggerated, and when they ultimately do, we think it will be more painful than if they had gone today. We expect as a consequence for there to be more market volatility, more uncertainty around the Fed’s motives and belief in the economy, and therefore more downside risk. Most importantly, however, the acknowledgment of weakness only bolsters our view that we are in the midst of the beginning of the end of this credit cycle, and we warn investors to tread carefully not try to be a hero into year end.
Now is the time that investors need to be managing risk rather than looking for alpha. 1 or 2 names will destroy the performance for what has otherwise been a good set of holdings. Remember what many have forgotten over the last 7 years, credit returns are skewed to the downside. The best case scenario is to earn coupon and the ultimate payment of principle. The worst case scenario is 40, 50, 60 or more points of loss.
We’re in the midst of watching a slow-moving train wreck, and in our view the Fed confirmed as much today.
According to VTB Capital:
http://is.gd/ibCddR
The Federal Open Market Committee (FOMC) Is Boxed-in
The Federal Open Market Committee (FOMC) decided to leave monetary policy on hold at the conclusion of its two-day meeting yesterday. Although the fed futures market had only given a 28% probability to a 25bp hike in the target range for the fed funds rate, there was still nervous anticipation over the FOMC’s intentions. In an ‘ideal world’, the FOMC would telegraph its intentions well in advance, make it crystal clear why it was raising interest rates so that when the actual announcement came, markets would react calmly.
That’s the theory. In practice, the FOMC had not communicated its intentions well and, as a result, there was a lot of speculation over whether they would raise rates by 25bp, 12.5bp and economists talking about a ‘hawkish hold’ or ‘dovish hold’ or would the FOMC raise rates just once (‘one and done’) and wrap it all up in a very dovish message that future rate hikes would be very gradual. As a result, investors faced a dizzying set of permutations and combinations with economists almost tying themselves up in knots over a relatively tiny move in the fed funds rate when in the real world, commercial borrowers and households face much higher and quite variable rates of interest.
Our view was that whatever the FOMC decided to do, the ultra-cautious nature of Janet Yellen and most of her colleagues was bound to result in a dovish outcome for financial markets. Markets have become highly dependent on every utterance from Fed officials for the simple reason that the markets have been pumped up by super-accommodative policies which have resulted in excessive risk-taking and high levels of leverage. The markets need the Fed to keep the life-support machine on. US equity market valuations are at historical extremes while corporate earnings and sales growth decline. S&P500 companies are incentivised through the Fed’s cheap money policy to spend its cash mountain on buying back its own stock rather than investing in fixed assets. Markets have become distorted and increasingly dis-connected from economic fundamentals.
Our view that we have articulated in our research through the course of this year is that the Fed has kept interest rates too low for too long. A monetary policy designed for emergency conditions back in 2007-2008 is no longer necessary. It is not as though the US economy is in a depression or that the US banking system is on its knees. “Unconventional” monetary policies are no longer necessary. Indeed, the FOMC’s latest set of economic forecasts upgraded its GDP projections for this year to a central tendency of 2.0-2.3% which actually is the long-term average growth rate of the US economy and lowered its forecast of the US unemployment rate for this year to 5.0% from 5.3%. In the last 50 years, the US unemployment rate has actually been very rarely below the 5.0% level (the 1960s, late 1990s and just prior to the 2007 crisis). The Fed should have started to ‘normalise’ monetary policy a lot earlier in this cycle. Now as the FOMC acknowledged in its statement, “international developments” are a key factor in its thinking.
“International developments” is code for China. The FOMC, by delaying the decision to raise rates and finding every excuse to delay, has now found itself at the mercy of external events. The collapse in the Chinese equity market, the worries about a ‘hard landing’ for the Chinese economy and the ‘mini-devaluation’ of the currency on 11 August are all things the FOMC cannot control. In the past, China did not matter for the Fed’s deliberations. Now China does matter.
A Chinese economic slowdown will affect the global economy and increase the risk of a ‘Made in China’ global recession. In addition, China is exporting deflation as a result of the massive over-investment made in recent years which is now redundant and resulting in the slump in commodity prices. These deflationary pressures affect the global economy and help explain the downward pressure in government bond yields in the major markets.
The twist for the US Treasury market, where China is the largest official holder of US Treasuries, is that the beginnings of a decline in China’s fx reserves is also corresponding to a decline in the holdings of US Treasuries. At the moment this is not necessarily a problem for the US Treasury as the US budget deficit as a percentage of GDP has fallen sharply from a peak of 10% in 2009 to 2.5% currently. If anything it is Chinese deflationary price pressure which is pushing US bond yields lower. So worries of some form of Chinese ‘Quantitative Tightening’ (QT) looks over-stated.
All of this presents a dilemma for the Fed. Having ‘missed the boat’ in normalising monetary policy, the door seems to be closing for future US interest rate increases. In the aftermath of yesterday’s FOMC decision, the fed futures market is giving just an 18% probability to a 25bp rate hike at the 28 October FOMC meeting and a 34% probability to a move at the 16 December meeting. The FOMC itself has lowered by 25bp its projections of the median fed funds rate increase though 2018: the FOMC sees the fed funds rate rising to 3.5%. This seems very over-stated. Global recession risks and a US economic ‘expansion’ that is long in the tooth suggest that the peak in the fed funds rate in this cycle will be a lot lower than 3.5%. In an extreme scenario where a global recession and/or financial crisis rules out interest rate increases completely then we go back to ‘square one’ with the Fed left with no option but to implement ‘QE4-ever’.
Whether more QE is the answer is very debatable as even the research findings of the St Louis Fed questioned the impact of QE on the real economy. At some stage, the channel of a reduction in long-term rates in creating any sort of stimulus must exhaust itself in the same way that at the zero bound in terms of short term official interest rates, the conditions of a liquidity trap exist. In this world, the next suggestion from economic theorists would be ‘helicopter money’ or in the UK, ‘QE for the people’ as advocated by the new Labour leader, Jeremy Corbyn. This is really moving into uncharted and potentially dangerous territory.
In the short term, the FOMC’s decision to do nothing does not remove the endless speculation over their intentions, which, on occasion, spark unnecessary market volatility. Mohamed El-Erian in the FT today warns that the Fed “risks finding itself in a cul de sac that, in itself, would risk transforming it from a volatility suppression machine to being a source of financial and economic instability”. Against a background of still high debt levels in the major economies as well as the massive credit expansion in China, the risk is also that monetary policy becomes ineffective. Central banks would then be in danger of losing credibility as investors wonder what comes next. Global deflation, global recession and a bursting of the credit bubble financed by the Fed’s ultra-easy monetary policy would all be a hard price to pay.