Via Scotiabank's Guy Haselmann,
If I had to simplistically decipher the Fed’s (often mutating) communication, I suspect that the FOMC is trying to convince markets that it is looking at a multitude of factors and will act accordingly when they deem it necessary. I suspect its efforts to discuss various contingencies are attempts to convince markets that it is flexible and open-minded in a highly uncertain world. Theoretically, such a position makes sense.
However, it may not be this simple. After decades of providing stimulus for every ebb in economic activity and without withdrawing it sufficiently enough, the stair-step downward path has basically emptied the ammunition cupboard. Rates are not just at zero, but the Fed’s balance sheet now hoards around 45% of the entire secondary market float of Treasuries longer than 10-years. Consequently, the balance sheet has probably reached its practical limit. (QE4 – nope.)
Many have recently drifted toward believing the Fed will be ‘lower for longer’. My view is that the Fed will be ‘sooner, but slower’. In other words, I expect the Fed to hike in March or sooner, but then run into problems that will slow the pace (and make it difficult to get to 1% by the end of 2015).
It is too bad that the Fed is just ending QE now, because it should actually be hiking.
The case is compelling. Economic performance has been decent. Q3 GDP is likely to print above 3% next week. Many other economic indicators have been strong in recent months. The unemployment rate is 5.9%. Claims are the lowest in over a decade. Market interest rates are low. The S&P 500 is only about 3% off its all-time high. Inflation has been stable. Oil has fallen 25% since July.
Moreover, today’s equity market ‘melt-up’ should be a warning sign to the Fed of the moral hazard, one-way, bubble-like conditions it has instigated.
I warned an equity market ‘melt-up’ might be the necessary warning sign that ultimately extracts the FOMC from its overly-aggressive accommodative stance. Moreover, I outlined in my “Cold Turkey” note from 10/15/2014 [7], the numerous reasons why current Fed policies have been or have become counter-productive.
Domestic factors supporting an early hike are all aligned. While international factors are more troubling, those countries are taking their own action to confront their own domestic challenges. Other geo-political uncertainties surrounding Ebola, the Middle East turmoil, or terrorism always exist, so they cannot be weighed too heavily.
By waiting until March or later, the Fed could miss its ideal window of opportunity to hike, because concerns today could easily morph into full-blown global crises next year.
In the meantime, ‘lower for longer’ hopes have propelled markets into a state of melt-up euphoria. I suspect that this perception will be reversed at next week’s FOMC meeting, when forward guidance –i.e., the words “considerable time” - are removed from the statement; and as acknowledgments of the improving state of the economy are added.
It was not a change to the domestic economic landscape that triggered the shift in Fed expectations to ‘lower for longer’. The main factor was last week’s violent ‘risk-off’ trade which was triggered by a leap in uncertainties due to fears of Ebola and the potential for a renewed Eurozone crisis. It was also due to portfolio P&L and margin call problems resulting from enormous volatility in currency and commodity prices (particularly in oil).
One consequence was a flight into the safety of Treasuries. Those fears have since partially receded (for the moment). However, the rise in uncertainties led the market to price-out several Fed hikes that were expected in 2015. One lesson is that in a highly uncertain and quickly changing world, and fragile economic environments, it is too dangerous to price-in too many hikes too soon. Yet, it may also be unwise to completely price-out all hikes before June 2015 and then use that pricing to justify a shift in FOMC expectations.
As such, I recommend investors replace ‘lower for longer’ with “sooner but slower”.
I still maintain my view that (commodity-like) long-dated Treasuries will move to lower yields over time (for the reasons outlined so frequently in earlier notes).
- Tactically, however, there will be times when legging into a curve flattening trade makes sense to protect the core long against a re-pricing event; e.g., the employment report, a FOMC meeting or an early hike (or next week’s GDP). After the event passes, I would cover the front end short and resume with the long-only position until the other reasons I’ve outlined in earlier notes play out. (I might even be right for different reasons, but so far so good.)
“Now everything’s a little upside down, as a matter of fact the wheels have stopped, what’s good is bad, what’s bad is good, you’ll find out when you reach the top, you’re on the bottom.” – Bob Dylan
