Two weeks ago, Citigroup presented what it thinks is the biggest nightmare for the Fed: it said that the FOMC’s "biggest worry is not lift off and its market and economic implications, but what happens if the economic recovery dies of old age without the Fed having done anything to tighten." And, according to Citi's FX strategists, "if this were to occur, the USD would probably fall faster than it rose from July-March." A precursor to loss of faith in the Dollar's reserve currency status perhaps.
Today, Citi's Steven Englander lays out what is the Fed's second biggest nightmare: a rebound which is so fast, the Fed's entire carefully planned renormalization schedule collapses.
Some further details:
Based on current trends we will be at zero unemployment before we are at 2% inflation (Figure 1). This is unlikely, even if you are a dedicated trend follower, so we have to decide which trend will bend first. It’s tempting to say that the unemployment trend will bend first because going to zero unemployment is a bit like breaking the speed of light. Paraphrasing Herbert Stein, if two trends are incompatible, they will collide, it will turn. However, it is quite plausible that unemployment is will keep on trend long enough for inflation to turn up. Moreover, given the strong employment bounceback that so far is not matched on the demand side, we could get a third quarter in a row of negative productivity and stunning unit labor cost numbers. This note examines the implications for asset markets and the USD of the Fed getting to its inflation targets quicker than the trends in Figure 1 and money market pricing would suggest.
We argue that the Fed's second biggest nightmare is discovering that they have hit both employment and inflation targets quicker than the market now prices in. The implication would be that they would have to get to neutral policy rates faster than they or the market now expect. That would be disruptive to asset markets, leading to much higher volatility and very likely to lower returns. It would also concern the Fed since it is much harder to calibrate an abrupt move in policy rates than the slow and gentle that they hope to achieve.
Today's sudden, jerky moves in the 10Y confirmed just that when the jobs number came in substantially hotter than consensus expected, leading to a dramatic and quite volatile sell off in both bond and equities, even if the initial dump has been stabilized.
So what happens to asset markers in this "nightmare" scenario? This is how Citi views the long-term FX reaction:
A quicker tightening and steeper lift-off is more USD positive in the short term than in the long term. The ‘inflation rises faster than expected’ scenario that we are discussing also means that slack diminishes more rapidly than expected. That gives us the faster path of rate hikes and the stronger USD. We suspect that USD will rise much quicker in the weak potential scenario (once the short-term risk concerns mentioned above) subside. So little inflation is expected that the flat line trend in Figure 1 is probably not very far off expectations for core inflation. Any pickup in inflation will come as a major surprise and as a jolt to the very flat pace of hikes that is expected.
But we suspect the USD cycle will be curtailed as soon as it becomes clear that rates will peak sooner and lower. However, if we are eliminating slack because potential growth is slower, then the terminal policy rate will likely be lower as well, reflecting lower returns to capital. This is shown schematically in Figure 5. The light blue line shows a hypothetical policy path when potential growth is low. The policy path is steeper because there is less slack at each moment in time, but it tops off at a lower level because slower potential growth is likely to mean a lower equilibrium rate. We are assuming similar paths of demand growth in both scenarios so the narrowing output gap reflects diminished potential rather than weak demand. Once the Fed indicates that it thinks it has tightened enough to prevent inflation from rising or the economy shows clear signs of slowing, we think USD selling pressures will quickly emerge.
Both the Fed and foreign investors will worry that the room for easing via conventional rate reductions is limited and that the zero bound will be rapidly hit on any slowdown. Once additional probability weight is added to dealing with the zero bound, the set of asset market moves associated with QE and liquidity additions becomes operational. So we could transition rapidly from a conventional rate normalizing Fed hiking cycle to concerns about hitting the zero bound again.
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The conclusion:
In an ideal world, as we approach full employment and full capacity, the pace of growth would slow so that capacity does not keep tightening once we hit full capacity. If you wanted the economy to ‘run hot’ you would aim for output stabilizing slightly above full capacity, so that there is gentle upward pressure on inflation. You would not want to be moving even further beyond full capacity because that would add to inflationary pressures that would increase the degree of subsequent tightening.
So any indication of a pickup in core inflation would be viewed by FX investors as solidifying and steepening the rates path, which would feed into USD strength. If the equilibrium policy rate moved up in consequence, that would add to USD pressure. The realization that the economy is running hot could lead to a reassessment of how much stimulus was actually in place. Nevertheless, it is sufficient that the market accelerates its expectations of rate hikes for the USD to spike up.
And while all of the above makes sense, there is a far bigger problem: if and when the market realizes that the Fed has overshot its mandate, what happens then will be the most epic, one-way and illiquid dumping of bonds ever. This is how another Citi strategist, Matt King, saw that particular event taking place [12]:
Central bank distortions have forced investors into positions they would not have held otherwise, and forced them to be the ‘same way round’ to a much greater extent than previously. The post-crisis increase in correlations, which has been visible both within credit and equities and across asset classes (Figure 35), stems directly from the fact that investors now increasingly find themselves focused on the same thing: central bank liquidity. Every so often, when they start to doubt their convictions, they find that the clearing price for risk as they try to reverse positions is nowhere near where they’d expected.
This explains why the air pockets have not just been in markets where the street acts as a warehouser of risk. It explains why they have occurred not only in the form of sell-offs which could have caused multiple market participants to suffer from procyclical capital squeezes. It also explains why the catalysts have often, while often trivially small, have nevertheless been macro in nature, since they have boosted expectations of a change in central banks’ support for markets.
Unfortunately, it leads to a rather ominous conclusion. The bouts of illiquidity will continue until central banks stop distorting markets. If anything, they seem likely to intensify: unless fundamentals move so as to justify current valuations, when central banks move towards the exit, investors will too.
Rather than dismissing recent episodes as relatively harmless, then, we are supposed to worry how much larger a move could occur in response to a more obvious stimulus. While financial sector leverage has fallen, debt across the nonfinancial sectors of almost every economy remains close to record highs, meaning that the potential for negative wealth effects in the real economy is very much there.
In principle, markets could gap to a point where they went from being absurdly expensive to being absurdly cheap, and then – as investors stepped in again – gap tighter, perhaps even without very much trading. But the existence of the feedback loop to the real economy means that the fundamentals tend also to be affected by extreme market moves: “cheap” may be a moving target. This in turn could force central banks to step back in again.
To sum up, we are left with a paradox. Markets are liquid when they work both ways. Market participants, though, find themselves increasingly needing to move the same way. This is not only because of procyclical regulation; it is also because central banks have become a far larger driver of markets than was true in the past. The more liquidity the central banks add, the more they disrupt the natural heterogeneity of the market. On the way in, it has mostly proved possible to accommodate this, as investors have moved gradually, and their purchases have been offset by new issuance. The way out may not prove so easy; indeed, we are not sure there is any way out at all.
"No way out at all" indeed, which is why yesterday we also wished the Fed, which is now completely trapped, the best of luck with the whole exit thing [12].
