In 66 trading days on September 17, 2015, the Federal Reserve will, according to Bank of America, hike rates for the first time since 2006, which according to BofA will "end the era of excess liquidity."
We disagree entirely, but let's hear what BofA's Michael Hartnett has to say:
On September 17th the Fed will hike the Fed funds rate by 25bps according to Ethan Harris & our US economics team, the first hike since June 2006.
Recent US economic data support this view, in particular the solid May payroll & retail sales reports. Note that after a Q1 wobble, one of our favorite cyclical indicators, US small business confidence, has also bounced back into expansionary territory. Ethan Harris forecasts 3.4% US GDP growth in Q2, after 0.2% in Q1, and US rates strategist Priya Misra forecasts a Fed funds rate of 0.5% by year-end, and 1.5% by end-2016. Like Ethan & Priya, the futures market also looks for a modest Fed tightening cycle: Eurodollar futures contracts are currently pricing in 3-month rates in the US rising from 0.01% today to 0.65% by year-end, and to 1.54% by end-2016.
Yes, the US economy is so strong the Bureau of Economic Analysis has to fabricate double seasonal adjustments to goalseek GDP data that is non-compliant with the narrative. As for economists being wrong about a rate hike, or overestimating future US growth, let's just say it won't be the first time they are wrong...
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Still, one thing BofA is right about: this time the normalization process will be different.
Past Fed performance is no guide to future performance
Gradual or otherwise, the first interest rate hike by the Fed since June 2006 marks a major inflection point for financial markets. Three reasons suggest that the impact of higher Fed rates will be far less predictable than normal, that historical comparisons may be less powerful, and that volatility across both credit & equity markets should continue to be owned.
Actually, the main reason is one, and it is very simple. It is shown in the chart below.
Here are some other reasons why the Fed's rate hike will lead to a period of, to put it mildly, volatility which "will mark the beginning of the end of massive monetary easing and a collapse of interest rates to effectively zero across the globe, and follows a humungous bull market in both equities and credit in the past 6 years:"
- Central banks now own over $22 trillion of financial assets, a figure that exceeds the annual GDP of US & Japan
- Central banks have cut interest rates 577 times since Lehman, a rate cut once every three 3 trading days
- Central bank financial repression created $6 trillion of negatively-yielding global government bonds earlier this year
- 45% of all government bonds in the world currently yield <1% (that’s $17.4 trillion of bond issues outstanding)
- US corporate high grade bond issuance as a % of GDP has doubled to almost 30% since the introduction of ZIRP
- US small cap 5-year rolling returns hit 30-year highs (28%) in recent quarters
- The US equity bull market is now in the 3rd longest ever
- 83% of global equity markets are currently supported by zero rate policies
Put simply, central bank's provision of liquidity for financial markets has been unprecedented. The extent of Wall Street addiction to liquidity is about to be revealed and the potential for unintended consequences is clearly high.
Which is not to say that attempts to "renormalize" rates are unheard of: previously both Israel and the RBNZ tried it and failed, with markets promptly forcing them to reverse tightening.
More notably, it was the ECB itself which in April of 2011 [28] under Jean-Claude Trichet tried to halt Chinese inflation exports in their tracks, and pulled off one rate hike... before the wheels came off from under Europe and the continent promptly entered a double dip recession, leading not only to a return to ZIRP, and the replacement of Trichet with an Italian Goldman Sachs apparatchik, but ultimately pushed Europe into its first ever NIRP episode.
But no episode is more notable than what happened in the US in 1937, smack in the middle of the Great Depression. This is the only time in US history which is analogous to what the Fed will attempt to do, and not only because short rates collapsed to zero between 1929-36 but because the Fed’s balance sheet jumped from 5% to 20% of GDP to offset the Great Depression.
Just like now.
And then, briefly, the economy started to improve superficially, just like now, and as a result the Fed tightened in a series of three steps between Aug’36 & May’37, doubling reserve requirements from $3bn to $6bn, causing 3-month rates to jump from 0.1% in Dec’36 to 0.7% in April’37.
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Here is a detailed narrative of precisely what happened from a recent Bridgewater note:
The first tightening in August 1936 did not hurt stock prices or the economy, as is typical.
The tightening of monetary policy was intensified by currency devaluations by France and Switzerland, which chose not to move in lock-step with the US tightening. The demand for dollars increased. By late 1936, the President and other policy makers became increasingly concerned by gold inflows (which allowed faster money and credit growth).
The economy remained strong going into early 1937. The stock market was still rising, industrial production remained strong, and inflation had ticked up to around 5%. The second tightening came in March of 1937 and the third one came in May. While neither the Fed nor the Treasury anticipated that the increase in required reserves combined with the sterilization program would push rates higher, the tighter money and reduced liquidity led to a sell-off in bonds, a rise in the short rate, and a sell-off in stocks. Following the second increase in reserves in March 1937, both the short-term rate and the bond yield spiked.
Stocks also fell that month nearly 10%. They bottomed a year later, in March of 1938, declining more than 50%!
Or, as Bank of America summarizes it: "The Fed exit strategy completely failed as the money supply immediately contracted; Fed tightening in H1’37 was followed in H2’37 by a severe recession and a 49% collapse in the Dow Jones."
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As can be seen on the above, in 1938, the stock market began to recover some. However, despite the easing stocks didn't fully regain their 1937 highs until the end of the war nearly a decade later.
Wait, the Fed hiked only to easy? That's right: in response to the second increase in reserves that March, Treasury Secretary Morgenthau was furious and argued that the Fed should offset the "panic" through open market operations to make net purchases of bonds. Also known now as QE. He ordered the Treasury into the market to purchase bonds itself.
Fed Chairman Eccles pushed back on Morgenthau urging him to balance the budget and raise tax rates to begin to retire debt.
How quaint: once upon a time the US actually had an independent Fed, not working on behalf of the banks, and pushing back on pressure to monetize debt and raise stock prices.
Those days are long gone.
So is the imminent rate hike which guarantees the ghost of 1937 is about to wake up and lead to stock losses which could make the Lehman crash seem like a dress rehearsal just the precursor to QE4, as happened nearly 80 years ago? We don't know, but neither does the manager of the world's biggest hedge fund. This is what Ray Dalio says ahead of the upcoming rate hike:
... in our opinion, inadequate attention is being paid to the risks of a downturn in which central bankers' abilities to ease are significantly impaired. Please understand that we are not sure of anything but, for the reasons explained, we do not want to have any concentrated bets, especially at this time.
We don't know either, but we do know that if the S&P is cut in half the Fed will launch not just QE4, but 5, 6 and so on, resulting in every other central bank doing the same as global currency war goes nuclear, and the race to the final currency collapse enters its final lap.
