"The Gig Is Up"

Via Scotiabank's Guy Haselmann,

In a switch from what are typically only one-sidedly dovish comments, NY Fed President Dudley was balanced this week, even citing reasons for why the Fed would want to hike rates.

Dudley stated that “being at the zero-lower-bound is not a very comfortable place to be”, because it “limits” flexibility and has “consequences for the economy”. He said it “hurts savers”, and while acknowledging “what is happening” to financial markets, he avoided directly citing risks to financial stability.  Anxiety-riddled conversations about financial instability are probably implicitly restricted to a ‘behind-closed-doors-only’ rule.

FOMC members are slowly and carefully trying to change the conversation.  Yellen completely diluted away any meaning behind “considerable period” to make it all but meaningless.  Bullard said to that he still “sees the first tightening at the end of the first quarter”.

A March 18th hike seems reasonable to me, since US economic improvement appears to remain on track (at least for the moment) and since the FOMC seems more anxious to begin the normalization process.  Actually though, by waiting even until March, it is possible that the FOMC risks missing its window of opportunity in terms of using US economic momentum as its cover (what irony).

Financial markets are becoming agitated and disturbed by shifting government and central bank policies, mounting geo-political tensions, and rising nationalist fervor.  QE has not yet ended and the Fed is likely still months away from hiking for the first time, but markets are using these factors to adjust portfolio exposures.  These are hints that a larger market reaction is likely to unfold as the Fed’s policy transition approaches. 

Macro signs are currently evident with steep commodity price declines, rising FX volatility, rallying global bond markets (long end), and sagging prices for low quality credits.  Some investors are clearly getting out of the Fed-generated “herd” trades of recent years and saying that they are doing so because "the Fed’s balance sheet is set to stop expanding next month".

The strengthening dollar is one consequence and it has already had an impact on commodities and Emerging Markets.  In turn, weakening currencies in EM countries are starting to trigger capital outflows. It may lead toward domestic central bank hikes (again) which weaken those economies and cause second-order effects.

The prolonged period of zero rates has enabled many EM-based corporations to issue debt in USD, so a weakening currency raises their liabilities and lowers the value of their assets.  Such a dynamic was a source of past crises.

Any anti-globalization actions, such as protectionism, will further act as global economic headwinds. Nationalistic momentum could become disruptive via social unrest or via surprises in the voting booth.  Extreme nationalist parties continue to gain in popularity in numerous European countries. Religious, ethnic and tribal conflicts are spilling across borders.  Putin’s annexation of Crimea was a bold nationalistic action that hid behind a veil of protecting Russian speakers.  China, Japan and India all have new nationalistic leaders who use patriotic jargon to spur structural and economic reform.

For investors, Fed stimulus has trumped all other factors.  It has lowered risk premia and inflated asset prices.  The gig is soon up, but investors have yet to adequately adjust. Unfortunately, they will attempt to do so with significantly compromised market liquidity.  The path to normalization is made even more challenging, because Japan and Europe are in recession, and China is slowing.

Note: Pentagon comments this week about foiling an “imminent attack” was negative for risk assets as were Treasury Department efforts to clampdown on “inversion”.

I maintain that one of the best places to hide remains in 30-year Treasury bonds.

“No one told you when to run, you missed the starting gun.”  - Pink Floyd