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.
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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."
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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.
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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).