As trained Kremlinologists we were truly baffled by yesterday’s FOMC statement. Yes, we know, they are eager to hike rates at least once, just so they can prove they can still do it, but the comments on the US economy in yesterday’s statement sounded as if the entire committee had just spent the past month in a submarine with a defect radio.
Here is a chart posted by John Hussman in his recent weekly missive, that illustrates US economic activity on the production side, a topic we have recently discussed extensively as well (see: “US Economy – Close to a Bust?” and “More Ominous Data Points” for details).
An amalgamation of incoming data from the Fed’s own district surveys via John Hussman
And just what 'improvement' and 'stability' The Fed sees in any US data is beyond us
As we have pointed out, in terms of total spending and output, the manufacturing sector is the US economy’s largest sector by far (even if it is just 13% of “GDP”). It seems therefore pretty clear that when its most important components are in the kind of free-fall normally seen only in recessions, that something is seriously amiss.
It does not matter what has caused this. It is not somehow made “better” by the fact that the only just beginning bust in the oil patch is one of the main triggers. After all, this is how all economic busts begin: the sector with the largest extent of malinvestment keels over first. Moreover, the fracking boom was the by far greatest contributor to capex and employment during the entire post crisis recovery, so its demise is bound to make waves.
You can compare the once gain relatively terse FOMC statement with the previous one with the help of the WSJ’s trusty FOMC statement tracker. What makes it so funny is that all words of warning or caution are gone – the US economy’s soggy performance is described as “solid”, the troubles in submerging markets, which exercised Mr. Draghi less than a week earlier, no longer even rate a mention. In short, it’s really bizarre.
Interest Rates and the Fed – Feedback Loop Confirmation
Mind, we are not making a comment here on whether or not the Fed should hike rates. We think it shouldn’t even exist, and just as the Fed cannot possibly know what the correct level of interest rates should be, neither can we. However, yesterday’s market reaction once again proved our contention that the markets and the Fed are in an observer-participant feedback loop, and that it is simply not true that the Fed “cannot influence interest rates” as was recently averred by Eugene Fama.
The degree of the Fed’s control is limited, that much is true, and there are situations when control can and will be lost entirely. However, most of the time said feedback loop undoubtedly exists. Below we show a chart illustrating the effect of the last two Fed decisions on the two year note yield:
The 2 year note yield is clearly driven by the market’s perception of future Fed policy. What is most astonishing about this is that people still seem to deem the Fed’s forecasts credible – in reality they couldn’t forecast their way out of a paper bag – click to enlarge.
Why are They Seemingly so Sanguine?
We have been wondering why the FOMC is showing so little concern when many US macro data – with the exception of lagging indicators (and even those have been weak of late) – are at their worst point in years. In fact, manufacturing seems to be approaching the dire situation of 2009. Furthermore, as we alluded to above, the bust in the oil patch is really only just in its initial phase. What is still to come is a wave of defaults, as oil hedges slowly but surely run off.
The only answer we can come up with is this: they are by and large Keynesians. Their focus is primarily on labor markets (a lagging indicator) and consumption, they aren’t concerned as much about the actual wealth-generating sectors of the economy. They are judging the economy’s performance in terms of aggregate data such as GDP, and in GDP accounting it appears as though consumption were 70% of economic activity and production (manufacturing) just 13%. The actual ratio in gross output terms is more like 35-40% consumption, 40-45% production (manufacturing alone!).
Should the Fed actually hike in December (the statement explicitly mentioned the possibility), we think it’s highly likely to become a “one and done” that will be taken back shortly, similar to the BoJ’s handful of attempts to hike rates after the bursting of the 1980s bubble. We say this simply based on the economy’s actual performance. After all, it took only a minimal tightening of policy (the “tapering” of QE3) to induce a bust in the sector most exposed to capital malinvestment.
This bust is still underway, and its downstream effects continue to spread. We believe it is highly unlikely that activity in other sectors of the economy will remain immune, especially given the fact that the economy is brimming with assorted debt bombs thanks to ZIRP (from corporate junk debt, to sub-prime auto loans, to the student loan bubble and the echo bubble in NINJA mortgages).
Note in this context that junk bond issuance has begun to stall out rather noticeably, which means that defaults are likely to rise noticeably as well – many companies in this segment simply don’t have the cash flows to service their debt and survive on “refinancing” alone. Needless to say, that’s a market segment that is not likely to be helped by an actual rate hike. This would actually be a salutary effect, but surely not from the perspective of the planners.