Raining on the Parade: Will the Center Hold?

The market is a fickle mistress.  At the end of September, and at the start of this month, we pushed against the hawkish read of the Fed’s dot-plots.  We resisted talk of a Fed hike in Q1 15.  We explained that the Fed’s policy signal emanates from the Troika of leaders, Yellen, Fischer and Dudley.    We warned that the US economy had lost some momentum at the end of Q3 and into Q4.  We had wrongly anticipated a softer employment report, but our larger economic suspicions are proving correct. 

We now find ourselves pushing back against the uber-pessimistic view that had taken hold.  Looking at the Fed funds futures strip, the market has pushed the first rate hike out of 2015 entirely and into the Q1 2016.  There is talk of a new round of QE.  The US economy grew above trend in Q2, as partly a payback for some of the weather-induced weakness in Q1, and it appears to have grown above trend in Q3.  It is not unreasonable to anticipate some modest slowing to a more sustainable pace.  It does not mean a recession.  The slowing from near 5% annualized pace in Q2 to around 3% in Q3, and a bit slower in Q4, does not feel good, it is not the apocalypse either. 

The global headwinds can be mitigated by the decline in energy prices and the decline in interest rates.  It is yet to be seen that American households will take advantage of savings at the pump to boost spending elsewhere.  But it is a reasonable expectation. 

As a headwind, the dollar’s appreciation was always conditional on its persistence.  In terms of magnitude, we have pointed out that on a real, broad, trade-weighted basis, which is the key metric in this context, the dollar’s rise has been minor this year.  Some bilateral nominal adjustments have been larger, and some companies will likely blame adverse currency moves for disappointing news during earnings season. 

However, few companies seem to draw attention to the tailwind that currency adjustments have sometimes given.  Two companies in the same industry with similar international exposure can and do report divergent impact from the developments in the foreign exchange market.  The proper level of analysis for this is the corporate treasurer’s office and its hedging strategies, not macro-economic policy. 

The moving parts in the international jigsaw puzzle are not to be found in the euro area or Japan.  There the investors are duly pessimistic, and the recent string of data indicates it is not unwarranted.  Rather, the change has been in perceptions of the UK and US. 

For the last few months, we have been highlighting how well sterling was tracking interest rate expectations as reflected in the March 2015 short-sterling futures contract.  As the UK economy lost momentum, and price pressures continued to ease, expectations of the first hike have been pushed from Q4 14 to Q1, then into Q2, and now into late next year, if not 2016. 

Similarly, the market, as reflected in the Fed funds futures strip, was never as hawkish as the FOMC dot-plots implied.  Many observers had warned of a rude awakening for investors.   However, rather than move toward the Fed, the market has run, not walked, in the opposite direction. 

 

Inflation expectations are at levels that have proceeded Fed’s QE operations in the past.  These are market-based inflation expectations.   However, they are far from clean.  One distortion stems from differences of liquidity between Treasuries and the inflation-protected securities.  At the risk of over-simplifying, inflation expectations tend to fall when US Treasuries rally strongly. 

Before the end of his term, Bernanke announced the Fed’s tapering operation.  Up until now, Yellen has been simply executing it.  This methodology was important.  The Fed announced months ahead of time what it was going to do, and even waited a few months longer than many had expected.  It then implemented what it said it would.   Some foreign countries did not like the unconventional US monetary policy in the first place, and then did not like that it was going to end.  However, they cannot complain of being surprised. 

As recently as last week, NY Fed President Dudley opined that it was reasonable to expect the first rate hike around the middle of next year.  A week or so before that Dallas Fed President Fisher, who dissented at the last FOMC meeting, suggested a hike in Q1 may be appropriate.    We suspect, given the price of oil and its impact on the Texas economy, we suspect that Fisher is more likely to change his mind than Dudley. 

Assuming that Yellen and Dudley are singing from the same songbook, Yellen’s comments to the Group of 30 in Washington suggest the center is holding.  Neither the hawk nor dove wing has wrestled the reins of monetary policy from the core centrists. 

There can be no mistake that the recent string of data since the September jobs report has been weaker than expected.  The Federal Reserve is likely to recognize this in its statement at conclusion of its month-end meeting.  However, it is also likely to recognize that progress continues to be made toward its mandates.  This is why the three elements of the Fed’s forward guidance will likely continue in the Fed’s statement later this month.

First, there is still significant slack in the labor market, even if the unemployment rate looks low or near NAIRU.  Second, it will be a “considerable” period between the end of QE and the first rate hike.  A June or July rate move would still put in 8-9 months out.  Third, even when the Fed judges to have achieved its mandates, Fed funds may stay lower than what the central bank believes is the long-term equilibrium rate. 

It may be a mistake to conclude that the Fed will not raise rates, or that a new QE operation will be launched.   The Fed’s mandates are being approached.  For policy purposes, the Fed targets the core PCE deflator.  Only the second round impact of falling energy prices would be picked up, for example if the price of airfare fell as companies passed on the lower energy costs to consumers. 

More importantly, Fed officials recognize its credibility is on the line.  It has said it will raise rates.  It has led investors to believe a rate hike will be forthcoming.   Barring a significant shock, it will raise rates.    Recall that even a sharp contraction in Q1 14, not all of which can be written off due to the weather, was not sufficient to get the Fed to change the pace of its tapering.  A move back to trend growth, which is a function of labor force growth and productivity, is unlikely to derail the Federal Reserve. 

Lastly, while officials would doubtlessly prefer less dramatic market swings, the sell-off of risk assets, and the rise in volatility from what many thought to be unsustainable and unhealthy levels, is not completely undesirable.   Many market participants see the size of the Fed’s balance sheet, and some of its composition, and wrongly conclude it is a hedge fund.  It most certainly is not, and such thinking will lead one to exaggerate the impact of the market turmoil on policy.

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Medium and long-term investor may also recognize the salutary effect of the market correction.  Value investors were finding little to chose from, and this setback will create new opportunities to buy good securities and companies at better prices.  A less violent path would be desirable, but this is often the case after a period of sustained trends and the compression of volatility.

Global investors have been best served by pushing against the dramatic swings in the pendulum of market sentiment.  First the hawks tried to dislodge the market.  This was successfully rebuffed. Now the doves/pessimists are pushing the market hard in the other direction.  There is still plenty of time before the middle of next year when the market consensus previously expected the first Fed rate hike. 

Our message to clients can be summarized in three words:  Beware of extremes.