Bonds, Currencies, Stocks

The Fed Is Already Easing Policy

By Joseph Y. Calhoun, Alhambra Investment Partners

Dollar - Flickr - Kurtis GarbuttThe Fed threw in the towel this week and acknowledged what the market has known for some time. The four rate hikes previously envisioned for this year are now just two – the dots are falling. According to the Fed, the economy is just fine, just not fine enough to handle interest rates that don’t have a zero before the decimal point. Or maybe the Fed’s dot moves weren’t based on the US economy at all. The Fed mentioned “global economic and financial developments” twice in the statement after the FOMC meeting. One is left wondering what exactly went on behind closed doors at that recent G-20 meeting.

Not only did the Fed repudiate its previous forward guidance but it managed to do it in a way that surprised the market. With some signs that inflation may well be making a comeback – and Vice Chair Fischer making exactly that observation not long ago – the consensus coming into the meeting was that the Fed probably wouldn’t do anything but would talk hawkishly to get the market to do its work. Well so much for that consensus. The statement along with the dot plot – the Fed’s guesses about rates, growth and inflation – was dovish beyond the wildest dreams of the most dovish dove. The statement cited soft “net exports and fixed business investment” as impediments to further hikes while also generally dismissing any rise in inflation saying that “survey based measures” are little changed; market indications notwithstanding I guess. They also cited “global economic and financial developments” as potential risks to growth. In general the statement emphasized the weakness of the economy while acknowledging that policy remains accomodative without saying aloud that the risks were tilted to the downside. All in all, a masterful bit of Newspeak.

The market’s reaction was immediate and extreme. No, I’m not talking about stocks. The big mover of the day was none other than the US dollar, down over 2.4% by the close of trading that afternoon. That might not sound like a lot but in the currency markets that is a gigantic move for such a short period of time. No matter how the Fed wanted its dog and pony show to be interpreted, the market took it as negative for the dollar and positive for all the things that do well when the dollar is not. Gold and TIPS surged along with the general commodity ETFs. The yield curve steepened and despite a continued rally in junk bonds, credit spreads widened, if ever so slightly. The steepening of the yield curve, if it continues, is particularly concerning as it indicates a fear of both recession – short rates falling – and inflation – long rates not falling as much.

In a sense, what the Fed did, despite doing nothing of substance, was to ease monetary policy. The tightening cycle everyone has been anticipating may already be over. The tapering of QE was the real start of the tightening cycle. That can clearly be seen in the yield curve which started its normal tightening cycle flattening almost immediately after the end of QE commenced. It can also be seen in the dollar index which started to rise in earnest during the tapering and continued to rally as the market anticipated the actual rate hike. If the rising dollar was evidence of a tightening of global financial conditions – “global financial developments” to use the Fed’s phrase – then the falling dollar must be interpreted as a loosening of said conditions. So, no change in rates but a de facto easing.

Which is what makes me wonder what a fly on the wall of the recent G-20 meeting might have overheard. Was there an agreement struck at that meeting to reverse some of the dollar strength? It certainly seems to have been just what the market doctor ordered although for some reason I keep hearing a voice in the back of my head whispering that old saw about being careful what you wish for, you just might get it good and hard.

I’m not big on conspiracy theories so I’ll just say that it appears the Fed is paying a lot more attention to the value of the dollar these days and its impact on international markets. Of course, that probably shouldn’t be a surprise since Stanley Fischer put a lot of emphasis on the Shekel when he was head of the Bank of Israel and he is now the Fed’s point man on international “developments”. I’m certain those phrases about global financial developments in the statement came directly from Fischer. In general, I think it is a good thing if they are watching the dollar since we know Bernanke paid it absolutely no mind – much to our detriment. If merely watching it, being aware of it and how it affects other economies, makes it more stable then we’ll all be better off for it.

Frankly, it would have been easy for the Fed to justify a hike at this meeting. The economic data has been better recently – marginally so, but better – and core inflation has been pushing higher although the Fed’s preferred gauge is still below their target. The dollar hit its high a year ago, gold is rising, oil prices are rising. Credit spreads are starting to narrow as the oil price rise provides comfort to energy bond holders and buyers. And of course, stocks have recovered from their early year swoon, something the Fed shouldn’t care about but apparently does. If they were going to hike, this meeting was as good a choice as they are likely to get.

But for whatever reason the Fed passed on hiking for now and reduced expectations for future hikes. The effect was primarily in the currency market but stocks responded positively as well. This expectation that a weaker currency will lead to better growth is one that I think will eventually be refuted rather rudely but for now the perception of the investing world is that if a rising dollar caused all this recent mess then surely a falling dollar will cure it.

I’m not so sure about that because while there has been some marginal improvement in the data recently, the general trend hasn’t changed. Both the Fed manufacturing surveys released this week were better than expected and positive. But we’re still getting conflicting signals from the economy. Housing starts were better than expected but permits were a big disappointment. Retail sales ex gas and cars was okay at +0.3 but last month’s retail report was revised from positive to negative across the board. The manufacturing portion of Industrial Production was positive but the overall report was negative again.

I think the Fed decided that the economic weakness outweighed the potential flare up in inflation. That may turn out to be the big mistake of this cycle. If the drop in oil prices hasn’t goosed spending imagine what rising prices might do. I said consistently the last two years that I didn’t know if the shale bust would be enough to cause a recession. So far, the answer has been no. But rising oil prices have a more traditional effect on the economy. The number of recessions caused by falling oil prices is stuck at zero but the tally for rising prices is quite a bit higher. The ’73-’75, ’80-’81, ’90-’91 and of course the ’08 recessions were all preceded by rising oil prices. And considering we are only growing at a bit less than 2%, it probably wouldn’t take much of a rise to push us right into the recession brier patch the Fed is trying to keep us out of. See the admonition above about taking care in one’s wishing.

There are plenty of economists, surely a lot at the Fed itself, who believe that inflation running a little hotter than desirable for a while is exactly what the US economy needs. You’ll have to ask them how higher prices are going to cure a problem of deficient demand. The Fed may be worried now about only one piece of their dual mandate but if they keep pushing the dollar lower pretty soon they’ll be worrying about both. And while they claim to know how to stop inflation – follow the Volcker playbook – I have serious doubts whether there is anyone at the Fed today with the guts to do it. If inflation ticks higher and the economic data doesn’t go with it, I think it’s safe to assume the Fed  will live with the inflation. Or more accurately, you and i will.

Courtesy of Alhambra Investment Partners © 2016


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