Over the past year, while the U.S. economy has continually missed expectations, Federal Reserve Chairwoman Janet Yellen has assured all who could stay awake during her press conferences that it was strong enough to withstand tighter monetary policy. In delivering months of mildly tough talk (with nothing in the way of action), Yellen began stressing that WHEN the Fed would finally raise rates (for the first time in almost a decade) was not nearly as important as how fast and how high the increases would be once they started. Not only did this blunt the criticism of those who felt that the delays were unnecessary, and in fact dangerous, but it also began laying the groundwork for the Fed to do nothing over a much longer time period. To the delight of investors, the Fed has telegraphed that it will adopt a "low and slow" trajectory for the foreseeable future and move, in the words of Larry Kudlow, like "an injured snail."
I would suggest that Kudlow is a bit aggressive. I believe that if the Fed raises rates by 25 basis points next week, as everyone expects it will, that the move will likely represent the END of the tightening cycle, not the beginning. (As I explained in my last commentary, the current tightening cycle actually started more than two years ago when the Fed began shortening its forward guidance on Quantitative Easing). The expected rate hike this month has long been referred to as “liftoff” for the Fed, an image that suggests the very beginning of a process that eventually puts a spacecraft into orbit. But, in this case, liftoff will be far less dramatic. I believe the Fed’s rocket to nowhere will hover above the launch pad for a considerable period of time before ultimately falling back down to Earth.
If we believe that the Fed will remain "data dependent", then we should not even expect an increase this month. The latest batch of data, including terrible retail sales figures, an ISM manufacturing number that indicates we may already be in a manufacturing recession, and a much weaker than expected ISM service sector number, show an economy that is rapidly decelerating. Even last week's supposedly good jobs report, that showed 211,000 jobs created in November, included a huge jump in the number of people (319,000) taking part-time jobs because they couldn't find full-time work.(Bureau of Labor Statistics, 12/7/15)
This current "recovery," engineered by the largest monetary experiment in history, that has left us with trillions of dollars of new debt that we will likely never be able to repay, is quickly running out of what little steam it had. On average, since the Second World War, the U.S. economy has experienced a recession every six years. Since it is approaching eight years since our last official recession began, time is not on our side. Interestingly, the Wall Street Journal reported this week on its front page that the "junk" bond market is poised to notch its first annual loss since the 2008-2009 financial crisis. Many economists consider distress in these high yield debt instruments as an early sign of a recession.
But rather than admit its rosy forecasts were too optimistic, and risk losing much of its remaining credibility, the Fed is apparently prepared to prove to the markets that it has the ability to deliver tough love with an actual rate hike. But that's the easy part. Although I believe that even 25 basis points may be too much of a headwind for this anemic economy to overcome, it's not something that should really spread fear in a marginally healthy economy. The dollar did not rally by 30% or more over the past year against many currencies based on the fear of a 25 basis point rate hike. What really moved markets and currencies was the prospect of a bona fide tightening cycle.
These fears moved into sharp focus in September when widespread fears of an imminent rate hike had caused the Dow to experience its first 10% correction in four years. That is when Yellen began stressing that it's not the first rate hike that is important, but what happens after. As a result, Wall Street now sees liftoff as a far less significant event, with far more attention being paid to the ultimate flight path.
As late as this summer many economists were predicting that Fed funds would be at least 2% by the end of 2017. The Fed’s own forecasters still see rates at more than 2.5% by early 2018, according to its Summary of Economic Projections released 9/17/15. But over the last few months, those predictions have flattened out more than an open can of soda in the sun. The current Fed Funds futures contracts imply a 79% chance that the Fed raises rates in December (Reuters, 12/4/15). That figure is about as high as it has been for quite a few months. But the market also indicates that rates may only rise twice more by the end of 2016. (Reuters 12/4/15) This would put Fed Funds at 75 basis points by next December, presuming a 25 basis rise this month. That pace is less than half of the last rate tightening cycle of 2004-2006, when the Fed raised rates by 25 basis points for 17 consecutive meetings (Federal Reserve Bank of NY). (It's interesting to recall that then Fed Chairman Alan Greenspan was criticized for moving too slowly at that time, and even more so in the aftermath of the bursting of the housing bubble, as many correctly concluded that the Fed's measured pace had allowed the bubble to grow unnecessarily).
I believe that when it comes to gold, commodities and currencies, we may be headed into a "buy the rumor, sell the fact" market that might turn the tables on the trends of the past four years. In this case, the "rumor" was a meaningful tightening cycle that would restore positive real rates, but the "fact" is likely to be a symbolic 25 basis point nudge. This "one and done/wait and see" scenario is gaining a surprising amount of support, especially among those Wall Street investment firms whose livelihood depends on perennially positive markets. How else could you explain the 4% rally in gold that had occurred from the lows on Thursday to the highs on Friday last week if not for the fact that markets are coming to expect much more tender loving care from the Fed?
I believe that the Fed understands the deteriorating economic data better than it cares to admit. But candor is rarely high on a Fed Chairperson's agenda. (In an interview this week on the Freakonomics Podcast, former Fed Chairman Ben Bernanke blundered by accidentally telling the truth regarding his penchant for painting unjustifiably rosy economic pictures while in office, saying, "I was representing the administration. And you don't really want to go out and say, 'Run for the hills,' right?" In other words, one should expect the same partisan cheerleading from the supposedly independent Fed chairman as one gets from the blatantly partisan White House Press Secretary). This time around the Fed's rhetoric has now backed it into a corner, where its credibility with the markets is at stake. If they fail to deliver 25 basis points in December, as they have failed to do many times this year, then the markets may be shocked by the Fed’s lack of confidence. As a result, they may reluctantly deliver a rate hike, even though the data they supposedly depend on would argue against it. But if all we get is a symbolic 25 basis point increase, then, I believe, any economic confidence that the Fed hoped would be implied by its actions will be lost anyway.
The real problem for the Fed will be how foolish it will look if it does raise by 25 basis points and is then forced by a slowing economy to lower rates back to zero soon after liftoff. At that point, the markets should finally understand that the Fed is powerless to get out of the stimulus trap it has created. But it looks like the Fed would rather look foolish later when it's forced to cut rates, than look foolish now by not raising them at all.
Given that we are going into an election year, look for the Fed to be hyper-vigilant in keeping the economy, and the financial markets, from contracting through the spring and summer. History has shown that the incumbent presidential party fares very poorly in an election year when the economy is bad. Just ask George H.W. Bush, whose post-Gulf War popularity evaporated in the face of the 1992 recession, which turned out to be one of the mildest in memory. Can anyone really expect that the Fed's left-leaning leadership will sit still while a recession gains momentum and, in so doing, run the risk of easing Donald Trump into the White House?
In her testimony before Congress last week, Yellen indicated that if the economy unexpectedly slipped back into recession in 2016, and it turned out that the Fed had raised rates, it would simply reverse course and lower them. She also stated she would launch another round of Quantitative Easing (QE), because the program “worked so well in the past.” But a recession that begins so soon after a 25 basis point rate increase, or even with rates still at zero, should prove to even the Fed’s biggest boosters that its stimuli were complete and utter failures. But in government, nothing succeeds like failure.
© Euro Pacific Capital