Friday, December 19, 2014

The Fed Is Patient
Thank you, Janet Yellen! You didn’t disappoint me. You are still the “Fairy Godmother of the Bull Market!” As I’ve noted many times before, the S&P 500 tends to rise after Yellen speaks about the economy and monetary policy. The S&P 500 soared 4.5% on Wednesday and Thursday in response to the dovish FOMC statement and Yellen’s bullish press conference.

On Wednesday, I wrote:
However, the plunge in oil prices and the turmoil in the junk bond market might increase the likelihood that the Fed will delay the so-called "lift-off" of interest rates beyond mid-2015. "None and done" in 2015 is a distinct possibility for Fed policy. Let’s see what Fed Chair Janet Yellen has to say later today. I’m counting on her to continue to be the "Fairy Godmother of the Bull Market.”
On Tuesday, I wrote, “The FOMC might surprise us and keep ‘considerable time’ in the statement.” I noted that inflationary expectations are falling. I also wrote:
The distress in the junk bond market might also dissuade the FOMC from changing the "considerable time" language. In any case, Fed Chair Janet Yellen’s press conference on Wednesday afternoon could have a big impact on the markets. I’m still betting that she is the "Fairy Godmother of the Bull Market.”
On Monday, I noted that FRB-Chicago President Charles Evans, one of the Fed’s uber-doves, has called on his colleagues to be patient and to delay raising interest rates.

Wednesday’s FOMC statement confirmed my analysis:
Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy. The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program in October, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.
The FOMC remains dovish and patient. It will be even more dovish and patient next year when Evans will be a voter. Two of the three dissenters (Richard Fisher and Charles Plosser) were hawks, who are retiring. The FOMC has to be concerned about the financial stresses caused by the plunge in oil prices and the strength of the dollar, as evidenced by the spike in junk bond yields and the selloffs in the bonds, stocks, and currencies of emerging economies. That’s why they are willing to be patient for a considerable time longer.
(Based on an excerpt from YRI Morning Briefing)

Monday, December 15, 2014

The Fed's Three Options
The Fed has three choices, as I’ve discussed in the past. Normalization would be great in theory. In reality, the odds increasingly favor “none and done,” more so than even “one and done.” While the labor market warrants tightening sooner rather than later, inflationary expectations are falling fast as oil prices plunge and the dollar strengthens.

On October 13, FRB-Chicago President Charles Evans gave a speech titled “Monetary Policy Normalization: If Not Now, When?” Back then he said:
Looking ahead, I am concerned about the possibility that inflation will not return to our 2 percent PCE target within a reasonable period of time. First, the recent monthly inflation numbers have been low, so there is not much upward momentum. Second, as I mentioned earlier, wage growth has been relatively low for some time. While wages don’t predict future inflation, the two often move together. And, third, it does not appear as if inflationary expectations are exerting much of an upward pull on actual inflation at the moment. ...

To summarize, I am very uncomfortable with calls to raise our policy rate sooner than later. I favor delaying liftoff until I am more certain that we have sufficient momentum in place toward our policy goals. And I think we should plan for our path of policy rate increases to be shallow in order to be sure that the economy’s momentum is sustainable in the presence of less accommodative financial conditions. I look forward to the day when we can return to business-as-usual monetary policy, but that time has not yet arrived.
(Based on an excerpt from YRI Morning Briefing)

Wednesday, December 3, 2014

Dudley’s Spin
FRBNY President Bill Dudley gave a speech on Monday titled, “The 2015 Economic Outlook and the Implications for Monetary Policy.” His views matter because he is on the FOMC and reflects the views of the dovish majority of the committee. He and Fed Chair Janet Yellen tend to have nearly identical views. Here are a few highlights of his speech:

(1) In general, he paints a reasonably positive picture of the economy and says, “if my own forecast is realized, I would expect to favor raising the FOMC’s federal funds rate target sometime in 2015.”

(2) He says that several of the “headwinds” restraining US economic activity in recent years have subsided. The housing industry is in better shape. So are consumers. There is much less fiscal drag. Financial conditions are good: “Equity prices are high, borrowing costs are low, cash flows are strong and corporate balance sheets are healthy.”

(3) Lower energy costs should “lead to a significant rise in real income growth for households and should be a strong spur to consumer spending.” He adds that in the aggregate, “the swing from oil producers to consumers is quite large. For example, a $20 per barrel decline in global oil prices results in an income transfer of about $670 billion per year from producers to consumers.”

(4) On the other hand, he doesn’t expect a boom. He doesn’t see much upside from the current levels of housing starts and auto sales. The global economic slowdown and stronger dollar could weigh on US exports.

(5) Despite the drop in oil prices and the strength of the dollar, he expects that the core PCED inflation rate will move back towards the Fed’s target of 2% next year as resource utilization tightens.

(6) He agrees with market expectations that the Fed will start raising the federal funds rate around mid-2015. However, he is also willing to be patient:
Finally, given the still high level of long-term unemployment and the outlook for inflation, there could be a significant benefit to allowing the economy to run "slightly hot" for a while in order to get those that have been unemployed for a long time working again.
(7) The pace of tightening will depend on the response of the financial markets:
If the reaction is relatively large--think of the response of financial market conditions during the so-called "taper tantrum" during the spring and summer of 2013--then this would likely prompt a slower and more cautious approach. In contrast, if the reaction were relatively small or even in the wrong direction, with financial market conditions easing--think of the response of long-term bond yields and the equity market as the asset purchase program was gradually phased out over the past year--then this would imply a more aggressive approach.
(8) Though all this implies that Fed policy is market dependent, Dudley then denied that the markets’ reactions matter:
Let me be clear, there is no Fed equity market put. To put it another way, we do not care about the level of equity prices, or bond yields or credit spreads per se. Instead, we focus on how financial market conditions influence the transmission of monetary policy to the real economy. At times, a large decline in equity prices will not be problematic for achieving our goals. For example, economic conditions may warrant a tightening of financial market conditions. If this happens mainly via the channel of equity price weakness--that is not a problem, as it does not conflict with our objectives.
Sorry, he lost me there.
(Based on an excerpt from YRI Morning Briefing)

Monday, December 1, 2014

Central Banks: Immaculate Intervention
The dramatic rebound in stocks around the world since October 15 once again demonstrates the overwhelming influence of the central banks on global equity markets. The Greenspan and Bernanke Puts have morphed into the puts of the major central bankers. As a result, they’ve made shorting stocks a losing proposition. Underweighting stocks simply because they are overvalued based on historical metrics also has been problematic for conservatively inclined institutional investors, who must at least match if not beat their benchmarks. Consider the following recent chronology of central bank interventions that have boosted stock prices:

(1) Bullard bounce. On Thursday, October 15, the dramatic rebound in stock prices from their lows was triggered by a comment by FRB-St. Louis President James Bullard that the Federal Reserve should consider extending its bond-buying program, currently at $15 billion per month, beyond October due to the market selloff--allowing more time to see how the US economic outlook evolves. Yet in his interview with Bloomberg News, Bullard also said he still believes that the FOMC should start raising the federal funds rate in March of next year.

Then after the FOMC meeting in late October, Bullard praised the Fed’s decision to end the bond purchases. He reiterated that he favors starting to raise interest rates next spring, ahead of the mid-year consensus among his FOMC colleagues. In an interview summarized in the 11/20 WSJ:
Bullard attributed some of the confusion to the fact that many market participants didn’t listen closely enough to what he said. He allowed that monetary policy making has become far more complex and thus more challenging to communicate. But he underscored an underlying consistency to his view, noting what he said about the Fed’s bond-buying program hadn’t altered his long-running view that short-term interest rates should be lifted off their current near zero levels next spring.
(2) Kuroda shock. On Friday, October 31, in a surprise move, the Bank of Japan (BOJ) stated that it is upping the ante on the QQE monetary stimulus program that was announced on April 4, 2013. The BOJ’s press release raised JGB purchases to an annual pace of 80 trillion yen from 50 trillion yen. The pace of buying was tripled for both ETFs (3 trillion yen) and J-REITs (90 billion yen). At the current exchange rate, ETF purchases would amount to about $27 billion. That’s not that much given that the market capitalization of the Japan MSCI is $2.7 trillion currently. So what’s all the excitement about?

The latest program is open-ended, according to the latest press release: “The Bank will continue with the QQE, aiming to achieve the price stability target of 2 percent, as long as it is necessary for maintaining that target in a stable manner.” The time horizon for achieving this goal was about two years in the 2013 press release.

On Friday, November 21, Japan’s finance minister told a news conference that the speed of the yen’s recent decline was “too fast.” He added, “There is no doubt about that.” Last Tuesday, November 25, the minutes of the October 31 meeting of the BOJ's governing board showed that the hurdle to further quantitative easing is high. Some board members were concerned that expanding the central bank's quantitative easing could raise the risk that it would be seen as financing the government deficit.

(3) Draghi’s pledge. On 10/11, Bloomberg reported that ECB President Mario Draghi told reporters in Washington that expanding the ECB’s balance sheet is the last monetary tool left to revive inflation, although there is no target for how much it might be increased. He said, “I gave you a kind of ballpark figure, say about the size the balance sheet had at the start of 2012.” That would be a remarkable increase of €1.0 trillion. On 11/21, in a keynote speech in Frankfurt, Draghi said that the ECB will “do what we must to raise inflation and inflation expectations as fast as possible.” In effect, he backed US-style quantitative easing.

Speaking in Finland on 11/27, Draghi said that the Eurozone needs a comprehensive strategy including reforms by governments to get it back on track. His comments and weak CPI data released on Friday lowered the euro to $1.246 and triggered a new set of record-low bond yields for the Eurozone's biggest economies, with France’s 10-year yield dropping below 1% for the first time.

The Eurozone flash CPI estimate rose just 0.3% y/y in November, down from 0.4% in October. Bank loans to nonfinancial corporations fell €132.0 billion (saar) during October, the ninth consecutive monthly decline, and the 26th in 27 months.

(4) Chinese rates. The People's Bank of China cut its benchmark one-year loan interest rate on Friday, November 21, to 5.6% from 6.0% and cut its benchmark one-year deposit rate to 2.75% from 3.00%. The nation's central bank also hiked the upper limit on deposit interest rates to 1.2 times the benchmark rate from 1.1 times the benchmark rate. The bank said that it took the actions, which were largely unexpected and are the first such changes since July 2012, in response to expensive borrowing costs rather than any direct worries about the economy's slowdown. Chinese bank loans rose 13.2% y/y during October, the weakest growth since November 2008.
(Based on an excerpt from YRI Morning Briefing)

Thursday, October 30, 2014

Taking Credit
There were no surprises in yesterday’s FOMC statement, in my opinion. A few Fed watchers thought it was more hawkish than they expected. The statement noted: “Labor market conditions improved somewhat further, with solid job gains and a lower unemployment rate. On balance, a range of labor market indicators suggests that underutilization of labor resources is gradually diminishing.”

That’s not hawkish. It’s a fact and makes sense given that the FOMC wanted to give the QE program lots of credit for the improvement in the labor market now that it has been terminated. That notion was reinforced by the following comment: “The Committee judges that there has been a substantial improvement in the outlook for the labor market since the inception of its current asset purchase program.” In other words, Mission accomplished.

I’m sure Fed officials were pleased by the headline for this story on Reuters: “Fed ends bond buying, shows confidence in U.S. recovery.” That’s undoubtedly the message they wanted to send.

The boilerplate “considerable time” clause remained in the latest statement:
The Committee anticipates, based on its current assessment, that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program this month, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.
So inflation might remain lower than the FOMC expects. Then again, pay no attention to any of this so-called “forward guidance” because it all depends: “However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.”

President Harry S. Truman famously lamented: “Give me a one-handed economist! All my economists say, ‘On the one hand, on the other.’” There certainly are lots of the two-handed variety working at the Fed. In what sense does all this nonsense constitute “forward guidance”?

I was asked yesterday how long before the Fed starts hiking rates might the FOMC drop the “considerable time” phrase. I figure three months. Here is the FOMC’s meeting schedule for next year through the summer, with asterisks marking the meetings with press conferences: January 27-28, March 17-18*, April 28-29, June 16-17*, and July 28-29. Odds are that “considerable time” will be dropped at the March meeting, giving Fed Chair Janet Yellen the opportunity to explain why at her press conference. The first hike might be announced after the June meeting, giving Yellen another opportunity to discuss the committee’s decision.

In this scenario, the question will be whether this would be the beginning of the gradual normalization of monetary policy with small rate hikes in subsequent meetings. It should be, unless the first hike unleashes lots of turmoil in financial markets. That would be the “one and done” alternative scenario.
(Based on an excerpt from YRI Morning Briefing)

Wednesday, October 29, 2014

Considerable Time
The FOMC statement this afternoon isn’t likely to pull any tricks. Given the strength in stock prices so far this week, investors might be expecting some treats. It’s likely that Fed officials were spooked by the violent selloff in stocks earlier this month. So at their pre-Halloween two-day meeting that ends today, they might decide not to surprise the markets one way or the other now that stocks have rebounded. In other words, there might not be any significant changes in the language that appeared in the previous FOMC statement on September 17. If so, then no news should be good news.

For the market, the treat would be if today’s statement still includes the following language from the previous one: “The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.”

After the release of September’s strong employment report on October 3, the odds of dropping the “considerable time” boilerplate of the past couple of years seemed to have increased, especially since QE was about to end. However, the turmoil in financial markets during the first half of the month might dissuade the committee from deleting it.

In a 10/19 WSJ interview, Boston-FRB President Eric Rosengren said:
So we’ll have to think about exactly what’s the appropriate wording and certainly the financial context that we’re in given the volatility we’ve seen in markets. We’re going to have to weigh how best to avoid further unsettling markets that seem to have unsettled themselves pretty well on their own. So we’ll have to take all those things into consideration. I can’t give you precise language because I think it’s really a committee decision.
In other words, Rosengren and many of his colleagues on the FOMC aren’t just “data dependent.” They are also “market dependent.” Of course, there’s a long tradition for this at the Fed starting with the Greenspan Put and followed by the Bernanke Put. I’ve noted that Fed Chair Janet Yellen has been the “Fairy Godmother” of the bull market since she first joined the Fed as a governor during October 2010. Stocks have usually rallied whenever she has spoken publicly about the economy and monetary policy.

The Fed has been criticized for worsening wealth and income inequality with its NZIRP (near-zero interest-rate policy) and QE policies. Ultra-easy monetary policy has done more to enrich the rich who own stocks than to help the economy. Low interest rates have certainly hurt fixed-income investors.

In his interview, Rosengren, who is in the dovish majority on the FOMC, countered:
The biggest factor that affects inequality is losing your job because if you have no income the income disparity is quite large. So being focused on getting labor markets back to where we think full employment is I think is the most tangible way that monetary policy can impact income inequality.
Then he acknowledged:
That being said, there is no doubt that asset prices are one of the mechanisms on which this is transmitted, so people that own stocks are going to do better than people that didn’t own stocks. But that’s not the only measurement, you need to look at the whole basket. The net effect is substantially weighted towards people that are borrowers not lenders, towards people that are unemployed versus people that are employed. Wealthy people are both employed and tend to lend. The people at the lower end of the distribution tend to borrow. So as a result, I think it’s very consistent with being worried about income inequality.
Fed officials undoubtedly spent some time debating whether to drop “considerable time” from the latest statement. Looking into the past, the fact is that all the major central banks have provided ultra-easy monetary policy for a considerable time ever since the financial crisis of 2008. Looking into the future, they may be forced to continue doing so for a considerable time. That includes the Fed, no matter how the FOMC statement is worded today.

In recent weeks, I’ve written about the possibility of “one and done.” In this scenario, the Fed votes to start raising the federal funds rate in mid-2015. That throws markets into turmoil, causing the FOMC to suspend further rate hikes until further notice. In this scenario, the Fed might get spooked by a true correction in the stock market more severe than this month’s quick dip. The dollar might resume soaring, sending commodity prices into a tail spin. Liquidity might dry up in the capital markets, particularly for high-yield corporate bonds. In other words, the past few weeks might have been just a warm-up act for what’s to come once the Fed starts “lift off.”

One explanation for the latest amazing relief rally in stocks is that investors are increasingly concluding that the Fed is trapped. There’s no way to exit its ultra-easing monetary policy without causing too much turmoil in global financial markets. In this scenario, the federal funds rate remains near zero for a very long time into the future. The 10-year Treasury yield remains below 3% for as far as the eye can see.
(Based on an excerpt from YRI Morning Briefing)

Monday, October 20, 2014

Bully for Bullard!
Over the past couple of weeks, I suggested that the bearish action in stocks might reflect investors’ concern that the central banks have run out of ammo. I corrected that assessment on Thursday, October 16, arguing that they still have bullets, but they may be blanks. The rally late last week suggests that even if they are blanks, investors are happy as long as the central banks keep firing them and make lots of noise.

How else to explain that Thursday’s rebound from the lows was triggered by a comment from FRB-St. Louis President James Bullard that the Federal Reserve should consider extending its bond-buying program, currently at $15 billion per month, beyond October due to the market selloff to see how the US economic outlook evolves. Yet in his interview with Bloomberg News, he also said he still believes that the FOMC should start raising the federal funds rate in March of next year.
(Based on an excerpt from YRI Morning Briefing)

Monday, October 13, 2014

Behind the Curtain
Last Tuesday, FRB-NY President Bill Dudley said that the FOMC is likely to start hiking rates around mid-2015. Last Thursday, Fed Vice Chairman Stanley Fischer agreed with Dudley on the timing of the “lift off” for rates. The latest FOMC minutes released last Wednesday strongly suggested that such forward guidance is meaningless since the Fed’s policy remains data dependent. In addition, the economic indicators that are important to the policy-setting committee can and do change. The minutes suggested that the FOMC is now giving some weight to the pace of foreign economic growth as well as the foreign-exchange value of the dollar.

These new considerations might delay lift off. So why have stocks sold off so hard? If the Fed is stymied from normalizing monetary policy by overseas developments, then our wizards might be trapped without an exit strategy. At the same time, there certainly isn’t much the Fed can do to stimulate global economic growth. In fact, if the Fed delays raising interest rates, then the euro might stop its recent freefall, which Draghi is counting on to revive Eurozone growth and inflation. The same can be said for the yen and Kuroda.
(Based on an excerpt from YRI Morning Briefing)

Thursday, October 9, 2014

Dudley Sees First Rate Hike Coming in Mid-2015
QE will be terminated at the end of this month. In and of itself, this shouldn’t be a problem for the stock market, in my opinion. However, its termination sets the stage for rate hikes by the Fed next year.

FRB-NY President William Dudley spoke on Tuesday. In his prepared remarks, he said, “What I can say with greater certainty is that there still is a significant underutilization of labor market resources.” He is among the leading doves on the FOMC and tends to have the exact same views about monetary policy as Fed Chair Janet Yellen.

This implies that the FOMC will be in no rush to raise interest rates next year, and will do so very gradually. Nevertheless, Dudley added, “The [FOMC’s] consensus view is that lift-off will take place around the middle of next year. That seems like a reasonable view to me. But, again, it is just a forecast.” Dudley did mention the stronger dollar, but toned down his concern about it, which he had expressed at a 9/24 Bloomberg conference. For now, he sees it as “limiting the upside risk” of better-than-expected economic growth and higher-than-expected inflation.

Dudley mentioned that inflationary expectations remain “well anchored” despite the recent drop in the yield spread between the 10-year Treasury and comparable TIPS recently. He did not say, as he had at the 9/24 conference, that the strong dollar might push the core PCED inflation further below the Fed’s 2% target as import price inflation diminished.
(Based on an excerpt from YRI Morning Briefing)

Tuesday, October 7, 2014

Anchor Aweigh
There’s a close inverse correlation between the expected inflation rate--as measured by the yield spread between the 10-year Treasury and the comparable TIPS--and the trade-weighted dollar Since the start of the year, expected inflation has been hovering in a range between 2.12% and 2.31%. It dropped significantly in recent weeks to 1.93% yesterday, coinciding with a sharp increase in the dollar. The TIPS yield has edged down recently, but isn’t down as much as expected inflation. In other words, most of the recent decline in the bond yield was attributable to falling inflationary expectations, which may be related to the stronger dollar.

Fed officials keep close watch on inflationary expectations in the TIPS market. Each of the 11 FOMC statements from December 12, 2012 through June 18, 2014 included the following boilerplate language: “longer-term inflation expectations continue to be well anchored.” That assessment is primarily based on the TIPS yield spread.

The TIPS spread suggests that inflationary expectations are no longer well anchored; instead, they are falling sharply. All the more reason to hold off on hiking the federal funds rate.

The question is why is the spread narrowing sharply? Here’s the rub: It may be narrowing because foreign investors are piling into the US bond market, which is why the dollar is strong. Of course, the strong dollar encourages foreigners to pile in some more since that increases their return in their local currencies. The reason they are doing so is because US bond yields well exceed foreign bond yields, especially in Japan and the Eurozone.

But US bond yields have exceeded foreign bond yields in Japan and the Eurozone all year. What’s changed? The drop in those overseas yields relative to US yields has been especially dramatic this year. Foreign investors have become increasingly convinced that the weak performances of the economies of Japan and the Eurozone will force the BOJ and ECB to maintain their ultra-easy monetary policies and provide additional easing measures if necessary.

In other words, the narrowing of the TIPS spread may have nothing to do with inflationary expectations in the US. Rather, the spread is narrowing because foreign investors are reaching for yield in the US. In Japan and the Eurozone, the central banks are seeking to avert deflation. Their efforts to do so are depressing their currencies and narrowing the TIPS spread in the US.

Fed officials might fret that inflationary expectations are declining, and hold off on raising the federal funds rate. That might actually push bond yields in the US still lower, exacerbating the decline in the TIPS market’s presumed measure of inflationary expectation.
(Based on an excerpt from YRI Morning Briefing)