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)

Monday, October 6, 2014

One and Done?
Friday’s employment report was so good that the Fed’s doves should be hard pressed to put a bad spin on it. They’ve been doing just that to previous employment reports especially since Janet Yellen became the Fed chair on February 3 this year. She’s consistently focused on the weakest numbers in the monthly employment reports. The Fed’s doves want to hold off on raising rates for as long as possible. However, they’ve also said that monetary policy is data dependent.

With the unemployment rate down to 5.9% during September (the lowest since July 2008), the FOMC will be under lots of pressure to start raising the federal funds rate sooner rather than later in 2015. Here’s next year’s FOMC meeting schedule: January 27-28, March 17-18*, April 28-29, June 16-17*, July 28-29, September 16-17*, October 27-28, and December 15-16*. The ones with an asterisk will be followed by a press conference, which will give Yellen the opportunity to explain why the Fed decided to finally start raising interest rates. Given the strength in the labor market, I pick March 18 as D-Day.

Let’s recall what Fed Chair Ben Bernanke said last year at his June 19 press conference:
And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear. In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7.0 percent, with solid economic growth supporting further job gains, a substantial improvement from the 8.1 percent unemployment rate that prevailed when the Committee announced this program.
Well, here we are with QE scheduled to be terminated by the end of this month and the jobless rate under 6.0%. Regarding when the Fed will raise interest rates after QE is terminated, Bernanke said, “As I mentioned, the current level of the federal funds rate target is likely to remain appropriate for a considerable period after asset purchases are concluded.”

The phrase “considerable time” has been part of the boilerplate of the FOMC statements (in this post-QE context) since the December 12, 2012 statement, when the FOMC voted to morph QE3 (Fed buys $40bn/month in mortgage securities to infinity and beyond) was morphed into QE4 (Fed also buys $45bn/month in Treasuries) until the unemployment rate falls to 6.5%. It did so in April, falling from 6.7% to 6.3%. The strength of the latest employment report suggests that “considerable time” should be dropped from the next FOMC statement on October 29, especially since QE will be terminated by then. (See our searchable archive of FOMC statements.)

Of course, doves will always be doves. Consider the following:

(1) Yellen has a dashboard. Yellen can still find some weak labor market indicators on her “dashboard.” Most importantly, wage inflation remained at 2.0% y/y, well below her target of 3.0%-4.0%. The labor force participation rate fell to 62.7% during September, the lowest since February 1978. On the other hand, the short-term unemployment rate remains very low at 4.0%, while the long-term rate is down to only 1.9%, the lowest since February 2009.

(2) Evans advocates patience. Last Monday, FRB-Chicago President Charles Evans, who flies with the FOMC’s doves, told CNBC that he believes it would be "quite some time" before it's appropriate to start tightening. Evans sees June as a possibility for the first rate increase.

(3) Dudley is watching the dollar.On 9/24, Bloomberg’s Simon Kennedy reported that FRB-NY President William Dudley is the first Fed official starting to freak out about the strong dollar:

The risk is that Evans and Dudley are both correct. If the dollar continues to strengthen on expectations of a Fed rate hike, it could go to the moon on the first actual hike and threaten to slam the brakes on the economy just as the Fed is finally convinced that it has achieved escape velocity. If so, then that could be “one and done” for rate hikes.

Conceivably, it could also be “none and done.” When the FOMC finally votes to implement its exit strategy from ultra-easy monetary policy, they might find that the door is locked and no one has the key. In this scenario, stock prices could very well melt up.

I’m just thinking outside the box here. Other than last year’s taper tantrum in the financial markets, the Fed has succeeded in exiting QE. The Fed might succeed in normalizing monetary policy starting next year by raising the federal funds rate in a gradual fashion. What’s changed recently for the FOMC, and could complicate the committee’s exit strategy, is the strength in the dollar, which bears watching.
(Based on an excerpt from YRI Morning Briefing)

Thursday, October 2, 2014

Fed Rate Hikes Coming
As I noted in my 9/30 Fed Blog post, FRB-Chicago President Charles Evans told CNBC on Monday that he believes it would be "quite some time" before it's appropriate to start tightening. Evans sees June as a possibility for the first rate increase, but said on CNBC’s Squawk Box that if it were his decision, he'd wait even longer. “If you look at the risks, we ought to balance those and be concerned that sometimes coming out of zero [rates] ... is really a difficult proposition for the economies. And so I'd like to be patient.”

I predicted that there might be more tightening tantrums ahead if investors share Evans’ concerns that the economy might go wobbly on the first rate hike. Most economists believe that once the Fed starts raising rates, that will be a sure sign that the economy has finally achieved the long hoped-for “escape velocity,” which should be bullish for stocks.

Why might a small initial increase in the federal funds rate turn into a serious problem for the economy and the stock market? For starters, it could send the dollar to the moon. That would depress the dollar value of corporate profits earned abroad. It would also depress exports and boost imports.

A more disturbing scenario would be a collapse of the corporate bond market. Investors have been piling into the market as they’ve been reaching for yield. Corporations have responded by issuing bonds at a record pace. Data compiled by the Fed show that nonfinancial corporations (NFCs) raised a record $741 billion in the bond market over the past 12 months through July. A significant portion of those funds were used to refinance outstanding debt at lower yields. The Fed’s Flow of Funds data show that net issuance by NFCs totaled $287 billion over the past four quarters through Q2.

On Tuesday, the WSJposted an article titled, “Corporate Bond Sales Coming at Blockbuster Pace.” Here’s the main finding:
Bond sales from highly rated companies in the U.S. clocked a record pace through the third quarter, as companies took advantage of low rates and investors sought out securities that pay more interest than low-yielding government bonds.

Highly rated firms sold about $913 billion of bonds in the U.S. in the first nine months of 2014, up from $869 billion last year, according to Dealogic's figures, which go back to 1995. That puts the investment-grade U.S. market on pace to beat last year's record issuance of about $1.1 trillion, according to Dealogic.
On Monday, the WSJ posted a similar article about the European bond market titled, “Europe’s Corporate Borrowing Set to Hit Pre-Crisis Peak.” Emerging market borrowers have also been raising plenty of money in the global bond markets.

Lots of those bonds have been purchased by retail and institutional investors, some of whom might try to sell them when the Fed starts actually raising interest rates. The problem is that the corporate bond market tends to be illiquid on a good day. This could be a nightmare scenario for bond funds if they are faced with lots of redemption orders with few buyers for their bond holdings. During July, there was a record $3.6 trillion in bond funds and ETFs.

Blackrock, the world’s largest money manager, is concerned. That’s according to a 9/22 Bloomberg story titled, “BlackRock Urges Changes in ‘Broken’ Corporate Bond Market.” Here’s the main point:
Banks have retained their stranglehold on corporate debt trading despite years of effort by BlackRock and other large investors to eliminate their oligopoly. The top 10 dealers control more than 90 percent of trading, according to a Sept. 15 report from research firm Greenwich Associates. To BlackRock, the dangers of price gaps and scant liquidity have been masked in a benign, low interest-rate environment, and need to be addressed before market stress returns.
If a minor initial Fed rate hike does destabilize global bond markets, then there probably won’t be a second rate hike. That would seriously damage the credibility of the Fed, where the official party line has been that exiting ultra-easy monetary policy won’t be a problem.
(Based on an excerpt from YRI Morning Briefing)