Monday, June 8, 2015

Central Banks: Pixie Dust
The latest global economic indicators are pointing to more growth and less deflation. Below, I review the likely response of the major central bankers:

(1) BOJ. Peter Pan is running monetary policy in Japan. In his opening remarks at a conference in Tokyo on Thursday, BOJ Governor Haruhiko Kuroda said:
I trust that many of you are familiar with the story of Peter Pan, in which it says, "The moment you doubt whether you can fly, you cease forever to be able to do it."
The WSJ observed:
Japan’s central bank chief invoked the boy who can fly to emphasize the need for global central bankers to believe in their ability to solve a range of vexing issues, whether stubbornly sluggish growth or entrenched expectations of price declines. Kuroda added, "Yes, what we need is a positive attitude and conviction."
Japan’s monetary base continues to fly, rising 36% y/y and 118% since April 2013, when the BOJ started to increase it dramatically as one of the three “arrows” of Abenomics. All this liquidity succeeded in devaluing the yen, boosting profits and stock prices, and providing some lift to the economy by stimulating exports. However, the main goal was to stop deflation. Unfortunately, the headline CPI rose just 0.6% y/y during April, with the core rate (excluding food & energy) up just 0.4%.

(2) ECB. Bond yields jumped higher on June 2, when May’s flash CPI for the Eurozone showed a gain of 0.3% y/y, up from a recent low of -0.6% during January. In addition, the core rate rose from a series low of 0.6% during April to 0.9% during May. That doesn’t seem like much, but investors bailed out of bonds fast. Then, in his press conference on June 3, Mario Draghi, when asked about the backup in yields, responded:
But certainly one lesson is that we should get used to periods of higher volatility. At very low levels of interest rates, asset prices tend to show higher volatility, and in terms of the impact that this might have on our monetary policy stance, the Governing Council was unanimous in its assessment that we should look through these developments and maintain a steady monetary policy stance.
Instead of offering bond investors more pixie dust, Draghi was more like Captain Hook, listing five reasons why yields have risen recently: better growth, higher inflation expectations, more supply of short-term bonds, self-perpetuating volatility, and poor liquidity. He said that the current pace of dusting would be maintained.

(3) Fed. In many ways, Japan’s poor economic performance and chronic deflation, along with the BOJ’s attempts to cure these problems with ultra-easy monetary policies, have been pacesetters for other major economies. Fed officials hope that’s not the case for the US, and are signaling that they believe that the economy may be ready to fly on its own soon and won’t need as much pixie dust to do so.

On Friday, in a lunch speech following the release of May’s employment report, FRB-NY President Bill Dudley reiterated that the Fed is still on course to start lifting the federal funds rate later this year, confirming similar comments recently by Fed Chair Janet Yellen and Vice Chair Stanley Fischer. Dudley said:
I still think it is likely that conditions will be appropriate to begin monetary policy normalization later this year.
Like his two Fed colleagues, he indicated that he hopes that the markets won’t be too upset:
How will financial markets react to the onset of normalization? My own view is that there likely will be some turbulence. After all, lift-off will represent a regime change after more than six years at the zero lower bound.
According to Dudley, if markets react badly, the Fed will back off:
If a small rise in short-term rates were to lead to an abrupt increase in term premia and bond yields, resulting in a significant tightening in financial market conditions, then the Federal Reserve would likely move more slowly--all else equal.
Presumably, if the dollar soars and stock prices plunge, the Fed will wait awhile before even considering lifting rates again.

Our “one-and-done” scenario for this year is that the FOMC will vote to increase the federal funds rate by only 25bps at the September 16-17 meeting of the policy-setting committee. At least three other FOMC participants have recently implied no rush to raise rates: 1) FRB-Boston President Eric Rosengren (a non-voter this year) said in a speech last Monday that the US recovery is too weak; 2) In her maiden speech on monetary policy last Tuesday, FRB Governor Lael Brainard suggested she does not support a rate increase at the upcoming June policy meeting; 3) FRB-Chicago President Charles Evans (a voter) said in a speech last Wednesday said he does not expect rates to rise until next year.

Last year, on October 6, I first predicted that one-and-done was the most likely scenario for the FOMC in 2015 because the strength in the dollar could complicate the Fed’s plans to normalize monetary policy.
(Based on an excerpt from YRI Morning Briefing)

Wednesday, May 27, 2015

Central Banks: Not So Easy
The major central banks of the world have been easing their monetary policies significantly since the financial crisis of 2008. They’ve succeeded in averting another financial crisis so far. They’ve also succeeded in recovering most of the fortunes that were lost during the crisis. Equity investors have benefited from the stock market rally. Bond investors also enjoyed big gains as yields fell and prices rose. The 12-month average of the median existing home price is up 29% since February 2012.

Nevertheless, the central banks have been frustrated by the slow pace of the recoveries in their economies since the crisis of 2008. Reviving self-sustaining economic growth hasn’t been as easy as easing has been. The ultra-easy monetary policies of the central banks might perversely have contributed to the slow pace of economic growth. Yesterday, I listed several reasons why the Fed’s policies actually have contributed to the subpar pace of the US economic recovery. Allow me to further elaborate:

(1) Not much trickling down from the wealth effect. It is widely believed that many retail investors who left the stock market following the bursting of the Internet bubble and the bear market of 2007-2008 never returned. If so, the wealth effect from the current bull market in stocks hasn’t trickled down to most Americans.

(2) Forcing savers to save more. Savers have been forced to save more, and spend less, as a result of the Fed’s NZIRP (near-zero-interest-rate policy). The 12-month sum of personal saving has been running around $700 billion since the end of the financial crisis in 2008, double the pace during the 1990s and the first half of the previous decade.

(3) Enabling fiscal excesses. Last Friday, Fed Chair Janet Yellen said that one of the headwinds that the economy faced during the current recovery until recently was fiscal drag. That’s true, as measured by federal, state, and local government spending in the real GDP accounts. However, it’s hard to see any such fiscal austerity in the federal deficit, which reflects the need to finance all government spending, including entitlements, in excess of tax receipts.

The Fed has clearly enabled the federal government to run large deficits. Fed officials may deny that their QE programs have monetized the debt, but that’s exactly what they have done. The Fed’s balance sheet now has $2.46 trillion in Treasury securities. The effective cost of that debt to the Treasury is just 25bps since all interest earned by the Fed is returned to the Treasury less expenses, which mostly includes the 0.25% paid on bank reserves deposited at the Fed.

(4) Worsening income inequality. Fed Chair Yellen in a 10/17/14 speech said, “The extent of and continuing increase in inequality in the United States greatly concern me.” She is quite alarmed: “It is no secret that the past few decades of widening inequality can be summed up as significant income and wealth gains for those at the very top and stagnant living standards for the majority.” She doesn't acknowledge that the Fed’s policies might also be contributing to inequality. An important source of income for many senior citizens has been the interest they receive on their fixed-income securities. Income inequality has certainly been worsened by the fact that older people are living longer on less interest income.

(5) Misallocating capital. The Fed’s policies have led to significant misallocations of capital. As a result of the Frank-Dodd Act, the Fed and other banking regulators have forced the banks to tighten lending standards. At the same time, extremely low interest rates have allowed investors to raise lots of money in the capital markets to buy up distressed properties around the country. As a result, home prices have rebounded significantly over the past few years, reducing affordability for first-time home buyers. Corporate bond yields have been trading below the S&P 500’s forward earnings yield since 2004, providing companies with an incentive to buy back their shares and engage in M&A rather than invest in plant and equipment. Relatively weak business spending to expand payrolls and capacity has boosted profit margins; the S&P 500 margin rose to a record-high 10.4% last quarter. Buybacks boosted earnings per share.

The result has been a great bull market in stocks, largely reflecting financial engineering rather than healthy economic activity.
(Based on an excerpt from YRI Morning Briefing)

Tuesday, May 26, 2015

Tiptoe Through the Soft Patch
The song “Tiptoe Through the Tulips” was originally published in 1929, just before the Great Depression, and famously revived by Tiny Tim in 1968. Fed Chair Janet Yellen and her colleagues on the FOMC have been tiptoeing all year through the economy, hoping that it will grow fast enough to handle the first rate hike in nine years without triggering a financial calamity that sets off another Great Recession.

On Friday, Yellen gave a speech on the economic outlook, observing, “As you all know, the economy is still recovering from the Great Recession, the worst downturn since the terrible episode of the 1930s that inspired its name.” She doesn’t seem to believe that it is completely over, though saying that it “began more than seven years ago.” Let’s have a closer look at her views:

(1) Labor market is laboring. Surely, she must recognize that the labor market has fully recovered. She answered her own implicit question: “Are we there yet?” by only conceding that it is “approaching full strength.” She then accentuated the negatives, noting that too many people have dropped out of the labor force, too many working part-time want full-time jobs, and wage gains remain too low, running around an annual rate of 2%. Notice that she highlighted the wage inflation shown in average hourly earnings rather than the wage component in the Employment Cost Index, which rose 2.7% y/y during Q1, the highest since Q3-2008. While she did mention the latter in a footnote, Yellen is certainly tiptoeing.

(2) Some homes still underwater. She also said that the economy continues to face some “headwinds.” The housing crash left lots of households with less wealth and more debt, leaving many of them “underwater.” Maybe so, but the Fed’s own flow of funds data show that real estate held by households has increased in value by $4.5 trillion from Q2-2011 through Q4-2014 and that owners’ equity as a percentage of household real estate has rebounded from a record low of 36.9% during Q1-2009 to 54.5% during Q4-2014.

(3) Less fiscal drag. A second headwind that “is mostly behind us” is the decline in fiscal spending. In real GDP, federal spending seems to have stabilized over the past three quarters after falling 13% from Q3-2010 through Q2-2014. State and local spending has recovered very gradually after falling 8% from Q3-2009 through Q4-2012.

(4) Global weights. The third and final headwind in Yellen’s list is the weakness in the global economy. During most of the US recovery, the biggest overseas problem was the renewed recession in the Eurozone. Now it seems to be a slowdown in emerging economies, especially China. She indirectly mentioned that the strong dollar might also have weighed on US exports. However, this too should pass, in her opinion.

(5) Headwinds still blowing. In any event, monetary policy will remain accommodative. She said that “the headwinds facing our economy have not fully abated, and, as such, I expect that continued growth in employment and output will be moderate over the remainder of the year and beyond.” She thinks that residential investment “is likely to improve only gradually.” Business investment will continue to recover modestly, though energy capital spending is likely to be weak.

Yellen said it all adds up to real GDP growth of about “2-1/2% per year over the next couple of years.” Given that real GDP excluding government spending has been hovering around 3.0% since 2010, Yellen seems to believe that the headwinds will shave about a half a point from growth.

(6) One and done. The Fed chair then laid out the implications for monetary policy. She came close to saying that there will be just one rate hike this year:
For this reason, if the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy.
That is as long as the labor market continues to improve and she is “reasonably confident that inflation will move back to 2 percent over the medium term."

She should certainly be pleased to see that the four-week average of initial unemployment claims during the week of May 16 fell to the lowest since April 2000, indicating that the pace of firing remains very low. Last week’s CPI news for April should make Yellen reasonably confident about achieving her inflation goal.

(7) Tiptoeing for many years. Finally, Yellen reiterated that the process of monetary normalization may take a very long time:
If conditions develop as my colleagues and I expect, then the FOMC's objectives of maximum employment and price stability would best be achieved by proceeding cautiously, which I expect would mean that it will be several years before the federal funds rate would be back to its normal, longer-run level.
Yellen’s term as Fed chair expires on February 3, 2018. That might be how long the Fed continues to tiptoe—unless she is reappointed for another four-year term by the next US president.

In my opinion, the Fed’s tiptoeing has significantly contributed to the weakness of the current economic expansion:

(1) By keeping interest rates near zero for so long, risk-averse savers have had to accept bupkis for returns on their liquid assets. Many of them have been saving more, thus spending less: The 12-month sum of personal saving has been running around $700 billion since the end of the financial crisis in 2008, double the 1990s pace.

(2) Ultra-easy money attracted investors rather than nesters into the housing market following the 2008 crisis. They bought up all the cheap homes and drove home prices back up to levels that may be unaffordable for many first-time homebuyers.

(3) Thanks to the Fed, corporate bond yields have been trading below the S&P 500’s forward earnings yield since 2004, providing companies with an incentive to buy back their shares and engage in M&A rather than invest in plant and equipment.

Cheap money did stimulate some business investment, but the increased capacity wasn’t matched by more demand, resulting in some deflationary pressures. Stock prices have soared, but this has exacerbated the perception of widespread income and wealth inequality. Nice job, Fed!
(Based on an excerpt from YRI Morning Briefing)

Thursday, May 21, 2015

Central Planners
On Monday, Josh Brown, a panelist on CNBC’s “Halftime Report,” commented that the major central bankers’ policy of “kicking the can down the road” seems to be working. Since the start of the bull market in stocks, the bears have argued that ultra-easy monetary policy was only postponing the “endgame.” They said that central banks were kicking the can down the road, implying that there was a cliff or a brick wall at the end of the road.

If you kick the can down the road, you delay a decision in hopes that the problem or issue will go away or somebody else will make the decision later. The phrase also means to defer conclusive action with a short-term solution. In this particular version of the game, there is no endgame as long as there is another short-term solution. The major central banks have been playing this game by providing additional rounds of monetary easing when the previous rounds didn’t revive growth or boost inflation as well as they had hoped. So ZIRPs (zero-interest-rate policies) have been followed by QEs and NIRPs (negative-interest-rate policies) and QQEs.

Brown was specifically talking about the Eurozone’s problem with Greece. It started in 2010, when the country needed a bailout to avoid a Grexit that threatened to unravel the monetary union. It was provided, and so was lots of easy money by the ECB. Brown opined that while the problem hasn’t been solved, the short-term fixes bought time for the Eurozone to reduce significantly the damage that would result from a Grexit. The strength in the EMU MSCI this year, despite the possibility that Greece might soon default after all, confirms Brown’s view.

The latest news is that Greece needs to borrow more to make its debt payments. The socialist government has rehired public employees and refuses to cut pensions. That news did unnerve Eurozone stock and bond markets last week. So ECB officials let it be known that their current QE bond-buying program will be front-loaded during June and July. Stocks and bonds recovered on this news.

The major central bankers have become central planners. They are using all the means available to them to manage their economies. Central planning invariably produces suboptimal economic performance. Central planners tend to be experimenters, like some mad scientists in a lab. When their plans don’t pan out as they predicted, they try something else or more of the same. If nothing else, it’s a good diversion. The public is told that while the previous plan was a disappointment, the next one will work great. If all else fails, blame a few of the planners and execute them.

So what’s the latest plan? More of the same, with an increased emphasis on driving stock prices higher. If so, then this raises the odds of a global stock market melt-up. The major central banks are run mostly by macroeconomists rather than bankers these days. They believe that one of the major “transmission mechanisms” between monetary policy and the economy is the wealth effect.

Their critics say that the policies of the central bankers have worsened income and wealth inequality and thereby perversely contributed to global secular stagnation. I’m inclined to agree. Needless to say, the monetary central planners reject this critique and insist that they’ve been relatively successful so far, at least in averting another global recession and financial crisis. Consider the following:

(1) China. Monday’s WSJ included an extremely germane article on this subject. It is titled “As Chinese Stocks Rise, Beijing Wins.” The main point is that the Chinese government, which in the past viewed the stock market as a casino for speculators, now is using it to boost the economy and enable reforms.

(2) Japan. They must be doing high-fives at the BOJ. Real GDP rose by an annualized 2.4% during Q1, much better than a revised 1.1% in Q4. It also beat a 1.5% growth forecast by economists in a WSJ survey. The BOJ continues to buy bonds under its QQE program. As a result, the monetary base is up 35% y/y. Japan’s central bank also continues to support the stock market, as a 5/13 Reuters article reported.

(3) Eurozone. The ECB isn’t buying stocks (just yet), but the bank’s officials are certainly doing their best to boost stock prices by depressing the euro and keeping a lid on interest rates. Last Thursday, ECB President Mario Draghi countered any notion that the bank’s QE might be tapered ahead of schedule. He was clearly concerned about the recent backup in bond yields, strength in the euro, and weakness in stock prices.

(4) US. So far, this year hasn’t been a good one for the Stay Home investment strategy. It’s been much better for the Go Global strategy. That’s mostly because the Fed has been out of sync with the other central banks. The FOMC terminated QE last October and has been chattering about whether liftoff for the federal funds rate should come sooner or later this year. The suspense has weighed on the US stock market.
(Based on an excerpt from YRI Morning Briefing)
Fed: Your Tax Dollars at Work
The Federal Reserve System employs hundreds of economists. Most of them work in the research departments of the Board of Governors in DC and in the 12 district banks. What do they do all day? A few spend most of their time providing an assessment of the economy that is summarized in the FOMC’s minutes. Most seem to write academic research papers that don’t seem to have much relevance to running monetary policy. They are very academic in nature, and mostly irrelevant for policymaking purposes.

I’ve spent some time scanning the papers posted on the Fed’s various websites from 2006-2008. Virtually none examined the credit excesses that set the stage for the financial crisis of 2008.

Nevertheless, there recently have been a few studies by the Fed’s staff that have some relevance to issues that actually matter:

(1) Picking on Piketty. Four Fed economists recently coauthored a paper titled “Measuring Income and Wealth at the Top Using Administrative and Survey Data.” Their conclusion will warm the hearts of those of us who believe that the income inequality arguments made by socialists like Thomas Piketty are based on questionable data and faulty analysis. I made a similar point in the 3/26 Morning Briefing:

(2) Season’s greetings. Did some “residual seasonality” distort Q1’s real GDP? That’s the hot debate among the economists at the Bureau of Economic Analysis (BEA), the FRB-SF, and FRB-DC. Why is this technicality important? Well, the data-dependent Fed is relying on GDP and other economic indicators to determine when to start raising interest rates.

Real GDP rose just 0.2% (saar) during Q1. An analysis by the FRB-SF concluded that it actually might have been more like 1.8%. On the other hand, FRB-DC research points to a lack of “firm evidence” to support the former’s claims. Interestingly, the BEA itself is unsure that its algorithms are performing as intended. The problem largely centers on the unexpected impact of aggregating a significant amount of bottom-up data. Thus, the BEA is reviewing its methods for possible revision in July of this year.
(Based on an excerpt from YRI Morning Briefing)

Wednesday, May 20, 2015

Eurozone: Draghi’s Latest Pledge
ECB President Mario Draghi is the Fairy Godfather of the Eurozone’s bond market. Bond yields dropped dramatically in the region after he pledged to do whatever it takes to defend the euro. He said so on July 26, 2012. He has delivered on his promise so far. He had to renew his vows with the bond crowd along the way. He proved he meant what he said by lowering the ECB’s official lending rate from 1.00% to 0.05%, and even cutting the bank’s deposit rate below zero to minus 0.2%.

Then on March 9, he implemented a massive QE program, finally overcoming lots of resistance to it coming out of Germany in particular. All of his words and deeds pushed the euro down from last year’s high of $1.39 on May 6 to this year’s low of $1.05 on March 13.

However, better-than-expected economic indicators in the Eurozone and worse-than-expected ones in the US have pushed the euro back up to $1.14, though it retreated below $1.12 yesterday after an ECB policymaker hinted that the Bank is preparing to ramp up its bond-buying program before the summer. A few observers question whether QE was even necessary. Some are wondering whether the program should be terminated sooner rather than later. Furthermore, bond yields, which fell close to zero in mid-April, have subsequently spiked up.

So last Thursday, Draghi updated his pledge in a lecture at an annual IMF series in Washington, DC:
After almost 7 years of a debilitating sequence of crises, firms and households are very hesitant to take on economic risk. For this reason quite some time is needed before we can declare success, and our monetary policy stimulus will stay in place as long as needed for its objective to be fully achieved on a truly sustained basis.
Thus, he tried to sink the suggestion that the ECB might wind up its QE scheme early.

To make sure everyone got the message, Benoît Cœuré, a member of the ECB’s executive board, said in London on Monday evening that the bank will front-load some of their purchases of sovereign debt in May and June to deal with an expected shortage of liquidity in July and August. (His remarks were not published by the ECB until Tuesday morning, raising questions about the release of market sensitive information by the central bank.) Obviously, ECB officials want to squelch any notion that they will taper the pace of bond buying.

The markets got the message, as the euro edged down and stock prices jumped higher.
(Based on an excerpt from YRI Morning Briefing)

Wednesday, May 13, 2015

The Fed: Prepping the Markets
“This is Ground Control to Major Tom” are lyrics from David Bowie’s classic “Space Oddity.” In Bowie’s song, the astronaut responds to Ground Control: “This is Major Tom to Ground Control / I'm stepping through the door / And I'm floating / in a most peculiar way / And the stars look very different today.” Bond investors have recently had this lost-in-space experience.

Fed officials at Ground Control have been preparing the markets for lift-off, i.e., the first rate hike during the current economic expansion. Bond yields aren’t waiting; They’ve already blasted off. However, they are likely to orbit at their current altitude for a while even when the federal funds rate finally gets off the ground. That’s because Fed officials have said that once they start raising rates, they will do so very gradually. That’s especially likely if the recent backup in bond yields and mortgage rates slows economic growth.

One-and-done is an increasingly likely scenario for Fed policy this year, which means that the federal funds rate won’t be any higher than 0.50% by the end of the year. In other words, investors can expect that Fed policy will remain in inner space rather than go to outer space.

Since the FOMC’s latest meeting on April 28-29, three top Fed officials have spoken publicly and indicated that investors should prepare for lift-off, i.e., “take your protein pills and put your helmet on,” as the song says. A fourth one is still in no rush to lift interest rates. Let’s review:

(1) Yellen. On May 6, Fed Chair Yellen sat down with IMF Chief Christine Lagarde for a discussion at a conference in Washington. As I noted in Monday’s Morning Briefing, Yellen is obviously trying to do her best to prepare the financial markets for the start of Fed rate hikes:
We need to be attentive, and are to the possibility that when the Fed decides it's time to begin raising rates, these term premiums could move up and we could see a sharp jump in long-term rates. So we're trying to, you know, as I've repeatedly said, communicate as clearly about our monetary policy so we don't take markets by surprise.
(2) Dudley. On Tuesday, FRB-NY President William Dudley spoke at a conference in Zurich. In his prepared remarks, he commented on the timing of normalization:
To be as direct as possible: I don’t know when this will occur. The timing of lift-off will depend on how the economic outlook evolves. Since the economic outlook is uncertain, this means the timing of liftoff must also be uncertain.

At the same time, though, I can be clear about what conditions are needed for normalization to begin. If the improvement in the U.S. labor market continues and the FOMC is ‘reasonably confident’ that inflation will move back to our 2 percent objective over the medium-term, then it would be appropriate to begin to normalize interest rates.

Because the conditions necessary for liftoff are well-specified, market participants should be able to think right along with policymakers, adjusting their views about the prospects for normalization in response to the incoming data. This implies that liftoff should not be a big surprise when it finally occurs, which should help mitigate the degree of market turbulence engendered by lift-off.

Nevertheless, I think it would be naïve not to expect some impact. After more than six years at the zero lower bound, lift-off will signal a regime shift even though policy would only be slightly less accommodative after lift-off than it is before.
(3) Williams. Dudley had company this week. FRB-SF President John Williams echoed similar sentiments in a discussion on CNBC. He forecasted:
A year from now, yes, we will have unemployment below 5%. Broader measures of unemployment or underemployment will be down to more normal levels like we've seen in other good economic times. Inflation will be heading back to 2% and yes rates will be moving up.
Regarding the specific timing of rate hikes this year, Williams said:
My personal preference is that we don't have the most telegraphed policy decisions in history like we did in 2004. I do believe that the data dependence is what we should be doing. We should be coming together every six weeks discussing what the outlook looks like and what the right appropriate policy decisions at that meeting are and then adjusting policy going forward.
(4) Evans. On the other hand, FRB-Chicago President Charles Evans still thinks that the economy isn’t ready for rate hikes just yet. His research staff posted a paper on May 8 entitled “Changing Labor Force Composition and the Natural Rate of Unemployment,” obviously supporting the uber-dovish stance of their boss. Contrary to the Fed’s consensus view of a 5.0%-5.2% range for the natural rate of unemployment, the authors claim that the rate should be at or below 5.0%!

On May 4, Evans concluded a speech to the Columbus Economic Development Board as follows:
In summary, I think we should be cautious in the timing of the first rate hike and our pace of policy normalization thereafter. My current view is that my economic outlook and my assessment of the balance of risks will evolve in such a way that I likely will not feel confident enough to begin to raise rates until early next year. But there is no prescribed timeline that must be adhered to, and no preset script to follow, other than that we should let economic conditions and risks to the outlook be our guides. Given uncomfortably low inflation and uncertainties about the economic environment, I see significant risks, but few benefits, to increasing interest rates prematurely.
(Based on an excerpt from YRI Morning Briefing)

Monday, May 11, 2015

Yellen: The Valuation Question
Fed Chair Janet Yellen gave a speech titled “Finance and Society,” on Wednesday at a conference sponsored by the Institute for New Economic Thinking, which was founded in October 2009 with an initial pledge of $50 million from George Soros.

The prepared text of her short speech was mostly boilerplate, with Yellen claiming that the Fed is doing a good job of monitoring the financial system and maintaining its stability. She has said so several times before. On the other hand, her comments in a subsequent discussion with IMF Chief Christine Lagarde at the conference caught the markets off guard. In particular, she stated that equity valuations are “quite high.” She’s made similar comments before too, yet stock prices sold off on the “news” that she still thinks stocks aren’t cheap.

She’s obviously trying to do her best to prepare the financial markets for the start of Fed rate hikes:
We need to be attentive, and are to the possibility that when the Fed decides it's time to begin raising rates, these term premiums could move up and we could see a sharp jump in long-term rates. So we're trying to, you know, as I've repeatedly said, communicate as clearly about our monetary policy so we don't take markets by surprise.
Regarding the stock market, she added:
I guess I would highlight that equity market valuations at this point generally are quite high. Now they're not so high when you compare the returns on equities to the returns on safe assets, like bonds, which are also very low. But there are potential dangers there. And in interest rates, obviously not only short but long-term interest rates are at very low levels. And that would appear to embody low term premiums, which can move and can move very rapidly. We saw this in the case of the taper tantrum in 2013 where there was a very sharp upward movement in rates and you do have divergent monetary policies, potentially around the world.
On Thursday, the S&P 500 rose 0.4% following a report showing that weekly initial unemployment claims remain extremely low, averaging just 279,500 over the past four weeks. On Friday, following the release of April’s “Goldilocks” employment report, the S&P 500 soared 1.3% to close at 2116, only 0.1% below the record high on April 24. Investors seem to have concluded that notwithstanding her warnings about valuations, Yellen remains the Fairy Godmother of the Bull Market.

This isn’t the first time that Yellen has given investment advice. In her prior two semiannual congressional testimonies on monetary policy and accompanying Monetary Policy Reports, valuations were mentioned. Notably, her tone has become increasingly cautious. Yellen’s qualifiers have gone from “in-line with historical norms,” to “somewhat higher,” and now to “quite high.” Let’s review, with the key words italicized by us for emphasis:

(1) In Yellen’s 7/15/14 testimony, she said: “While prices of real estate, equities, and corporate bonds have risen appreciably and valuation metrics have increased, they remain generally in line with historical norms."

The Monetary Policy Report that accompanied her testimony noted: “…valuation measures for the overall market in early July were generally at levels not far above their historical averages, suggesting that, in aggregate, investors are not excessively optimistic regarding equities.”

(2) According to the same July report: "Nevertheless, valuation metrics in some sectors do appear substantially stretched--particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year." Yellen added in her remarks: “In some sectors, such as lower-rated corporate debt, valuations appear stretched and issuance has been brisk.”

(3) The 2/24/15 Monetary Policy Report stated: "Overall equity valuations by some conventional measures are somewhat higher than their historical average levels, and valuation metrics in some sectors continue to appear stretched relative to historical norms."

(4) At her last press conference, on March 18, Yellen was asked to update her views on the overall valuation of the market and on the biotech and social media sectors. Her curt answer was: “Well, I don’t want to comment on those particular sectors. You know, as we said in the [February] report, overall measures of equity valuations are on the high side but not outside of historical ranges.”

(5) Last Wednesday, as noted above, she said: “I guess I would highlight that equity market valuations at this point generally are quite high.”

The S&P 500/400/600 forward P/Es were 15.6, 17.2, and 17.9 on July 15, 2014;17.2, 18.2, and 18.9 on February 24 of this year; 16.9, 18.3, and 19.4 on March 18; and 16.7, 18.1, and 19.0 last Wednesday.
(Based on an excerpt from YRI Morning Briefing)

Thursday, May 7, 2015

Fed: Bond Bath
Fed officials are probably very confused right now. They all say that their policy is data dependent. Some of them have said that the decisions of the FOMC are also market dependent. The latest batch of economic data has been mixed, with some indicators on the strong side but many still on the weak side, as discussed below. In addition, the recent dramatic backups in bond yields and in the price of oil must be new concerns that they need to factor into their policymaking. In other words, they have quite a mess on their hands, which means that investors are also looking at a tricky situation right now. Here’s the Fed’s conundrum, and ours:

(1) Bonds. US bond yields have jumped recently. The 10-year Treasury is up from a recent low of 1.87% on April 17 to 2.26% yesterday. Everyone is blaming that development on the spike in Eurozone bond yields, particularly the surge in the 10-year German government yield from its all-time low of 0.033% on April 17 to 0.58% yesterday. That’s despite the implementation of QE by the ECB starting on March 9.

With the benefit of hindsight, the backup in yields isn’t a surprise. Yields simply fell too low at the start of the year on fears that plunging oil prices might trigger widespread deflation, especially in the Eurozone, and maybe cause another financial crisis if oil companies started to default on their debts. Now that oil prices have rebounded, those concerns are evaporating and yields are normalizing. I think it’s that simple.

In any event, the backup in bond yields is doing the same to mortgage rates in the US. That could stall the already lackluster recovery in the housing industry, which might explain why lumber prices are falling. So maybe the Fed should postpone its lift-off given the lift-off in bond yields?

(2) The dollar. Furthermore, global bond markets may also be responding to the possibility that the FOMC will start lifting interest rates sometime this year come what may, to show that they can do it. What’s confusing is that the trade-weighted dollar is down 3.5% from its recent high on March 13, suggesting that forex traders believe that the Fed won’t start tightening anytime soon. A weaker dollar would boost US exports and bolster inflation. How might the Fed’s next policy decision (or indecision) be influenced by developments in the bond and currency markets?

(3) Commodities. A weaker dollar tends to be associated with rising commodity prices, including oil prices. Sure enough, the price of a barrel of Brent crude is up 45% from this year’s low on January 13 to $67.52 on Tuesday. The CRB raw industrials spot price index seems to be bottoming now, led by rising copper, lead, and zinc prices. That should encourage the Fed to start tightening.

(4) Inflationary expectations. A weaker dollar also tends to be associated with rising inflationary expectations in the bond market. Sure enough, the spread between the 10-year Treasury yield and the comparable TIPS yield has widened from the year’s low of 1.54% on January 13 to 1.94% on Tuesday. So tightening now makes more sense than it did earlier this year when inflationary expectations were lower.

(5) Wages & confidence. There are finally a few signs suggesting that wages are rising at a faster clip. During Q1, ECI wages & salaries rose 2.7% y/y, the highest since Q3-2008. Average hourly earnings rose only 2.1% y/y through March, but by 3.9% during the first three months of the year at an annual rate. Is that enough for the FOMC’s doves led by Fed Chair Janet Yellen to commence with raising interest rates? Or will they argue that doing so too soon might abort the recovery in wages, which may still be frail?

(6) Economy. The rebound in gasoline prices is already making the evening news shows. The nearby futures price is up 79 cents since this year’s low on January 13 to $2.06 a gallon. That increase will offset some of the wage-related rise in consumers’ purchasing power, and chip away at their confidence. Has the weather-related ice patch during the first three months of the year turned into the spring’s soft patch? I am leaning toward the soft-patch scenario.

(7) Conclusion. Confused by all this? You are not alone. I’m sure Fed officials are also confused. Maybe that’s why we haven’t heard as much from them over the past week as we usually do right after FOMC meetings. My takeaway is that bond yields are getting mighty attractive, though the 10-year Treasury probably bottomed earlier this year at 1.68% and should trade between 2.00%-2.50% over the rest of the year. I remain in the one-and-done camp on the Fed’s lift-off, and wouldn’t be surprised by none-and-done.

Stocks, bonds, and currencies should mark time at current levels through the summer until the Fed is less confused and less confusing.
(Based on an excerpt from YRI Morning Briefing)

Thursday, April 9, 2015

Fed: Dudley's on First
March employment data were released on Friday, when the stock market was closed. Futures dropped sharply on the disappointing news. Nevertheless, the S&P 500 rose 0.7% on Monday. That day, FRB-NY President Bill Dudley was the first member of the FOMC to comment on the economy following the employment report. Here were his key points:

(1) Snow. He put a positive spin on the weakness of the economy during the first quarter. He blamed it mostly on the weather, as Debbie and I have been doing:
For example, some of the recent softness is likely due to yet another harsh winter in the Northeast and the Midwest. My staff’s analysis of a measure of both the amount of snow and the population affected indicates that January and February weather was 20 to 25 percent more severe than the five-year average. Such large deviations appear to have meaningful negative impacts on a number of economic indicators.
(2) Oil. As Debbie and I have noted, he agreed that the plunge in oil prices may have a negative impact on the economy, particularly the energy industry. However, he accentuated the positive impact:
Starting with the positives, since the U.S. is still a net importer of petroleum, this development has provided substantial benefits, with our oil import bill down by about a ½ percentage point of GDP. As I indicated earlier, that represents a significant boost to real disposable income for households. How much this energy windfall boosts consumption will depend, though, on how much is spent versus saved.
(3) Dollar. About the dollar, Dudley said:
Another significant shock is the nearly 15 percent appreciation of the exchange value of the dollar since mid-2014. Such an appreciation makes U.S. exports more expensive and imports more competitive. My staff’s analysis concludes that an appreciation of this magnitude would, all else equal, reduce real GDP growth by about 0.6 percentage point over this year.
(4) Liftoff. His mostly optimistic spin on the economy suggested that he is still expecting the Fed to start raising interest rates this year. Previously, he suggested that it could happen at mid-year. In his latest comments, he was vague about the timing. Nevertheless, he reiterated that the process of normalizing monetary policy will be very gradual:
For financial markets, the likely path of short-term rates after lift-off is just as important as the timing of lift-off. Here, I anticipate that the path will be relatively shallow. Headwinds in the aftermath of the financial crisis are still in evidence, particularly the diminished availability and tougher terms for residential mortgage credit.
(5) Hedged. Dudley hedged his optimism on the economy as follows:
The unemployment rate was 5.5 percent in March: analysis by my staff suggests that the unemployment rate is nearing the point where we may begin to see a pickup in the pace of real wage gains. If this proves correct and unemployment continues to decline as I expect, then these stronger wage gains could help support solid income growth even if the pace of employment growth slows. However, it will be important to monitor developments to determine whether the softness in the March labor market report evident on Friday foreshadows a more substantial slowing in the labor market than I currently anticipate.
Dudley is the consummate two-handed economist.
(Based on an excerpt from YRI Morning Briefing)
Fed: The Minutes
The minutes of the March 17-18 FOMC meeting were released yesterday. The key point was that Fed officials were split on whether to start raising interest rates in June:
Several participants judged that the economic data and outlook were likely to warrant beginning normalization at the June meeting. However, others anticipated that the effects of energy price declines and the dollar’s appreciation would continue to weigh on inflation in the near term, suggesting that conditions likely would not be appropriate to begin raising rates until later in the year, and a couple of participants suggested that the economic outlook likely would not call for liftoff until 2016.
The trade-weighted dollar was mentioned 9 times, up from 7 times in the previous minutes.

Yesterday, in an interview with Reuters, FRB-NY President Bill Dudley said the Fed could still hike rates in June despite a weak start to the year, if economic data pick up over the next two months:
I could imagine circumstances where a June rate hike is still in play. If the next jobs report is strong...if second-quarter GDP look like it is bouncing quite sharply.
He said there were still good reasons for the Fed to hold off on liftoff to make sure as many workers as possible are pulled into the labor force. In addition, the weak first-quarter data and recent weak jobs report mean “the bar is probably a little bit higher” for a June hike. Seems to me that Dudley has too much free time.
(Based on an excerpt from YRI Morning Briefing)

Tuesday, March 31, 2015

Fed: Deconstructing Yellen
Fed Chair Janet Yellen gave an important speech this past Friday updating her latest thoughts on monetary policy. It was titled, “The New Normal Monetary Policy.” As I’ve noted frequently in the past, stock prices tend to rise on days that Yellen speaks publicly about monetary policy and the economy. Sure enough, the DJIA rose 34 points on Friday. That’s not much, but last week was a tough one for stocks. (In any event, the DJIA soared 1.5% Monday on expectations the PBOC will join the Fed, ECB, BOJ, and BOE in pouring more liquidity into the financial markets.)

In my opinion, the key new insight in Yellen’s speech is how inflation might impact the course of monetary policy. She is obviously pleased with the performance of the labor market overall. However, she and most of her colleagues have recently lowered their estimate of the unemployment rate that is “normal in the longer run” down to 5.0%-5.2% from 5.2%-5.5%. The actual jobless rate fell from 10.0% at its peak to 5.5% during February, very close to the new normal range.

She believes that if this rate falls closer to 5.0%, then wage inflation should rise, which should push price inflation back up closer to the Fed’s 2% target. She is willing to start raising interest rates before this actually happens as long as she is “reasonably confident” that it will happen. I presume that an unemployment rate closer to 5.0% would make her reasonably confident. In other words, Yellen still believes in the Phillips Curve--i.e., the inverse relationship between the unemployment rate and wage (and price) inflation--although it doesn’t seem to be working so far this time.

Nevertheless, Yellen expects that rates will remain below a normal ascending trajectory for some time. As my friend Mike O’Rourke, the chief market strategist at Jones Trading, observes: “The basic take away is that the FOMC policy normalization process will be only a minor transformation from Zero Interest Rate Policy (ZIRP) to Low Interest Rate Policy (LIRP).” Here are some of the most relevant excerpts from her speech:

(1) Falling joblessness should boost inflation, justifying liftoff:
An important factor working to increase my confidence in the inflation outlook will be continued improvement in the labor market. A substantial body of theory, informed by considerable historical evidence, suggests that inflation will eventually begin to rise as resource utilization continues to tighten. It is largely for this reason that a significant pickup in incoming readings on core inflation will not [emphasis hers] be a precondition for me to judge that an initial increase in the federal funds rate would be warranted.
(2) If inflation weakens, liftoff will be postponed:
I have argued that a pickup in neither wage nor price inflation is indispensable for me to achieve reasonable confidence that inflation will move back to 2 percent over time. That said, I would be uncomfortable raising the federal funds rate if readings on wage growth, core consumer prices, and other indicators of underlying inflation pressures were to weaken, if market-based measures of inflation compensation were to fall appreciably further, or if survey-based measures were to begin to decline noticeably.
(3) Anything is possible:
Let me first be clear that the FOMC does not intend to embark on any predetermined course of tightening following an initial decision to raise the funds rate target range--one that, for example, would involve similarly sized rate increases at every meeting or on some other schedule. Rather, the actual path of policy will evolve as economic conditions evolve, and policy tightening could speed up, slow down, pause, or even reverse course depending on actual and expected developments in real activity and inflation.
(4) Asymmetries justify cautious approach to liftoff:
International experience therefore counsels caution in removing accommodation until the Committee is more confident that aggregate demand will continue to expand in line with its expectations--a view that is also supported by the research literature. A second reason for the Committee to proceed cautiously in removing policy accommodation relates to asymmetries in the effectiveness of monetary policy in the vicinity of the zero lower bound. In the event that growth in employment and overall activity proves unexpectedly robust and inflation moves significantly above our 2 percent objective, the FOMC can and will raise interest rates as needed to rein in inflation. But if growth was to falter and inflation was to fall yet further, the effective lower bound on nominal interest rates could limit the Committee's ability to provide the needed degree of accommodation. With an already large balance sheet, for example, the FOMC might be concerned about potential costs and risks associated with further asset purchases.
(5) Normalization shouldn’t be postponed for too long if jobless rate continues to fall:
Second, we need to keep in mind the well-established fact that the full effects of monetary policy are felt only after long lags. This means that policymakers cannot wait until they have achieved their objectives to begin adjusting policy. I would not consider it prudent to postpone the onset of normalization until we have reached, or are on the verge of reaching, our inflation objective. Doing so would create too great a risk of significantly overshooting both our objectives of maximum sustainable employment and 2 percent inflation, potentially undermining economic growth and employment if the FOMC is subsequently forced to tighten policy markedly or abruptly.
(6) Normalization is needed to discourage financial bubbles:
In addition, holding rates too low for too long could encourage inappropriate risk-taking by investors, potentially undermining the stability of financial markets. That said, we must be reasonably confident at the time of the first rate increase that inflation will move up over time to our 2 percent objective, and that such an action will not impede continued solid growth in employment and output.
(Based on an excerpt from YRI Morning Briefing)

Monday, March 30, 2015

Fed: Talking Heads
The FOMC certainly has lots of talkative personalities. They love to share their opinions with us on a regular basis, especially just before and just after their meetings, and in between. The only time we ever seem to get a break from them is during the “quiet period” of five business days in which they stop talking publicly about monetary policy as they prepare for their next policy meeting. It didn’t take them long to start yapping away after the latest meeting ended on March 18. The FOMC clearly has a split personality on the issue of when to start raising interest rates, a.k.a. “liftoff”:

(1) Lockhart. In a NYT interview on Wednesday, FRB-Atlanta President Dennis Lockhart said the following about the timing of liftoff: “So for me to say June-July-September [with] full confidence is probably overstating it, but I think it’s quite likely.” On Thursday, he hedged a bit, saying that he is paying more attention to the rising dollar to see if it’s weighing on the economy.

(2) Bullard. In a speech on Thursday in Frankfurt, FRB-SL President James Bullard said that current low levels of US inflation are likely temporary and the risks of keeping the federal funds rate zero for too long “may be substantial.” He believes that the FOMC should start tightening: “Now may be a good time to begin normalizing US monetary policy so that it is set appropriately for an improving economy over the next two years.”

(3) Evans. FRB-Chicago President Charles Evans warned that there were considerable risks in raising rates too early in an environment where core inflation is persistently below 2%. “Some say we are behind the curve, that interest rates are unusually low but we’re not at a point of business as usual,” he said during a FT interview.

(4) Yellen. In a speech on Friday, Fed Chair Janet Yellen said, “Like most of my FOMC colleagues, I believe that the appropriate time has not yet arrived, but I expect that conditions may warrant an increase in the federal funds rate target sometime this year.” She concluded her speech by saying, “Nothing about the course of the Committee's actions is predetermined except the Committee's commitment to promote our dual mandate of maximum employment and price stability.”

(5) YRI. Debbie and I are now assigning the following subjective probabilities to the three possible scenarios for the Fed’s liftoff this year: Normalization (20%), One-and-Done (60), and None-and-Done (20). I’m still expecting the one and only rate hike this year in June, while Debbie thinks September is more likely. The FOMC isn’t the only organization with split personalities.
(Based on an excerpt from YRI Morning Briefing)

Tuesday, March 24, 2015

Yellen: On Bubbles
Once the Fed starts to normalize monetary policy, stocks could stumble or even tumble on fears that rising interest rates will pose more of a competitive challenge for stocks or, worse, cause a recession. However, in her press conference last week, Fed Chair Janet Yellen reiterated that when rate hikes start they are likely to be small and gradual:
Once we begin to remove policy accommodation, we continue to expect that--in the words of our statement--"even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run."
There’s certainly no reason for monetary policymakers to raise interest rates in an effort to bring down inflation given that inflation remains below their 2% target. If so, then the current economic expansion isn’t likely to end anytime soon as a result of tighter monetary policy.

Last Wednesday, at Fed Chair Janet Yellen’s press conference, Peter Barnes of Fox News asked:
I wanted to check in again with you on whether or not you see or have any concerns about bubbles out there in the economy, particularly the financial markets, debt and equity markets and I want to refer to your most recent Monetary Policy Report to Congress last month in which you said overall equity valuations by some conventional measures are somewhat higher than their historical levels, valuation metrics in some sectors continued to appear stretched relative to historical norms. In the same report last year, in July, the reports specifically mentioned biotech and social media stocks as being substantially…stretched. Do you still feel that way, and can you comment on bubbles and particularly these sectors?
Her answer was short and a bit curt:
Well, I don't want to comment on those particular sectors. You know, as we said in the report, overall measures of equity valuations are on the high side, but not outside of historical ranges. In some corporate debt markets, we do see evidence of unusually low spreads. And that's what we referred to in the report.
Let’s have a closer look:

(1) Sure enough, the July 2014 report stated:
Nevertheless, valuation metrics in some sectors do appear substantially stretched--particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.
In her prepared remarks for her July 15, 2014 congressional testimony on monetary policy, Yellen said:
While prices of real estate, equities, and corporate bonds have risen appreciably and valuation metrics have increased, they remain generally in line with historical norms. In some sectors, such as lower-rated corporate debt, valuations appear stretched and issuance has been brisk.
During the Q&A, she warned about biotechs and social media stocks being overvalued as well.

(2) In the February 2015 report, there was no mention of any specific “stretched” sectors, though:
“[o]verall equity valuations by some conventional measures are somewhat higher than their historical average levels, and valuation metrics in some sectors continue to appear stretched relative to historical norms.
Now, during her latest press conference, Yellen said, “equity valuations are on the high side, but not outside of historical ranges.”

Yes, P/Es are on the high side of their historical ranges. Yes, they are not outside their historical ranges. However, doesn’t the high side of the historical range suggest that stocks might be a wee bit overvalued? Back in July of last year, Yellen said that valuations seemed a bit “stretched.” Now she doesn’t want to discuss the subject.

Yellen’s number-one priority remains the labor market. She acknowledged that it has improved, but said last week that she sees “room for further improvement.” If postponing or slowing monetary normalization is necessary to achieve her goal, so be it, even if it leads to a melt-up in stocks.

On Friday, a day after retiring as president of the Federal Reserve Bank of Dallas, Richard Fisher appeared in an interview on CNBC. He warned:
Are we vulnerable in my personal opinion to a significant equity market correction? I do believe we are, and the reason for that is people have gotten lazy. They've depended totally on the Fed.
He added that in the event of a market correction, the Fed should not intervene because the market is “hyper overpriced.”

Fisher, unlike Yellen and his other colleagues at the Fed, has had some experience actually managing money. His resume includes stints at Brown Brothers, where he was assistant to former Undersecretary of the Treasury Robert V. Roosa. He specialized in fixed income and foreign exchange markets. From 1978 to 1979, he served as Special Assistant to Secretary W. Michael Blumenthal at the US Treasury, where he worked on issues relating to the dollar crisis. In 1987, Fisher created Fisher Capital Management and a separate funds management firm, Fisher Ewing Partners, managing both firms until 1997.
(Based on an excerpt from YRI Morning Briefing)

Monday, March 23, 2015

No Shortage of Guidance
Prior to last week’s FOMC meeting, several members of the committee suggested that the first rate hike was likely to be approved at their June 16-17 meeting. Now the latest statement and Yellen’s comments at her press conference suggest that this guidance is no longer valid.

Yellen said:
Let me emphasize again that today’s modification of the forward guidance should not be read as indicating that the Committee has decided on the timing of the initial increase in the target range for the federal funds rate. In particular, this change does not mean that an increase will necessarily occur in June, although we can’t rule that out.
So the latest guidance is that anything is possible. Furthermore, consider the following:

(1) The FOMC members’ median estimate for the fed funds rate target at the end of this year was lowered to 0.625% from 1.125% at the end of December. The median projection at the end of 2016 is 1.875%, down from 2.500%, while the longer-run estimate of the fed funds target rate held steady at 3.750%. (Notice that the Fed is forecasting the rate to three decimal points!)

The Fed’s latest guidance tends to confirm our view that “none-and-done” or “one-and-done” are more likely than a normalization of monetary policy over the rest of this year. A fed funds rate of 1.000% by the end of this year would be more normal than 0.625%.

(2) I first raised the possibility of one-and-done in our 10/6 Morning Briefing last year. I based this scenario on the possibility that the dollar might be almighty:
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.
The JP Morgan trade-weighted dollar is up 10% since I wrote that, and up 16% since July 1 of last year. The “dollar” was mentioned nine times in Yellen’s latest press conference. It was mentioned once at her previous press conference on December 17, 2014. The word was mentioned 15 times in the Fed’s February Beige Book of Current Economic Conditions. It was mentioned eight times in the January Beige Book.
(Based on an excerpt from YRI Morning Briefing)

Wednesday, March 18, 2015

Yellen’s Mindbender
In her congressional testimony on February 24, Fed Chair Janet Yellen reiterated that Fed policy is data dependent:
Provided that labor market conditions continue to improve and further improvement is expected, the Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when, on the basis of incoming data, the Committee is reasonably confident that inflation will move back over the medium term toward our 2 percent objective.
There’s no doubt that labor market indicators continue to improve. Since her testimony, we learned that the total number of job openings rose to 5.0 million during January, the highest since January 2001. Quits rose to 2.8 million, the highest since April 2008. The NFIB reported that the percentage of small business owners with job openings soared to 29% during February, the highest since April 2006.

Nevertheless, in their meeting yesterday and today, the members of the FOMC must have voiced some concerns about whether the recent weakness in other economic indicators is weather related or not. They are dependent on data that may be hard to read right now. Can they be reasonably confident that the economy is doing well enough to push inflation back toward 2% over the medium term (whatever that means)?

As we await the Fed’s latest decision this afternoon, let me highlight this priceless quote from Yellen’s latest testimony:
The FOMC’s assessment that it can be patient in beginning to normalize policy means that the Committee considers it unlikely that economic conditions will warrant an increase in the target range for the federal funds rate for at least the next couple of FOMC meetings. If economic conditions continue to improve, as the Committee anticipates, the Committee will at some point begin considering an increase in the target range for the federal funds rate on a meeting-by-meeting basis. Before then, the Committee will change its forward guidance. However, it is important to emphasize that a modification of the forward guidance should not be read as indicating that the Committee will necessarily increase the target range in a couple of meetings. Instead the modification should be understood as reflecting the Committee’s judgment that conditions have improved to the point where it will soon be the case that a change in the target range could be warranted at any meeting.
Let’s see how Yellen updates this mindbender at her press conference this afternoon.
(Based on an excerpt from YRI Morning Briefing)
What's the Rush?
A 3/6 NYT editorial opposed any monetary tightening for now: “The Fed should hold off until wages are growing in tandem with inflation and productivity.” In a speech in India yesterday, IMF Chief Christine Lagarde warned of a repeat of high market volatility and capital outflows when the Fed hikes rates next time and asked India and other emerging market economies to be prepared for such an eventuality. Amir Sufi, an economics professor at the University of Chicago, was widely quoted yesterday saying that inflation doesn’t justify a Fed rate hike this year.

What’s the rush? Well, the federal funds rate has been at zero since December 16, 2008. That’s over six years. One of these days, the Fed will need to lower interest rates to avert or moderate the next recession. To be prepared for that eventuality, the Fed should start raising interest rates.

We think that’s the main reason why the Fed will do so at the June 16-17 meeting of the FOMC. However, it may still be “one-and-done” for Fed rate hikes this year since there is no rush to raise interest rates rapidly. We are expecting a “patient pace” of rate increases. Stocks and bonds should respond positively to that. The dollar might stop soaring as well.
(Based on an excerpt from YRI Morning Briefing)

Wednesday, March 11, 2015

In Dollars We Trust
Over the past few years, several Fed officials have said that they would start raising interest rates only when they believed that the economy had achieved “escape velocity.” In recent months, they’ve been preparing the launching pad for “lift-off” around mid-2015. To do so, they tapered QE last year and terminated it last October. They dropped the “considerable time” language from the January 28 FOMC statement, indicating that since QE bond purchases were finished, the time for hiking rates was drawing near.

The result so far has been that the JP Morgan trade-weighted dollar lifted off from last year’s low of 83.75 on July 1 to 98.33 yesterday. The dollar immediately achieved escape velocity, rising almost vertically by 17% over this period to the highest level since September 3, 2003. The Fed’s “major” and “broad” measures of the trade-weighted dollar are following the same path as the JP Morgan version--which includes Australia, Canada, China, Denmark, Eurozone, Hong Kong, Japan, Korea, Mexico, New Zealand, Norway, Singapore, Sweden, Switzerland, Taiwan, and the UK.

Adding rocket fuel to the almighty dollar have been moves by the ECB and BOJ towards ultra-easier monetary policies, which further weakened their currencies. Let’s review recent developments that have sent the dollar soaring and consider the implications for Fed policy:

(1) Euro getting trashed. The ECB’s Governing Council agreed at the June 5, 2014 meeting of the committee to “targeted longer-term refinancing operations” (TLTROs). At his monthly press conference on August 7 last year, ECB President Mario Draghi said, “the fundamentals for a weaker exchange rate are today much better than they were two or three months ago.” At the time, the euro was at $1.30.

On October 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. The euro was at $1.26.

On November 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. On January 22, the Governing Council voted to implement QE, with bond buying starting this week. The euro was down below $1.07 yesterday, probably on its way to parity with the dollar.

(2) Yen is stir fried. On October 31 of last year, the BOJ announced a significant increase in bond and stock purchases. During April 2013, the BOJ implemented a similar program that was supposed to revive Japan’s economy and end deflation as part of Abenomics. The BOJ upped the ante at the end of October 2014. According to the BOJ’s press release, the bank would triple the pace of its buying of stock and property funds, extend the average maturity of its bondholding by three years to 10 years, and raise the ceiling of its annual Japanese government bond purchases by ¥30 trillion to ¥80 trillion. The yen has declined by a whopping 36% since late 2012.

(3) Commodity exporters freefalling. Also jumping off the currency cliff since last summer have been the commodity producers. The Canadian and Australian dollars are down 12% and 15% on a y/y basis. The Brazilian real is down 25% y/y. The South African rand is down 13% y/y. The Mexican peso is down 15% y/y.

(4) Downside of depreciation. Some of the currency depreciation pressures are home brewed. However, adding to everyone’s misery is the anticipation of monetary normalization in the US. While the US economy might be ready for it, the rest of the world may not be so ready. Indeed, plunging currencies are offsetting some of the benefit of falling oil prices for oil-importing countries. Rising US interest rates might also unsettle foreign bond and stock markets, especially in the emerging economies. The risks that something will break are increasing as the dollar continues to soar.

(5) Risky business for US. There are also risks for the US in a soaring dollar. It gives a competitive advantage to our trading partners. That means it stimulates our imports while depressing our exports. In addition, it depresses the dollar value of profits from overseas. Profits drive employment and capital spending. So weaker profits attributable to the strong dollar can slow the economy down.

There is a strong correlation between the y/y growth rates in S&P 500 forward earnings and aggregate weekly hours worked in private industry. The y/y growth rate of capital spending in real GDP is also driven by this profits cycle.

(6) Fed’s tough exit act. The bottom line is that the Fed has a problem. The FOMC rarely considers the impact of the dollar on the US economy. The subject is almost never discussed at the FOMC meetings. The members of the committee may need to give more weight to the soaring dollar in their deliberations. They have three options for the rest of this year. They can proceed to normalize monetary policy and raise interest rates a few times this year. “One-and-done” is another option. So is “none-and-done.” Debbie and I still believe that the last two are more likely than normalization given that the dollar will continue to soar if the Fed doesn’t back off.
(Based on an excerpt from YRI Morning Briefing)

Monday, March 9, 2015

Central Banks: Diverging
China’s government is predicting a “new normal” for the Chinese economy with growth continuing to slow. The PBOC started lowering interest rates late last year, signaling that China’s central bank will do whatever it takes to slow the slowdown. At the same time, the US monetary authorities are preparing to transition from the new normal of NZIRP (near-zero interest rate policy) back to the old normal of rising interest rates as the US economy shows signs of stronger self-sustaining growth, led by the labor market.

The ECB and the BOJ remain committed to their ultra-easy monetary policies. Last week, the ECB confirmed that its new QE program will start today. The BOJ remains on course with its QQEE, which is the expanded and extended version (since October 31, 2014) of its QQE program (first announced on April 4, 2013). The resulting freefalls in the euro and the yen may be starting to boost the exports of both the Eurozone and Japan, as we discussed last week. Here’s a brief review of the latest developments among the major central banks:

(1) US. The 2/27 WSJ reported that after Fed Chair Janet Yellen’s congressional testimony on February 24 and 25, Fed “officials fanned out to drive home the message that they are likely to start raising short-term interest rates later this year.” They included Fed Vice Chairman Stanley Fischer and the leaders of the Atlanta, St. Louis, and San Francisco Fed banks.

I’m sure we will shortly hear from many of them about their reaction to the latest stronger-than-expected employment report. In his Barron’s column this week, Randy Forsyth probably expressed the widespread consensus view:
When the Fed’s policy-setting panel gathers on March 17 and 18, there’s a good chance the ‘patient’ will be gone. That would leave the path open for the FOMC to lift its target for the federal-funds rate at the June 16-17 confab from the near-zero level that has prevailed since the crisis days of December 2008.
That assessment was instantly discounted in the bond market on Friday.

(2) Eurozone. Even though the ECB’s QE program will start this week, ECB President Mario Draghi came close to declaring “Mission Accomplished” at his press conference last week:
First of all, let me say, our monetary policy decisions have worked, and it’s with a certain degree of satisfaction that the Governing Council has acknowledged this. … The market reaction to the announcement, the expectation first and the announcement second, of our asset purchase program has also been quite effective and quite positive.
The ECB said it expects real GDP to grow 1.5% this year, 1.9% in 2016, and 2.1% in 2017. That 2017 forecast marked the first time since the end of 2007 that ECB economists have been so bullish. They also predicted that inflation, which is forecast at zero this year, should gradually move towards the ECB’s target of just below 2% by 2017.

Last August, Draghi indicated that QE was coming and that the goal was to devalue the euro to stimulate exports and revive inflation. The euro is down 22% since last year’s high of $1.39 on May 6 to $1.09 currently. That mission was certainly accomplished.

(3) Japan. The BOJ has also accomplished a dramatic depreciation of the yen, which is down 36% since late 2012. Haruhiko Kuroda, governor of the BOJ, never specifically stated that the bank’s goal was to devalue the yen. How do you say, “Who is kidding who?” in Japanese. Despite the plunge in the yen, which lifted import prices, the BOJ hasn’t accomplished its goal of boosting inflation.

As noted in the 3/7 issue of The Economist:
The BOJ’s target, laid down in 2013, was to raise core inflation (a measure that includes energy but excludes fresh food) to 2% by April. It remains far short of that goal. In January, core prices rose by a mere 0.2% year on year, excluding the effect of a recent increase in the consumption tax.
The “core core” CPI, which excludes energy as well as fresh food, was at 0.4%, much closer to zero than 2%.

(4) China. Last Thursday, Reuters reported:
China plans to run its biggest budget deficit in 2015 since the global financial crisis, stepping up spending as Premier Li Keqiang signaled that the lowest rate of growth in a quarter of a century is the ‘new normal’ for the world's No.2 economy. Speaking at the opening of the country's annual parliamentary meeting on Thursday, Li announced a growth target of around 7 percent for this year, below the 7.5 percent goal that was narrowly missed in 2014.
Li actually sounded quite alarmed:
The downward pressure on China's economy is intensifying. Deep-seated problems in the country's economic development are becoming more obvious. The difficulties we are facing this year could be bigger than last year.
The article noted:
The fight against pollution and corruption have contributed to the slowing economy, as Beijing has clamped down on dirty industries, and the fear of being caught in the anti-graft net has had a chilling effect on some business activity.
On February 28, the PBOC cut interest rates for the second time in three months. Last week, the WSJ Grand Central observed:
For much of last year, the PBOC, under long-serving Governor Zhou Xiaochuan, insisted on targeted efforts rather than broader moves like rate cuts out of concern that broadly easing credit would worsen debt problems. The central bank is acceding to demands from the Chinese leadership to reduce financing costs for businesses and bolster growth, according to officials and advisers to the bank. A rate cut in November was the first such move in two years and was followed last month by an across-the-board measure lowering the amount of money banks need to hold in reserve, thereby freeing up more funds for lending.
(Based on an excerpt from YRI Morning Briefing)

Wednesday, February 25, 2015

Yellen: A Dash of Fairy Dust
There really weren’t any surprises in Fed Chair Janet Yellen’s semiannual congressional testimony and report on monetary policy yesterday. She signaled that while the normalization of monetary policy might begin around mid-year, the FOMC is likely to do so very gradually. Both stock and bond prices responded positively. The S&P 500 rose to 2115, another record high. The Nasdaq rose to 4968, only 1.6% below its record high of 5048 on March 10, 2000. Let’s review what she had to say:

(1) Labor market. Fed policy remains dependent on “incoming data.” Despite the awesome employment report released on February 6, Yellen said in her prepared remarks that “a high degree of policy accommodation remains appropriate to foster further improvement in labor market conditions and to promote a return of inflation toward 2 percent over the medium term.”

(2) “Patient.”. She didn’t say when or under what conditions the word “patient” would be deleted from the FOMC’s forward guidance. However, she reiterated that the “FOMC's assessment that it can be patient in beginning to normalize policy means that the Committee considers it unlikely that economic conditions will warrant an increase in the target range for the federal funds rate for at least the next couple of FOMC meetings.”

This does suggest that the word could be dropped from the March 18 statement if the FOMC anticipates liftoff at the June 16-17 meeting. I still think the FOMC might keep the word, but change its context to suggest that the Fed will be patient about raising interest rates further after the first rate hike.

(3) Normalization. Now, I challenge you to decipher the following from Yellen’s prepared remarks, which seems to have been written in Greenspan-speak:
If economic conditions continue to improve, as the Committee anticipates, the Committee will at some point begin considering an increase in the target range for the federal funds rate on a meeting-by-meeting basis. Before then, the Committee will change its forward guidance. However, it is important to emphasize that a modification of the forward guidance should not be read as indicating that the Committee will necessarily increase the target range in a couple of meetings. Instead the modification should be understood as reflecting the Committee's judgment that conditions have improved to the point where it will soon be the case that a change in the target range could be warranted at any meeting. Provided that labor market conditions continue to improve and further improvement is expected, the Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when, on the basis of incoming data, the Committee is reasonably confident that inflation will move back over the medium term toward our 2 percent objective.
The main point seems to be that the FOMC might continue to normalize monetary policy even if inflation remains below 2%, as long as the committee expects it will move back up there in a reasonable time.

However, the federal funds rate is likely to remain below “normal” for quite some time:
It continues to be the FOMC's assessment that even after employment and inflation are near levels consistent with our dual mandate, economic conditions may, for some time, warrant keeping the federal funds rate below levels the Committee views as normal in the longer run. It is possible, for example, that it may be necessary for the federal funds rate to run temporarily below its normal longer-run level because the residual effects of the financial crisis may continue to weigh on economic activity
(4) Bubbles. In her prepared remarks during her previous semiannual testimony on July 15, 2014, Yellen mentioned that she had some concerns about speculative excesses as some investors “reach for yield.” She didn’t mention that this time. However, the formal report observed:
Overall equity valuations by some conventional measures are somewhat higher than their historical average levels, and valuation metrics in some sectors continue to appear stretched relative to historical norms.
There was no specific mention of stretched valuations for smaller firms in the social media and biotechnology industries, as there was in the July 2014 report. Back then, overall valuations seemed consistent with historical norms for the prices of real estate, equities, and corporate bonds
(Based on an excerpt from YRI Morning Briefing)