The Anti-Fed
What is the groupthink of which I speak? It’s a groupthink on monetary policy tactics, tools, governance and strategy, all. Its stated mantra of data dependence causes erratic lurches owed to noisy economic measures. Its statutory medium-term policy objectives are at odds with its myopic compulsion to keep asset prices elevated. Its inflation objectives are far more precise than the residual measurement error. Its preferred output gap models are deeply flawed and troublingly unreliable, obfuscating uncertainty and masking policy bias
Moreover, the groupthink seeks to fix interest rates and control foreign exchange rates simultaneously. Its forward guidance begets ambiguity in the name of clarity. It licenses a cacophony of communications in the name of transparency. It recasts poor economic results with a high-sounding slogan of secular stagnation. And it expresses grave concern about income inequality while refusing to acknowledge the effect of its policies on more consequential asset inequality.
We should take note of a simple, troubling fact: from the beginning of 2008 to the present, more than half of the increase in the value of S&P 500 occurred on the day of Federal Open Market Committee (FOMC) decisions.
Kevin Warsh – BIS paper –August 2017 [link below]
Above are a couple of excerpts of from a BIS paper by Kevin Warsh. According to Predictit.com website, he is neck and neck with Janet Yellen to be named the new Fed Chair now that Gary Cohn has been kicked to the curb by Trump. On Friday, Steve Liesman of CNBC interviewed Bill Dudley of the NY Fed who said the Federal Reserve has a very clear mandate and any new members “…will probably want to follow a pretty similar set of policies to achieve that mandate as the existing team.” That is, ‘don’t expect any big shake-ups.’ When I read Warsh’s very recent comments, I tend to think that there COULD be a shake-up. One other note: from an interview in March 2015, Warsh said, ‘When we instituted QE, the idea was to reverse QE and THEN raise the funds rate.’ The Fed has actually raised rates first, and now is moving to reverse QE. It’s pretty clear Warsh doesn’t see things exactly the way some current members do. By the way, Dudley, even allowing for a mark-down in Q3 GDP due to Harvey and Irma, said he doesn’t think “…they’ll have any meaningful effect on balance sheet normalization decision.” In my interpretation, that means a start at the Sept 20 FOMC, though Yellen always leans to caution. In terms of further rate increases, he said storms could have an effect on timing.
Consider this: according the Fed Funds futures curve, the first fully priced rate hike does not show up until April of 2019…that’s nineteen months! That is, the current front October contract is 9884.5 or a rate of 1.155%, and the first contact that is 25 bps higher in yield is FFJ’19 at 9859.5 or 1.405%.
In last week’s note, I talked about cause and effect between the curve, the dollar, and core inflation, and touched upon models with which we view the economy and the markets. I used to have a client who polled me every day about what I thought the primary factor was for 30 year bond yields. “What are we watching today?” As we all know, sometimes the focus is energy, sometimes stock prices, sometimes other data. Now we’re in an environment where the catalysts bounce around pretty quickly. As a result, there hasn’t been much in the way of market follow-through in the past couple of years, conditioning traders (and machines) to take smaller profits even though a huge move might be coming. For example, it’s f’ing obvious that if a hurricane is going to hit Florida, then there’s a good chance orange trees will be wiped out, and the price of OJ will go up. You know it, I know it, and the Duke brothers know it. But orange juice futures barely reflected the possibility with the contract ranging between 130 and 140 through August. RJO’s own Andrew Geiser suggested buying Oct 160 OJ calls in the middle of last week at just 0.95 offer. By Friday they were 4.50 with the contract pushing 155. I would guess there will be gains to follow. The point here is that there are likely to be some much clearer catalysts for rates going forward. For example, rebuilding stimulus, price pressures, balance sheet reversal, increase in the deficit, a new politically pressured Fed.
Consider this: On Friday, 3 month libor set at 1.3103. Late in the day, EDU7 was being bought in good size at 9870, or 1 bp below libor with one week to go. On the same topic, the three month libor setting is 4.5 bps HIGHER in yield than the 2 year treasury note (1.266%).
I saw an interesting snippet that Harvey, with losses estimated at $180 billion, is about 1% of GDP. Put Irma in the mix and it’s at least 2% of GDP. Those are significant numbers in terms of lost wealth, lost wages, and jobs that will be gone for a long period (which may never come back), let alone the extraordinary human trauma. But these amounts will also represent opportunities for rebuilding for Trump the developer, who may now be linking with Democrats for funding in spite of deficit objections made by Republicans. The program will depend in part on low rates and a weak dollar. In this respect, Trump would do well to stick with Yellen. A Warsh or Taylor Fed might look very different.
Consider this: all one-year Eurodollar calendar spreads from the second year to the third year and from the third year to the fourth year, and from the fourth year to the fifth year are nearly identical, between 15 and 18 bps….not even 3/8th of one percent.
It will be interesting to see if Bank of Canada’s Poloz rate hike last week will stick, standing up to property speculation in spite of “elevated household indebtedness” [Canada household debt to GDP well over 100%], while justifying the move on the slender reed of global synchronized growth. My contention is that global growth is a lagged response to the strong dollar seen from mid-2014 through 2016; that tide has turned with DXY at a new ytd low. There is not a single policy maker that doesn’t make some reference to fx rates, from Dudley to Mnuchin to Draghi (“Not a target but very important to policy”). It’s critical.
One other thing worth mention. A Bloomberg piece last week notes that volumes for CDS to protect against corporate bond defaults has recently surged. [link at bottom]. Along with some other early signs of credit stress, like increases in credit card late payments, these are indications that financial conditions may not remain as buoyant as they’ve been.
In summary, US financial conditions have been very welcoming, with a flat curve, low long term rates, tight credit spreads, firm asset prices. These conditions may be on the verge of changing with both a new Fed and federal gov’t spending stimulus through 2018. In terms of the Fed, there will either be a head that resists rate increases due to political pressure on the excuse of low wages, or a more hawkish chair that is bound to clash with Trump. Either way, it’s likely to erode Central Bank confidence by the end of next year.
My conclusions from the above with respect to positioning are the following. The curve, while extremely flat now, will be steeper by the end of next year. Implied volatility, in both equities and in rates, will increase. There will probably not be another rate hike this year, Yellen will defer to the next Fed Chair (even if it’s her).
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| 9/1/2017 | 9/8/2017 | chg | |
| UST 2Y | 134.4 | 126.6 | -7.8 |
| UST 5Y | 173.2 | 163.8 | -9.4 |
| UST 10Y | 215.5 | 205.8 | -9.7 |
| UST 30Y | 276.6 | 267.9 | -8.7 |
| GERM 2Y | -72.6 | -75.9 | -3.3 |
| GERM 10Y | 37.9 | 31.2 | -6.7 |
| JPN 30Y | 81.6 | 81.1 | -0.5 |
| EURO$ H8/H9 | 21.0 | 19.0 | -2.0 |
| EURO$ H9/H0 | 16.5 | 15.5 | -1.0 |
| EUR | 118.63 | 120.37 | 1.74 |
| CRUDE (1st cont) | 47.29 | 47.48 | 0.19 |
| SPX | 2476.55 | 2461.43 | -15.12 |
| VIX | 10.13 | 12.12 | 1.99 |
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http://www.bis.org/publ/bppdf/bispap92.pdf
