Nicholas Glinsman | December 16th, 2021
Now, I fully admit that the following is not necessarily imbued with actionable trades as of now, as flows can always overwhelm fundamental views, but I have written this with the idea that we should keep the headlights on whilst navigating thee markets. I suspect the real action will come with the next set of inflation data and/or unemployment data, however, I am very suspicious of yesterday’s equity rally, particularly the technology sector. Anyway, here goes.
Yesterday, I wrote my first reaction to the FOMC statement after Jerome Powell’s press conference at 3:51pm (EST) on Twitter as follows:
To summarize the supposedly hawkish Powell’s points yesterday:
And yet we ended up with overall financial conditions the same/somewhat looser than they were before the Fed’s announcement. Well, I would posit that some people are ignoring the literal meaning of the Fed’s statements, which show that the “Powell pivot” is a tactical tweak by the Fed that remains very dovish indeed. Given the record of the Fed’s inflation forecasts, we watched Powell yesterday make his first policy error in real time. Let me explain.
The most surprising thing in the Fed’s sedate December meeting was the news — delivered in the notorious “dot plot” — that monetary policy committee members project three interest rate increases next year, rather than the two consensus called for. Even this spooked no one. The stock market was pleased, in fact, rising by a merry per cent or two. The policy-sensitive yield on the two-year Treasury note did not move at all. Five and 10-year yields rose an indifferent couple of basis points. The US central bank’s communications strategy seems to be working perfectly.
This chart shows you the market’s implicit expectation for the fed funds rate after each FOMC meeting next year, and in February 2023, as of the close on Tuesday, and again on the close after the committee had spoken:
Indeed, it is true that the dot plot, charting central bankers’ expectations for future rate rises, unambiguously shows the Fed eyeing higher rates sooner. Here is the plot from back in September:
And here is the new dot plot:
But this is tactics, not strategy. As telegraphed, the Fed is acknowledging short rates will need to rise somewhat to hedge against persistent inflation. That is evident in the 2022 and 2023 dots. But the median forecast for rates in 2024 nudged up only a bit, from 1.75 per cent to just over 2 per cent. The longer run dots have stayed the same.
In the background is the very clear fact that the committee thinks, with a high level of unanimity, that a short raising cycle, topping out at 2.5 per cent, will ensure that inflation is transitory. The committee’s median projection is that personal consumption expenditure inflation in 2022 will be 2.6 per cent, and it is unanimous in thinking that in 2023 it will be barely above 2 per cent.
That is, above target inflation will last about a year. Everybody, say it together now: transitory! The Fed retired the word, but it still thinks the same way.
The bond market appears to wholeheartedly agree with the Fed’s attitude. Five-year inflation break-evens, after trending down this month, float near 2.7 per cent. However, of ominous note, they did rise after the press conference.
And the rate futures market is actually more dovish than the Fed: it thinks the rate raising cycle will top out below 2 per cent. The flat yield curve does not, as some people have argued, predict a too-late, over-tightening Fed mistake. It predicts that the US central bank can stop inflation with a feather. As highlighted yesterday, both consumers and a majority of money managers agree with the bond market that inflation will not last long. The only market signal that might be expressing the contrary view is long-shot technology stocks, which have been selling off hard (though they rose yesterday, but have started to sell off again today). One explanation for this is that they are very rate-sensitive and are anticipating rising long-term rates – in fact, many in the market refer to them as the equivalent of long convexity bonds. Another explanation, though, is that they were trading at stupid prices, and stupidity has been subsiding.
Bottom line on a 2-plus per cent policy rate, if we were to get there, is that it will constitute a very mild tightening of policy.
That Fed chair Jay Powell’s attitude has not changed with his rhetoric was made clear in yesterday’s press conference after the FOMC meeting, where he expressed serious concerns about the labour market and the participation rate in particular. This is not a man who sees the US economy settling at a strong level after the pandemic. The Fed’s projection for real gross domestic product in 2024 and beyond is an uninspiring 2 per cent. Even that may be above trend, given weak productivity growth and demographic headwinds. After inflation subsides, the new “new normal” will probably look a lot like the old “new normal,” which worried everyone in the years leading up to the pandemic.
The Fed, the bond market, consumers and money managers may all be wrong that inflation is unlikely to persist. But don’t be confused by a change in terminology by the Fed. Everyone, from Powell on down, is betting on transitory. If the bet is lost, it’s going to be ugly.
Now for our point of view. This New Keynesian models of Western central banks failed to anticipate this inflationary spike. The academic economists guiding these institutions denied emphatically that it would happen, all along blaming “supply disruptions” rather than the galloping increase in the broad money supply (up 32pc in the US during Covid) caused by their own policies. Is it churlish to point out that supply disruptions are a change in relative prices? They cannot in themselves cause sustained inflation unless accommodated by money creation.
The central banks have continued to conduct QE à outrance even after economies had hit capacity constraints and at a time when structural fiscal deficits are running above 5pc of GDP. They have let real interest rates keep falling in a self-reinforcing pro-cyclical vortex. They know they are close to a credibility crisis and this can lead to unpredictable behaviour.
Despite yesterday’s move by the Fed, the dollar’s subsequent negative reaction against the majors hence, the world’s dollarized financial system has already suffered some convulsions. The Fed’s real broad dollar index has rocketed to secular extremes, and in doing so is draining liquidity from the $14 trillion offshore dollar markets.
We are at a rare turning point in the global monetary regime, and such moments are pregnant with danger.
As you can see in the above table, the eminent Jim Reid and his team at Deutsche Bank have looked at what has happened over the 13 US rate cycles since 1955. The average lapse before the next recession is 42 months, and none has occurred sooner than 11 months. The S&P 500 index typically rises by 7.7pc over the first year but then treads water for another year or so before the final push higher. Does this rule of thumb apply today? The obvious snag is that we have never before started from such an abnormal situation. The ratio of total US stock market capitalisation to GDP – the Buffett indicator – is just off its all-time high of 213pc, far above the dotcom bubble.
The second snag is that a decade of QE has rendered the normal instruments unreadable. The whole world is leveraged to the hilt, with global debt stretched to a record 360pc of GDP. Matt King, Citigroup’s global markets strategist, said it is the ebb and flow of bond purchases that now matters for equity prices and credit spreads. Every time the Fed tries to taper QE – let alone reverse it with quantitative tightening – the markets fall out of bed. There is an acute sensitivity to any change in the flow of Fed liquidity
The question today is whether the Fed’s de facto financing of the Trump and Biden deficits with printed money has allowed such inflationary pressures to build that even tightening still amounts to loose policy. The Atlanta Fed’s instant tracker of GDP growth for the fourth quarter is running at 8.7pc. This is red hot.
It sounds heartless to say but the omicron variant at this stage is largely just “noise” for markets chiefly preoccupied with what the Fed, the ECB and the Bank of England are going to throw at them. Investing is always the art of calculated risk based on imperfect knowledge, and epidemiology is no different. Based on what we know so far, the investible probability is that omicron is, if anything, the solution to the pandemic: a variant that spreads like wildfire but with mostly mild symptoms, delivering a short, sharp shock that clears the way for a rapid return to life as normal. This is bullish, ceteris paribus, but it also implies a hotter global economy in 2022 and therefore a quicker end to easy money.
As an aside, and contradicting JP Morgan’s new forecasts, China may have to miss the recovery party. The regime cannot keep such a transmissible variant out of the country without hermetically sealed isolation. The latest Hong Kong study found that the Sinovac jab offered no antibody defence at all against omicron. In a sense China is stuck with the success of its zero-Covid policy, oversold at home as a propaganda triumph. It is forced to opt for scorched-earth suppression rather than put its vaccines to the test. China may be the great economic loser of the pandemic, trapped in semi-stagnation as the world moves on, the opposite of conventional wisdom a year ago.
Given all the above, I go back to my point – the Fed has made its first policy error.