The Grand Illusion
by Guy Haselmann, Director, Capital Markets Strategy, Scotiabank GBM
• Ever since Bullard's agoraphobic* performance last week on Bloomberg TV, it should be crystal clear to the FOMC and investors just how powerfully markets will react to any shifts in Fed policy or attempts at policy normalization. An equity market freefall abruptly took an about-face, resuming its 'melt-up' trade, after a worried Bullard merely hinted at the possibility of more QE stimulants. (A highly unlikely outcome: see "Cold Turkey" 10/15/2014).
• The FOMC should take this as a warning sign. It would be irrational for the Fed to believe that after QE purposefully elevated asset prices and generated a one-way moral hazard spectacle, that there is not going to be some-type of reversal (reaction) when QE is withdrawn and the first hike nears.
• The new flaw in Fed communication that has arisen recently, and that was amplified by Bullard's interview, is how Fed policymakers fundamentally assess and mollify the trade-off between attempts at stimulating real economic activity and financial stability risks.
• For several years, the FOMC has been confronted with the delicate balance between removing accommodation too slowly and removing it too quickly. Since the Fed is basically out of effective bullets and its balance sheet has ballooned to the practical limits of prudence, the Fed is therefore trying to err on the side of not removing accommodation too quickly. In this regard, the Fed has allowed the fog to roll in, by repeatedly and cunningly changing the markets' focus in order to 'buy time'. (As a case in point, the first hike never arrived when the unemployment rate hit 6.5% as the Fed initially said it would.)
• Yet, how far can this asymmetrical leaning go before negative second-order effects and risks to financial stability via asset bubbles make this stance a (ever-growing) poor trade-off. It seems to me that if the Fed were truly data dependent then it would have ended QE a long time ago and even hiked rates already.
• The Unemployment Rate is currently 5.9%; not far from the 5.5% level that is widely considered full-employment. It could be argued that technological advancements or demographic shifts alone could have structurally lifted the level considered full-employment. Given this, and the plenty of other economic indicators that look quite strong, I find it astonishing that the Fed is still providing depression-like policies, let alone not already hiking.
o No wonder why financial markets are (temporarily) in 'melt-up' mode': the appearance of an accommodative Fed, maintains the relative-peer-performance race that is driving so many portfolio managers.
• Last week's wild trade was a precursor of the unwind trade that will occur when the one-way bets have to find a two-way equilibrium clearing price. Dreadful market liquidity due to regulatory constraints have been evident recently and will cause a down-side overshoot during the unwind process. I suspect that barring some negative global event, the Fed will want to hike in March (if not sooner to regain some credibility). However, the chance of 6 months passing without encountering a problem is probably small; thus the Fed could be confronted with losing its ideal window to do so.
• The FOMC's dialog needs to change immediately. The current trade-off is not the contemporaneous one between more versus less policy stimulus today, but is an intertemporal trade-off between more stimulus today at the expense of more challenging and disruptive policy exit (and disruptive markets) in the future. (see "Time Inconsistency" 6/25/14)
• Another factor that has magnified market stresses and helped to keep a bid in the Treasury market recently has been the release by the Fed and other regulators of the final version of the liquidity coverage rule (LCR). LCR-mandates have led to large bank hoarding of 'level-one' risk-free highly-liquid securities (e.g., Treasuries) at the expense of riskier less-liquid securities. Volatility has increased partially due to those risks migrating to less well-capitalized institutions. This factor is not going away any time soon.
o I still expect long-dated Treasuries to maintain an underlying bid and grind to lower yields over time.
o I expect the pace toward lower yields to quicken once the Fed's policy pivot leads to unwinds of the QE-generated asset bubbles that have been created; and which were chased by so many who were fearful of missing the upside or of underperforming peers. This circumstance is a Hobson's choice which now has a shortening 'half-life'.
• "Someday soon we'll stop to ponder what on Earth's this spell"we're under" – Styx
[*Note: Agoraphobia is fear of open or public spaces, or alternatively (as used above), fear of the inability to escape or extract one-self from one's circumstance.]Regards,
Guy
Guy Haselmann | Director, Capital Markets Strategy
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