Moving the Goal Posts
by Guy Haselmann, Director, Capital Markets Strategy, Scotiabank GBM
• If the Fed were truly ‘data dependent’ they would have tightened already. Yet, it has been difficult to react to this fact, because of the FOMC’s recent history of fluctuating policy objectives and shifting interpretations as to how best to achieve its dual mandate. Simply stated, the goal posts and communication around them keep moving.
• In 2006, Bernanke said that “stable prices are a prerequisite to the achievement of the Federal Reserve’s other mandated objectives….” In other words, achieving maximum employment and low long-term interest rates, required price stability foremost. However, in the past few years, the FOMC expressed its willingness to compromise price stability in order to gain improved employment. It seems to me that markets have been duped into believing that inflation is a proxy for growth.
• The Fed even went so far as to explicitly state, “The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic condition may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run”. This declaration was euphoric for risk assets and music to the ears of speculators.
• It further served to turbo-charge already rampant moral hazard. It now appears that any unanticipated outcome or another deviation could trigger an unwelcomed unwind of those exposures, damaging (further) the Fed’s long-run credibility.
• Was the Fed forced to delicately shift focus because stable inflation was inconsistent with the aggressive scaremongering they were doing about deflationary fears? After all, the PCE deflator tracking around 1.5% (not falling) and seemed ‘close enough’ to the Fed’s 2% target. Were exaggerated fears of deflation merely a smokescreen to justify risky and politicized policies? We may never know, but it is possible that the Fed’s experimental actions might be worse than the deflation risk itself.
• Charles Calomiris of Columbia University stated in his paper Phony Deflation Worries, “There is no obvious directional connection between disinflation or deflation today and changes in real economic activity tomorrow”. He goes on to say that “The right way to frame the question of deflation risk is to identify the circumstances under which deflation outcomes propagate adverse economic shocks, leading to further decline in economic activity”.
• The paper goes on to explain the reasons why the Fed fears about deflation are unfounded. He concluded that three necessary conditions must be satisfied in order for a potential deflation to be associated with adverse change in economic activity: 1) it (deflation) must come as a surprise; 2) it must be sufficiently large and persistent, and; 3) it must reflect a negative aggregate-demand shock.
– In other words (and I paraphrase Calomiris) if the deflation was caused by improvements in technology, then this would be good, because it would not be associated with a reduction in the debtors’ net worth, and therefore, will not be a source of financial distress or reduced spending by debtors.
• These conditions clearly have not existed, particularly in the past few years under QE3 and extended ZIRP. Ironically, the reengineered focus on labor markets also seems to have been a smokescreen and has now also become ‘close enough’ to its employment mandate. Measuring slack is imprecise at best. A downward trending 5.9% unemployment rate is not far from what is considered to be NAIRU. The Fed appears to be behind the curve with economic facts not supporting the Fed’s data dependency dialog.
• So, where does this leave the Fed? As I said on October 23, “sooner but slower” seems more practical to me than “longer for longer”. Should it move soon (March latest), maybe it can even regain some credibility. Fisher said in his speech on Tuesday that “monetary policy is like bagging a Mallard, you aim where the bird is going, not where it has been” (due to its lag effects).
• Since investors have chased the same one-way bet for many years, encouraged along by the Fed - and since they remain confused by the Fed’s fluctuating message – I suspect the market’s reaction to an approaching hike in rates is likely to be problematic and have characteristics that resemble the flash crash observed last month.
• The Fed is unlikely to be swayed by challenges facing Asia, Europe, Emerging countries or the Middle East, because most of the countries in those areas are taking actions to confront their own domestic issues.
• However, fragmented global policy shifts - as opposed to the quasi-coordination from 2008-2013 - are causing enormous volatility in currency and commodities. It is likely to spill over into equity and bond markets, and have the potential to trigger disruptive second order effects. Hopefully, the Fed does not miss its window of opportunity to hike before this occurs.
• “Beware of the naked man who offers you his shirt” – Navjot Singh Sidhu
Markets
• I remain a bond bull. The long end of the Treasury market will stay well bid as demand will continue to outweigh supply. The Fed is voluntarily hoarding 45% of all issuance longer than 10 years. Primary dealers have a regulatory-mandated need to hoard Treasuries due to the new liquid coverage ratio (LCR), as well as a shortage of high-quality collateral. PBGC rule changes also encourage LDI long duration Treasury demand for private DB pension plans. I believe the 30-year will continue to march to lower yields.
• On the other hand, the front end is still not priced properly for a Fed that may move “sooner”. As I’ve been saying in recent weeks, there will be periods prior to economic releases when flattening trades will be preferred. Negative carry makes it too difficult to hold then over time.
• In April, I was calling for the 5’s 30’s curve to trade under 140 basis points before the end of the year (142 today). I expect it to trade under 100 bps in early 2015.
• In addition, taking a short position in April Fed Funds futures (FFV5) seems to have an excellent risk/reward profile, strong optionality and a binary profile.
• “You don’t need a weatherman to know which way the wind blows” – Bob Dylan
Regards,
Guy
Guy Haselmann | Director, Capital Markets Strategy
▬▬▬▬▬▬▬▬▬▬▬▬▬▬▬▬▬▬▬▬▬▬▬▬▬▬▬
Scotiabank | Global Banking and Markets
250 Vesey Street | New York, NY 10281
T-212.225.6686 | C-917-325-5816
guy.haselmann[at]scotiabank.com
Scotiabank is a business name used by The Bank of Nova Scotia
Read/Download Guy Haselmann's complete report below:
Global Macro Commentary Nov 5, 2014
Copyright © Scotiabank GBM
