by Guy Haselmann, Director, Capital Markets Strategy, Scotiabank GBM
· There is an absurdity about the term ‘Data Dependent’. Everyone uses it and no one can define what it means. For over a year, every FOMC member has used those two words unremittingly. Yet, neither the FOMC as a group, nor any individual FOMC member, has ever provided any guiding economic details as to what constitutes sufficiently-attractive-enough economic data , suitable for ‘lift-off’.
· The market has priced only a 2.4% and 10% chance of a hike for the June and July FOMC meetings, respectively. It appears that market participates have somehow come to their own conclusion that the ‘data’ must not be adequate-enough to entice the FOMC to hike for the first time in 9 years. How can that conclusion be ascertained with any confidence when no one really knows how to measure economic progress? Since the Fed says that “every meeting is on the table”, is the Fed succeeding or failing in its communication?
· The economy has made great progress. The unemployment rate (U.R.) is 5.4% (down from 10%); a level that for several decades had been considered full-employment. Core inflation has been stable even in the face of plummeting oil and commodity prices. Since many of those prices appear to have bottomed, year-over-year effects will add to inflation indicators by early 2016. Wages are accelerating as seen by ECI (Employment Cost Index), ULC (Unit Labor Costs of Productivity), and Aggregate Hours (Payrolls report – not average hours). I suspect wage growth has already started to hurt corporate earnings and will soon start to be reflected in share prices.
· The strongest part of the economy has been in services (not goods). Consumers are spending money on vacation-type activities, and not as much on ‘things’. This might be one reason why Retail Sales this morning was on the softer side. The bulk of job gains have been concentrated in leisure and hospitality, education, and health services. Hence, amusement parks, travel, hotels, and airlines are doing well. (See Disney stock: higher by 82% in past 12 months)
· As a matter of fact, 2.7 million total jobs have been created in the past 12 months; an average of 226K per month. According to Chicago Fed economists Dan Aaronson and Scott Brave, only 80,000 jobs need to be created to bring down the unemployment rate. This is well-below the 150k-200k required in the 1990s. They argue that the new figure take into account slowing population growth and the decline in the share of the population that is working (demographics).
· Certainly, the U.R. has fallen far faster than the FOMC forecasts. Recall, the Fed initially gave guidance that it would begin raising rates when the U.R. reached 6.5%; a level achieved way back in March 2014. This supports my charge that the Fed has already been ‘lower for longer’. The US exited recession six years ago.
· There are other robust economic indicators and numerous signs that the economy has healed. The NFIB Small Business Optimism has not fallen below 95 in over a year. April non-manufacturing ISM printed 57.8 and has not been below 56 in the past year. The Taylor Rule suggests that rates should be above 2%. Even the Taylor Rule which substitutes U6 for U3 went positive in 2014. The bottom line is that the Fed’s zero interest rate policy is an emergency level that is simply no longer necessary.
· Weak GDP in early 2015 is not an adequate-enough excuse to prevent a near term hike. Most members of the FOMC have said that the wintry pocket of economic weakness will prove to be transitory (similar to what happened in 2014 and 2013).
· Once upon a time, FOMC members used to mention the 18 to 24 month lag of monetary policy action. Somehow the FOMC has gone from looking-out 1.5 to 2 year, to looking at month-by-month economic data that is backward-looking.
· If the FOMC’s indecipherable ‘data dependency’ policy is a convenient excuse to continue with its current aggressive accommodative stance, then it poses a logical question. Why is the FOMC so afraid to lift rates?
· It is my understanding by speaking with a few of them that there are several schools of thought. A few would have preferred hiking already. Some want to ‘lift-off’ ASAP in order to have ammunition in case it is needed. In other words, since almost all are in agreement that QE4 is a non-starter for political reasons, some would like to re-establish ‘ammunition’ ASAP. However, there are others who believe that should a hike be followed by a cut soon thereafter, Fed credibility might be damaged.
· Chair Yellen’s comments last week showed concerns about financial market stability and market froth. The FOMC is rightly concerned, but the only way to know what the market’s reaction to a hike will be, is to actually hike. The longer the Fed waits, the greater the likely reaction.
· The FOMC is best served by getting the first hike out of the way. It should not leave markets to contend with this uncertainty for many more months. The September meeting is 5 months away: an eternity. Recent wild market volatility is a function of this uncertainty; and markets do not like uncertainty.
· The Fed’s balance sheet will play a larger role in Fed policy in 2016. This is a major reason behind my belief that the FOMC will (and needs to) hike sooner (July). I can see two hikes in 2015 and (only) two more in 2016 as the Fed uses a shrinking of its balance sheet as its main de-facto hiking tool in 2016.
· In this note, I outlined reasons why I believe the market is too complacent regarding the potential for a near-term hike. The FOMC does not want to surprise the market, but the Fed cannot afford to have the market fully price in a hike too soon either. Therefore, the Fed may not mind how the markets are trading at the moment.
· With all this in mind, the (FOMC OIS) odds of a hike that I stated above are far too low. I’ll go out on a limb and say that my odds of a hike at the June and July meeting are 25% and 70%, respectively. If I am right, it means that those who have just unwound flatteners and long dollar trades should look to re-establish them in the next few weeks. It also means that those who have just moved into steepeners, short US dollars positions, and added to credit and equity longs, could experience major strife as the summer months approach.
“Living is easy with eyes closed / misunderstanding all you see” – Beatles
Regards,
Guy
Guy Haselmann | Director, Capital Markets Strategy
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Scotiabank | Global Banking and Markets
250 Vesey Street | New York, NY 10281
T-212.225.6686 | C-917-325-5816
guy.haselmann@scotiabank.com
Scotiabank is a business name used by The Bank of Nova Scotia
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