The Dovish Hike
by Guy Haselmann, Director, Capital Markets Strategy, Scotiabank GBM
· The FOMC needs to rip the band aid off and hike rates already. The uncertainty surrounding the timing of the first hike has made markets untradeable and wildly volatile.
· Many believe that mixed messages coming from FOMC members are damaging credibility. However, a hike would allow FOMC members to get back on the same page by focusing on a unified message of being ‘gradual’ and emphasizing the extraordinary amount of accommodation still being provided. Hence, it would be agreed that a hike would, no doubt, be spun in the most dovish light possible.
o In August 2014, I first labeled the Fed’s dovish/hawkish duality “Great Aunt Addy Policy” in honor of my Great Aunt Addy who drove simultaneously with one foot on the accelerator and one on the brake.
· Since the Fed is likely more concerned about the fragility of financial markets than it is in derailing economic growth, Chair Yellen will probably use her best psychoanalyst skills to convince markets that the hike feels and sounds almost like an ease. Adjectives describing actions will be carefully chosen. The press conference will probably emphasize the ‘slight’ removal of extraordinary accommodation, rather than sounding like a tightening has just occurred, or that a tightening cycle has just begun.
· Markets will be left with the impression that further action is not forthcoming anytime soon. The FOMC is fully aware that by sounding dovish while hiking rates, they can influence the market’s reaction function, particularly High Frequency Traders (HFTs) who use data-mining algorithms to dictate trading actions.
· The Fed cannot be seen as caving into political pressures from lobbyists, Jackson Hole protestors or international organizations. Today, the front pages of many newspapers have articles about the World Bank joining the IMF in warning and advising the Fed against hiking rates next week. The World Bank Chief economist stated that the Fed “risks triggering panic and turmoil” in emerging markets (EM). He added that a hike would lead to “fear capital” leaving emerging economies as well as to sharp swings in their currencies.
· In my opinion, the basis of the World Bank’s argument is naïve, myopic and short-cited. Haven’t these market movements and capital flows already happened to EM with many currencies down 20%-70% in the past year? Isn’t it possible that part of this re-pricing is a reflection of the FOMC readying markets for well over a year for a ‘mid-2015’ rate hike? The World Bank seems worried about capital flows that have largely already taken place.
· How can it not mention any of the risks of market distortions due to years of having rates at zero? Credit spread widening is also partially in anticipation of the Fed’s well-advertised hike. A hike would help to slow the extreme amounts of corporate debt that is being issued at current levels.
· There is risk in the Fed preparing the market for a hike only to pull away and then have the market contend with pricing it back in at a later date.
· Part of the World Bank’s argument is that conditions are on shakier footing today than they were at the March or June meetings when the FOMC took no action. This is a weak argument, as it presupposes that the Fed made the correct choice by not hiking in March or June.
· Many, including myself, would argue that the Fed should have hiked back in 2014. Actually, in my humble opinion, the Fed never should have engaged in QE3 or Operation Twist. But I digress. If market volatility is partially a function of past risk-seeking behavior encouraged by the Fed’s uber-policy accommodation, then waiting longer to lift rates will only trigger even greater fits of volatility down the road.
· Last year, the Fed moved its guidance (once again) to a hybrid of calendar guidance (mid-2015) and data dependency (loosely defined as economic progress). Each part has been met. Hence, a Fed delay next week risks a hit to its credibility in the eyes of the market. Pausing would not just damage credibility, but it could scare markets, and would keep the uncertainties surrounding the timing of ‘lift-off’ (and the accompanying negative consequences that come with such), lingering above markets.
· Yellen has given countless speeches implicitly acknowledging insight into the Phillips Curve. Her speech at Jackson Hole in 2014 tried to define labor slack. The CBO defines the natural rate at 5.38%. Yellen has argued that it has fallen below the perceived level of 5.5% to a range of 5% to 5.5%. Either way, how is 0% justified? Even a Taylor Rule using U6 figures says that the Fed should not be at zero rates.
· Now that the unemployment rate has fallen to 5.1%, it makes no sense for her to maintain or to try to justify the emergency level of zero rates any longer. Under the Phillips Curve argument, labor slack in the economy is negative (UR-NAIRU). In every cyclical expansion, when the UR falls through NAIRU, wages accelerate. The Fed holds the belief that wages generate inflation, although empirical research is inconclusive.
· Other pockets of data have been strong. Car sales were a near 17.7 million units. Commercial real estate prices have surpassed bubble-era peaks. According to Federal Reserve data, household net worth is 25% higher than the high reached in 2007.
· Some argue that the Fed should wait to hike rates, since inflation is low. As Fed Vice Chair Stanley Fischer said two weeks ago, once the Fed sees inflation it is too late. Moreover, there are measurement issues with correctly determining inflation accurately. Low inflation is likely being mis-diagnosed and is probably a function of the positive benefits of technological advancements and globalization, rather than concerns about the consumer.
· In addition, zero rates may actually be counter-productive to lifting inflation. It may cause over-production (among other factors) as I wrote in my note from July 21st entitled, “Too Much of Everything”.
· Furthermore, the Fed’s Congressional Statutory mandate is “stable prices”. Aside from a brief period around the 2008 crisis, prices have been stable for over a decade. The Fed’s 2% inflation target is a self-created objective. Why has the Fed unilaterally decided that a 2% inflation target is the best policy? Why is it considered optimal policy for hard earned wages of workers to be discounted by 2% each year? Again, I digress.
· Markets will only stop gyrating wildly after central banks discontinue trying to control them. The implicit “Fed put”, combined with zero rates, creates unsavory behavior and misallocation of resources. When underlying economic fundamentals begin to diverge too far from asset prices, particularly when central bank policy begins to change from a highly aggressive seven-year course, high volatility and steep market corrections should be expected. I maintain my view to buy Long Treasury bonds.
“Is this the real life? / Is this just fantasy? / Caught in a landslide / No escape from reality / Open your eyes /
Look up to the skies and see.” – Queen
Regards
Guy
Guy Haselmann | Capital Markets Strategy
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Scotiabank | Global Banking and Markets
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T-212.225.6686 | C-917-325-5816
guy.haselmann[at]scotiabank.com
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Global Macro Commentary September 9 - The Dovish Hike
