Running the U.S. Federal Reserve has never been an easy job, and the degree of difficulty is only getting higher. Eight years after the crash, the economy is sending confusing signals, and the Fed’s policy makers aren’t sure what they mean. That’s awkward when the one thing investors want from this week’s interest-rate decision is clarity.There are so many things wrong with this editorial comment but before I criticize it, Gerard MacDonell beat me to it in his blog comment, Bloomberg editorial brings it all together (added emphasis is mine):
Under these circumstances, the Fed is bound to disappoint. The best it can do is press cautiously ahead on normalizing monetary policy, explain what “normal” now means, and promise to keep an open mind as new information comes in. What this requires right now, it should also say, is a quarter-point rise in interest rates.
The U.S. unemployment rate stands at 4.9 percent, which once would have been seen as full employment. The target for the federal funds rate is currently 0.25-0.50 percent, which once would have been seen as extraordinary monetary stimulus. Before the crash, economists would have called this combination out of balance: Full employment calls for withdrawal of stimulus, or inflation will rise.
Today both sides of this calculation are in doubt.
It’s unclear what full employment means. The labor-force participation rate isn’t back to where it was before the crash, suggesting that further stimulus might get more people back to work. Wages are rising at a slightly faster rate lately, but there’s no real sign of pressure on prices: The inflation rate stands well below the Fed's 2 percent target, and expectations of future inflation are still subdued.
So full employment isn’t what it used to be -- and interest rates, many economists argue, aren’t as low as they seem. That’s because the degree of monetary stimulus is best measured as the gap between actual interest rates and the so-called neutral rate of interest -- the hypothetical rate that neither adds to nor subtracts from demand. In the U.S. the estimated neutral rate has been trending down, according to the Fed, and now stands at 2 to 3 percent, rather than 4 percent or more. This implies that the current degree of stimulus is 1 to 2 percentage points less than meets the eye.
Reasoning along these lines could be used to justify not just leaving the fed funds rate unchanged but actually cutting it -- as former Federal Open Market Committee member Narayana Kocherlakota recently argued. Either of these courses, though, would be a mistake.
What this kind of analysis leaves out is the growing threat to future financial stability. Very low interest rates (together with a massively enlarged central-bank balance sheet, courtesy of quantitative easing) have supported demand as intended, albeit with ever-diminishing effectiveness; at the same time, however, they’ve artificially boosted financial-asset prices and distorted normal patterns of risk-taking in financial markets.
These distortions were the unavoidable price of emergency stimulus. The emergency is over. Reducing and then eliminating them needs to become a higher priority.
That’s one thing the Fed can be clear about this week. With unemployment at less than 5 percent, a gradual withdrawal of monetary stimulus is appropriate. The Fed should say so -- and should prove it means what it says by raising rates.
In my opinion, the reason the consensus among Fed watchers has been so badly off during the past several years has very little to do with witting speculations having gone awry. Witting speculations are hard.Gerard could be crude at times (seems to imply Fed officials need Kefir in their diet) and he's definitely cheeky here but he's right, the arguments raised in the Bloomberg editorial are extremely weak, not to mention self-serving (tell me those folks at Bloomberg aren't openly worried about the crisis in active management crimping into their profits and that's why they want the Fed to raise rates).
It is much more to do with those unknown unknowns, things people believe are beyond questioning and yet are not.
This editorial on what the Fed “should” do tomorrow is the best I have seen in terms of collecting all these unwitting premises into a tight, comprehensive non-argument. You don’t often see not thinking in its Platonic essence:A rate hike would bring “clarity”, because after Wednesday people would just stop worrying about the Fed.I think all of those arguments are extremely weak, as I have belabored pretty much since I started this blog. I could be wrong on a lot of that. The markets are not spotting you much to bet dovish for tomorrow. Dovish is clearly the consensus among people who actually bet money.
It would be part of “renormalization.” Clearly the normal funds rate is way different from what it has been for eight years.
It would follow the logic of a Taylor Rule, which is a good thing, having worked so well lately.
It would reduce the risk of bubbles. All bubbles happen when rates are 40 bps or less for precisely eight years and none happen with rates “normal.”
It would unwind the “distortions” caused by low interest rates and the Fed’s bloated balance sheet. What the Fed really needs is to let go with a good fart to deal with all the bloating associated with shortening the average maturity of the federal debt.
It would recognize that you don’t need “crisis” policy when the economy is not in crisis. Monetary policy is best conducted as a semantics debate.
But what strikes me is the popularity of the belief that these points are not even debatable. They are just breezily taken as self-evidently true, even though believing in them has been practically speaking a huge loser for years now.
One innovation that the Bloomberg editorial does bring, besides collecting all unwitting premises into one place, is the promotion of intentional anchoring. They want the Fed to conduct policy on the basis of what people previously would have believed. I had not quite seen that one before. Innovative.
[Note: Make sure you read Gerard's other comments on why the market for inflation overestimates remains well bid and Nice catch by Kocherlakota.]
Now, go back to read my comment at the beginning of the month, Is the Fed Set to Hike Rates?, where I stated the following:
[...] is the Fed going to hike rates in September and then follow up with another rate hike in December? Maybe, who knows? Most experts think you need a really "wow" jobs report on Friday to justify a September rate hike but given that employment growth has been decelerating (year over year), I seriously doubt we're going to see another huge upside surprise in the US jobs numbers and today's lackluster manufacturing numbers don't augur well for a September rate hike.And I ended off by stating:
More importantly, let's take a step back and think about the repercussions of the Fed hiking rates once, twice or more:
- The US dollar will climb relative to the euro and yen, something I foresee no matter what the Fed does. A rising US dollar will impact commodity prices and lower US import prices (on goods). Lower goods prices lead to lower inflation expectations, which is what the Fed is trying to stoke higher.
- Emerging market stocks (EEM) and bonds will likely get hit but so will commodity and energy shares. This is why in my comment questioning to sell everything except gold, I explicitly stated to steer clear or even short gold miners (GDX) and junior gold miners (GDXJ), Metal & Mining (XME) and Energy (XLE) shares and pretty much anything leveraged to emerging markets.
- If things get really bad, you can have another emerging markets crisis which will mean the US and Europe will be importing deflation for a very long time.
I still maintain the Fed would be nuts to raise rates in a world where global deflation is still lurking. All this will do is reinforce deflationary headwinds around the world and risk another emerging markets crisis and a prolonged deflationary episode, one that might hit the US economy.Not to toot my own horn but biotechs have been on fire this month to the point where it seems I wake up every day and see an announcement like this one which propelled Tobira Therapeutics (TBRA) up a whopping 700+% in one day!
Quite frankly, no matter what the Fed and other central banks do, all they're doing is buying some time. Inevitably, the deflation tsunami will strike the developed and emerging world, and this will likely bring about a massive fiscal policy response, but by then, it will be way too late.
On that cheery note, let me get back to trading and accumulating some biotech shares (IBB and XBI). This is where I see huge potential (and risk) going forward no matter what the Fed decides to do.
Yesterday, it was shares of Sarepta Therapeutics (SRPT) that leaped by 90% after the FDA approved the company's muscular dystrophy drug eteplirsen. This news made an arse of the Street's Adam Feuerstein who thinks he's a biotech expert (no serious biotech investor takes this hack seriously), but it was music to the ears of Gerard MacDonell's former boss, Steve Cohen, as his fund hit another home run on this announcement (Cohen needs to smile more often):
Anyways, enough biotech babble, let's get back to more serious stuff, the Fed, or more precisely Fed hysteria as my friend Brian Romanchuck aptly calls it.
So far, I've told you what I think the Fed should do. I'm not alone thinking this way. Much smarter and a lot more important people like Larry Summers and Ray Dalio have also voiced their concerns about the Fed raising rates in this debt/ deflation environment.
But what we all want to know is not what the Fed should do but what will it do? Here, I will refer you to something I wrote about last week when I went over the 2016 Delivering Alpha conference:
[...] discussing the Fed with a buddy of mine who runs a one-man currency hedge fund in Toronto, he brought up a good point, "if you look at how the BOJ, ECB, Bank of England and Bank of Canada didn't move on policy, maybe the Fed is going to surprise everyone and hike rates in September and December, after all, these central bankers all talk to each other."
He also told me it's very tough making money in currencies even if you have range-bound views. "Even if you have access to counterparties willing to take the other side of your trade (ie. you're a big player), they will only execute it at a guaranteed profit. More and more banks are acting as agents where in the past they were willing take risk on their books and this adds to costs and volatility."
He thinks the Fed should raise rates and worries about its $4.5 trillion balance sheet but Ben Bernanke doesn't seem too concerned and the Fed is in no hurry to reduce it.
So, the distinction between what the Fed should do as opposed to what it will do is a bit unclear if you look the recent announcements from other central banks.
And to add to the confusion, the Bank of Japan is also making an announcement on Wednesday and some think the BOJ might end up stealing Janet Yellen’s thunder tomorrow.
I don't know and don't really care if the Fed hikes or doesn't hike on Wednesday or if the BOJ maintains or doesn't maintain its asset purchases. All I know is the global deflation tsunami is gaining steam and investors who ignore it are doomed.
I'll tell you something else, even if the Fed hikes rates and the BOJ curbs its asset purchases, which I strongly doubt will happen this year, I'm still going to be trading biotechs no matter what (click on image to see my current watch list):
Let me end with some final thoughts. Newsmax Finance recently reported, Fed: Household Wealth Rises by $1.08 Trillion to Record:
The net worth of U.S. households increased in the second quarter as a rebound in stock market prices and further gains in real estate values bolstered wealth, a report by the Federal Reserve showed.Notice the positive spin put on the gain in household wealth? But just like pension deficits are all about assets and liabilities, if the increase in household debt is growing faster than the increase in net worth, Americans are still in the hole, especially if they're increasing mortgage debt because they can't afford housing costs.
The Fed reported that net worth climbed by $1.08 trillion, or 1.2 percent, to $89.1 trillion, led by a $474 billion increase in housing wealth. Americans’ stock and mutual portfolios climbed by $452 billion. Money in checking and saving accounts also rose slightly.
Household wealth, or net worth, reflects the value of homes, stocks and other assets minus mortgages, credit card debt and other borrowing. The Fed’s figures aren’t adjusted for population growth or inflation.
A 1.9 percent gain in the Standard & Poor’s 500 Index in the second quarter, along with household wealth generated from rising house prices, signal Americans’ financial positions continue to strengthen in the eighth year of the expansion. A re-acceleration in wages would provide a further boost to balance sheets, giving consumers even greater wherewithal to continue spending.
However, Americans are also taking on more debt, particularly mortgages, which suggests they are more confident in their economic futures and their ability to handle the debts.
Household borrowing rose at a 4.4 percent annual rate, the report also showed, up from 2.7 percent growth in the first quarter of 2016. Mortgage debt rose 2.5 percent, the most since the recession.
Consumer spending has propelled economic growth this year as the nation nears what economists consider full employment. The housing market continues to strengthen too.
However, the U.S. central bank is seen keeping interest rates unchanged next week amid concern that inflation is mired at low levels, Reuters reported.
Meanwhile, the Wall Street Journal explains that the data "underscore the U.S. economy’s round trip over the past decade, from a housing bubble to a deep recession to a long and slow recovery that, while impressive in aggregate, has left many households behind."
The Fed’s report provides no information about how assets are distributed among households, but a relatively modest share of the stock market is owned by middle-income households. Edward Wolff, an economist at New York University, has estimated that as of 2013, about 90% of stocks and mutual funds were owned by the wealthiest 10% of households.
“The winners in recent years aren’t the same people who lost out in the crash,” Ian Shepherdson, chief economist at Pantheon Macroeconomics, told the Journal.
This is yet another reason why I can't see the Fed raising rates this year and even if it does, it will have to proceed cautiously and ubber gradually.
On that note my fellow Fed watchers, let me remind you that while I love sharing my insights on pensions and investments, I also appreciate it when people step up to the plate and actually subscribe or donate to this blog via PayPal on the right-hand side under my picture.
A very kind retail investor shared this with me after sending me something:
As you might have inferred from the size of my donation, I’m a retail investor. I tried to subscribe using one of the categories on your site, but each time the system moved me to PayPal the amount entered was 10X the amount it should have been. You might want to look at this.Let me publicly thank this individual for contributing whatever he was able to my blog and publicly thank all retail and institutional investors who contribute. Whenever I get frustrated and down, questioning all the work I put into my blog comments, it's kind messages like this one which lift my spirits.
I really appreciate your posts. I’ve learned a lot about pensions, and I have been in the deflation camp for at least 20 years, so your comments resonate with me. You put me in touch with Messrs. Romanchuk and Bhiorach (ie. Gerard MacDonell), and while I had been following Mr. Trahan for some time, your endorsement of him was helpful. It suddenly occurred to me that between the four of you, it is amazing how much top-level thinking is available to small investors like me for free; and that it would be unethical not to contribute something as a gesture of appreciation. I will try and make it a habit.
Let me however correct this individual on something, François Trahan's research is not free and he doesn't write a free blog. His research is expensive and coveted investment research which is only available by subscribing to Cornerstone Macro, but he was nice enough to allow me to post his opener on my blog.
Also, I am unaware of any problems via my new retail subscription options on the right-hand side under my picture. I asked my girlfriend to look into it and she said it didn't multiply the amount in each option but she didn't go all the way, so if you encounter a problem, please let me know (LKolivakis@gmail.com).
My girlfriend did mention something, however. Those of you reading my comments on your cell phone are not able to see the right-hand side if you're not viewing the web version of my blog, so let me show you the images I am referring to in case you've never donated or subscribed (click on image):
Again, you need to view the web version on your smart phone to view these options and all the links on the right-hand side and you need a PayPal account to contribute to my blog.
Below, while all eyes are on the Fed and BOJ, take the time to listen to Bank of Canada Governor Stephen Poloz talk about the adjustments that savers and companies need to make in response to low interest rates, and economic policies that can help.Canadians need to understand the forces that have led to a prolonged period of low interest rates and make adjustments, Poloz said.
Poloz, another BCA Research alumnus who I had the pleasure of working with years ago, spoke before the Association des économistes québécois, the Cercle finance du Québec and CFA Québec earlier today and his speech is in both official languages.
Also, listen to another recent speech by Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada, (S)low for Long and Financial Stability.
This too is an excellent speech (transcript available here) where Mrs. Wilkins explains why the decline in the global economy’s potential to grow, and the lower interest rates that come with it, pose risks for financial stability. I think Hyman Minsky would totally agree with her if he were still alive today.
Lastly, Michael Contopoulos, Bank of America Merrill Lynch head of high yield, explains why he thinks the Bank of Japan decision is more important than the Fed meeting, and how its outcome could hurt markets. Interesting discussion, listen to his comments on flow of funds and high yield credit (HYG).