Posts tagged ‘Fed’
It is almost four months since Donald Trump won the US presidency but the shockwaves from his victory still reverberate. Coverage of supposed scandals, protests and presidential Tweets have continued to abound. Those who were delighted by November’s result, so polling suggests, remain so; those who reverted to hysteria continue their frenzy. Amid all the drama it is perhaps an odd expression to pick, but: Amercian politics has found an equilibrium.
Assumptions about the US economy have also become entrenched. It has long been obvious that a Trump presidency would be inflationary and the bond market reacted to the result accordingly: on the day of the election the ten-year Treasury yielded 1.85%, but by the end of November had hit 2.4%. It has stayed firmly in a range of 2.3%-2.6% ever since. The dollar likewise strengthened sharply after the election and has comfortably held its range against other major currencies. Eurodollar rates moved from pricing in two Fed hikes by the end of this year to pricing in three, and have held that view right up to the present.
While American politics has become energized, however – by the ambition of the new incumbent and the vitriol of his critics – financial opinion has become complacent. While markets and observers have in many cases settled on a static view, the ground since the election has shifted. Look away from fixed income and the currency, and towards risk markets and the data and this is easily clarified.
The US stock market found a secure range after the election, but only for a time. Last month it smashed it. From meandering around the 2,250 level throughout December-January the S&P 500 broke 2,300 in early February and 2,400 less than a month later. The index has now risen by more than 6% since the beginning of the year, comfortably beating other major bourses around the world.
It is not just the stock market that is optimistic, and setting new records. Consumer confidence hit a new high this week, eclipsing the levels reached prior to the credit crunch and threatening to visit territory last occupied during the go-go boom of the later 1990s. This is of a picture with earlier data on retail sales, showing the fastest annual rate of growth (+5.6% in January) since the early stages of the recovery in 2010-11, and buoyant numbers on existing home sales, which have reached a pitch last seen before the credit crunch in 2007. (Bear in mind that mortgage costs have actually been increasing at the same time, pushed up by higher long-term interest rates.)
Industrial indicators have strengthened too. Purchasing manager activity surveys out this week for both manufacturing and service sectors continued their sharp rise. The rotary rig count released last Friday showed that US oil production has continued to recover even though the price of crude has been no better than stable since December. Again, this is consistent with earlier data such as the NFIB survey of smaller firms and the “Philly Fed” report on the national outlook for business, both of which have been rocketing up, in the latter case to a 33-year high.
If one tries very hard to find them there are more equivocal releases. Monthly variability on jobs data, for instance, has been weak in some instances; then again, the broader context is one of effectively full employment, and short-term moves from 4.6% to 4.7% in the headline jobless rate are neither here nor there.
More seriously, while vague expectations of higher inflation have been priced in since November, underlying price indicators have started to move. Import price inflation, which had been negative since mid-2014, flattened out to +0.2% in election month and has since hit +3.7% (year to January). The price components of PMI surveys have also risen. Public statements from various Fed presidents and board governors has been preparing markets for a hike this month which leaves ample scope for those three rises this year, and more.
Put all the pieces together and it seems more and more obvious that there is no longer any broad backdrop of bad economic news, whatever one’s views of American politics. The credit crunch hit housing and the banking sector – all recovered. The oil price collapse hit the shale business – recovering nicely. A strong dollar dampened activity – that effect has fallen away.
On the other hand, sentiment and output indicators are on the up. The economy is at full employment. The core rate of CPI inflation has already been running above 2% for more than a year and in January posted its fastest monthly increase since 2006.
The US economy is catching fire. This will make a novel change from the sclerotic pace of recovery we have seen there to date. The question is: are markets properly discounting the eventual need to put the fire out?
Well that clinches it, surely. Today’s US data showed the unemployment rate down again to 4.9%. Payroll growth continued at a strong pace, with non-farm jobs up by 161,000 last month. Both these prints came out in line with expectations – but wage growth beat every estimate going, hitting a new post-recession high of +2.8% on the year. Purchasing manager surveys out over the last couple of months suggest that the rate of job creation will accelerate into the end of this year if anything. The American labour market is showing clear signs of warmth. Surely, a Fed hike next month is certain.
This chimes with the consensus view. Of the 66 forecasts currently made available to Bloomberg, 15 expect no change and all the rest are for a 25bp hike. The interest rate markets also expect the Fed to see out 2016 with a target rate of 0.75%, then go on to hike again around the middle of next year.
So far, so uncontentious. Indeed it is reassuring from an investor’s perspective that the market reaction to somewhat firmer expectations for interest rates has, thus far, been sanguine. Halfway through this year a December hike had yet to be priced in; by the autumn the eurodollar futures market had become unequivocal on the subject – Treasuries sold off too – but the S&P 500 still rallied, turning in its strongest quarterly performance of the year so far.
The key word there is: “somewhat”. In the US as in Britain there is now a real risk that tightening occurs more quickly than people think.
That +2.8% wage growth is part of the reason why. A connected reason is that the energy sector has recovered some of its strength this year, taking away a recent source of downward pressure on activity and employment. Then there are import prices: stable oil and a stable dollar have now closed off that source of deflation. Core CPI has already been running at its strongest sustained level this year since the Great Recession. Both the headline CPI measure and the consumption deflator used to calculate chain-weighted GDP have been catching up. Finally, unreliable indicator as it is and completely unfashionable as it has become, broad (M2) money supply growth is running at its fastest pace for nearly four years.
The question to which nobody knows the answer is: will the labour market start really overheating and, in the circumstances, contribute to an uncomfortable level of inflation? At the moment, US policymakers are split on the subject, but the Fed’s actual monetary response to date, together with the interest rate markets’ pricing, implies a near-total lack of concern.
Another wild card is our old friend political risk. At present, polling at the national level and in some of America’s “battleground states” suggests that Secretary Clinton is on course for a narrow victory. If Mr Trump were to pull off a surprise win, however, it is not just the market response but the economic consequences which could be significant. There has already been extensive coverage of the effect that the candidates’ fiscal policies might have on the national debt, but consider some of the Republican candidate’s other measures: the expulsion of migrant labour, swingeing tariffs on imports, less accommodative trade agreements (as well as big tax cuts for businesses and households). All of these would be inflationary.
It would be imprudent to expect a crisis. But the possibility of a problem is clear and what matters to us as investors is that this is not recognised – indeed, quite the reverse. Bond markets think that inflation over the next ten years will run at an average of 1.7%, below the 2.1% they have priced in on that horizon over the last 15 years. Consumer expectations for near term inflation, as measured by the University of Michigan survey, are below average too, and for long term price behaviour are at their lowest ever level.
So there could well be a surprise or two in store. And whatever its scale, this ought to have consequences for portfolio construction.
Central bank activity has been a linchpin feature of market activity in recent years. Rather than following rate trajectories and getting on with life, markets have been paying such attention to every last detail of bankers’ announcements and emergency programmes around the world that there have been some curious butterfly effects. In 2013 for instance the Fed announced that one day, quantitative easing would come to a halt. Now this programme had exhibited next to no economic effect on the US itself. But it weakened the currency of Brazil to such an extent that rates went up to defend against import price inflation, thereby contributing to that country’s recession and associated woes.
So what have central banks been up to lately, and what might come of it?
In the US the Fed has attracted criticism for its confusing guidance ever since it bottled tightening policy last autumn. The most recent statement from Chair Yellen said she was “cautiously optimistic” on prospects for the US economy, and she has said on several occasions that she would rather point people towards indicators which the Fed follows than give specific commitments to policy decisions in advance, which is understandable. But it has created uncertainty: some observers find signs in the data that the Fed is falling behind the curve, while others see no case for any more tightening at all this year. Markets are pricing in no move over the summer – which conflicts with Fed briefings as recent as 12 days ago – but expect the target rate to have risen to 0.75% by the end of 2016. Bloomberg summarized the situation well in a piece headlined: “Yellen Data Dependence Leaves Investors Dazed And Confused“.
For investors, this means continued uncertainty over the imminent path of US interest rates and that is not a comfortable situation for markets to find themselves in. Today’s sell off in equity on both sides of the Atlantic is, in part, a reflection of this. As to what will actually happen it is plainly anyone’s guess though if oil remains at the $50 level the deflationary contribution from energy will fade in August, core inflation remains above 2% and last week there was a positive data surprise in the form of a 4.7% unemployment rate (down from 5% and a new post-Great Recession low). Fundamentals aside, however, the Yellen era has been characterized thus far by uncertainty and that remains the key watch point from the Fed at present.
Over at the ECB talk on monetary measures has quietened down, though a noteworthy kilometrestone was reached this week when the bank began its latest phase of QE through buying corporate debt. Mr Draghi has instead been opining on supply side reform and keeping a studied silence on some issues which might possibly be of broader interest, such as the ability of Greece to finance itself next month.
That particular elephant in the room, and perhaps – who knows? – a Brexit vote here in a couple of weeks will give investors rather more to chew on than the ECB’s plans for monetary policy over the next few months. Having said that, eurozone unemployment has stayed stuck above 10% despite what passes there for a robust rate of growth. (Mr Draghi certainly does have a point about structural reform.) There is no realistic prospect of monetary tightening for a long time: markets suggest 2020. The ECB watch point for markets will be rhetoric and planning over emergency measures. However effective they may or may not be in practice their announcement always carries the power to disappoint and while a second-order issue relative to European politics at the moment this remains a source of risk.
Over at the Bank of Japan the story is similar. The yen has strengthened by 11% this year which is a disaster for Japan’s economy. Abenomics, too, have been faltering for some time. Deflation is back. The central bank is torn over the issue of negative interest rates adopted earlier this year and whose effects, if there are to be any, have yet to be felt. At a public meeting this week Deputy Governor Nakaso signalled the BoJ would do more if needed – but this was possibly nothing more than an effort to talk the currency down.
The BoJ’s next meeting is next week. It has not attracted half so much of the market’s attention as the Fed or the ECB but as in Europe the watch point is the reaction to policy announcements. If the BoJ adopts more emergency measures unexpectedly that could give Tokyo a nice boost, especially if it led to a weaker yen. The interest here though is more domestic than global for now.
Over at Threadneedle Street there has been a period of calm – at least on the monetary front. (Mr Carney’s regular warnings about the dire consequences of a Brexit have been a feature of life at the Bank of England since the early spring.) Rates wise expectations are as low as they were during the panic in February and the futures market is not pricing for an increase in the base rate until the second half of 2018.
In terms of things to watch the Old Lady is at the more interesting end of the spectrum. Carney has decried negative rates as ushering in a “zero sum game” via currency wars but that was before the hideous spectre of Brexit loomed. The possibility of negative rates has been mooted by one of his MPC confreres and if the Bank is serious about its rhetoric a Brexit vote could see a major surprise in that direction. That would potentially be great news for gilts but probably not much else.
On the other hand the May Inflation Report, as usual, forecast that under present conditions CPI would bosh back up to 2% in time to meet the Bank’s commitment to that target on a two year horizon. We know about the fading of energy-driven deflation. We know that the UK economy is at or close to full employment. The industrial production number for May was the strongest in nearly four years and core CPI inflation, which bottomed at 0.8% over a year ago, has yet to fall below 1.2% in 2016. So we could find ourselves with something of an earlier hike than is currently priced in, and that again might surprise markets depending on the circumstances.
Despite the dominance of politics there is thus much to follow from the central bankers, and most of it would seem to present more of a threat to risk markets than an opportunity.
The big news this week, of course, was the Fed. Rarely has inaction been so exciting! The statement put out by its Board of Governors is quite pithy as these things go and worth a read in full, and the salient policy points are all sandwiched within a single paragraph as follows:
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account … labor market conditions … inflation pressures and … expectations, and readings on financial and international developments. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.
US unemployment for August was 5.1%, down half a point from the beginning of the year and nearer the bottom than the top of the Fed’s own range for the “longer-run normal rate of unemployment” of 4.7-5.8%. There is nothing here to justify emergency monetary conditions whatsoever. Despite the statement, therefore, the US labour market was in practice irrelevant to the decision taken by its central bank.
On inflation, the Fed notes elsewhere the “transitory effects of declines in energy and import prices”, and is absolutely right to do so. Fortunately it also has access, just like the rest of us, to “core” measures of both consumer and producer price inflation which specifically exclude food and energy. Headline CPI has crashed down from 2.1% in the spring of last year to 0.2% today, but the core measure has risen this year from 1.6% to 1.8%, not meaningfully distant from the stated target of 2%. Again, this is not consistent with an emergency monetary stance.
Having abandoned at least one and a half of the two elements of its mandate, then, the Fed has effectively announced it is acting with reference primarily or solely to an unofficial third: “financial and international developments”.
In one sense this is a masterstroke. Attributing loose policy to sources other than the domestic economy eliminates the risk of a bearish response to a downbeat assessment of the situation at home. (The Fed has come a cropper here before.) When a central bank produces an economic assessment that is news. When it points to events offshore that everyone has already seen, it says nothing new.
From another angle, however, yesterday’s decision does not look quite so masterly. Invoking the stock market as a reason for cheap money used to be known as the Greenspan Put, a source of moral hazard under the eponymous Fed chairman which attracted some of the blame for the financial crisis. And at least efforts were made to justify Mr Greenspan’s option writing in terms of a “wealth effect” on US household spending. Extending the put to the stock market in China seems startlingly multilateral even for these enlightened times.
Furthermore, all the Fed has done is postpone a move which would have taken nobody by surprise if they had done it this week. It is still perhaps a little early to gauge the market reaction but stocks are down in both the US and Europe today. The dollar has weakened just a touch against the euro, is pretty much unchanged against sterling and the yen and the Chinese yuan has not budged, so there is as yet no consoling impact for American exporters and multinationals. All that is certain is that the postponement has prolonged a key source of uncertainty.
The impact of a 25bp rate hike would have had a negligible impact on everything apart from sentiment. And it is far from clear that its market impact would have been any worse than that of the Fed’s eventual, barely defensible decision to dither.
So much for the new mandate to shore up financial and international developments.
Kudos, in conclusion, to Jeff Lacker, President of the Federal Reserve Bank of Richmond, the only one of the Fed’s twelve decision-makers to vote for a hike yesterday. His colleagues have in reality opted for nothing more cogent than mañana.
One of the effects of the market’s recent taper tantrum has been to depreciate developing-world currencies, provoking fears in some quarters that we are on the cusp of a re-run of the events of 1997 which saw various tiger-shaped dominos tumble across the Asian part of the emerging market landscape. Particularly badly hit has been India. At one point on Wednesday the rupee stood 31% weaker against the dollar than it had done at the beginning of May, when the panic kicked off. Despite a muted recovery it is still down about 25% at present. Is the writing on the wall for the BRICs? Is it the Asian crisis all over again?
The short answers are “no”, and “no”.
It is true that Indian GDP has slowed and that today’s release for the year to Q2 came in below expectations. On the other hand, 4.4% annual growth in real terms doesn’t look so bad from a developed-world perspective, disappointing though it is set against an average rate for India over the last ten years of 8%.
It is also true that the Indian balance sheet is not as strong as some of its EM peers, with IMF putting its gross government debt to GDP ratio for 2012 at 67%. And India is running a budget deficit of about 5% of GDP at the same time – though again, these figures look downright enviable if you’re the US, Eurozone, UK or Japan.
So far, so worrying. But we are still some distance from 1997 and here’s why.
Going into the ’90s collapse the Asian tigers had been over-hyped and over-invested in by exuberant developed-world investors drunk on low inflationary growth and technological advancement. At the same time they had begun to have the rug pulled under them in certain industries by lower-wage China through an insistent combination of economic liberalisation and currency devaluation. (When Thailand, first casualty of the 1997 collapse, stood on the brink of annihilation in June of that year its economy was already in recession.)
Furthermore, the level of foreign currency debt at the time was huge, and countries including Thailand were trying to maintain currency pegs against the dollar with derisory levels of foreign exchange reserves to back them. On the way into the crisis, external debt to GDP in Thailand and elsewhere in the region was running at over 60%.
Today the attitude towards emerging market investment is far from exuberant – indeed has been relatively gloomy since the crash of 2011. And even with debt to GDP of 67% India has gold and foreign exchange reserves of almost $300bn. That’s much less than China, or Russia, but brings the net debt position down to under 50% of GDP. In addition, with budget deficits and real GDP growth balancing each other out, that debt ratio is not increasing.
Neither is there a sudden attack on a currency peg to contend with. The rupee already devalued from 45 to 55 against the dollar in 2011-12 and inflation at that time peaked just shy of 11%. There seems little reason to expect the current devaluation to 65 to result in something much more dramatic.
At the same time, export growth has bounced: up 11.6% on the year to July, an eighteen-month high. We should expect that kind of thing in a period of material currency weakness. (This is exactly the supposed cure-all remedy some have in mind for the beleaguered members of the eurozone periphery.)
It is precisely when we come to exports and growth, however, that we stumble over the real disconnect between fantasies about a reprise of the Asian crisis and the reality of the situation today. When India was booming back in 2010 and the rupee was moving sedately sideways, US monetary policy was in very much the same position as it is today. It has not changed in the interim. Therefore, the slowdown in the Indian economy cannot reasonably be attributed to a change in American monetary tapering, tinkering or anything else. Therefore, there is no reason necessarily to expect the Indian economy either to benefit or to suffer from changes in the US monetary environment over the next few quarters.
What has changed since 2010, however, is that Europe (including the UK) re-entered recession, Japan joined them in the aftermath of a calamitous natural disaster, the US recovery slowed, Greece defaulted and confidence collapsed. If we seek the cause of strain on the economy of India as elsewhere in the developing world, it is surely here that we find it – not in the press releases of the Federal Reserve.
Which brings us back to the present. It is not 1997 which lies around the corner, but 2014. So far – further shocks permitting – the coming period looks likely to be one of continued recovery. This will make an especial change coming from Europe, though if this week’s GDP revision for Q2 is anything to go by the pace might be picking up in the US too.
Can the Indian economy benefit from stronger growth across the developed world without reacting to changes in quantitative easing by the Fed any more than it has done so already?
Now there is a question to which the answer might just be, “yes”.
The release of minutes from the July meeting of the Federal Open Market Committee generated headlines this week. Fears of the effects of “tapering” – the reduction by the Fed of the amounts of fixed income security purchases it makes under its “QE3” programme of quantitative easing – have continued to unsettle markets.
There was no clear steer from the minutes as to when this will eventually begin. But according to research released by the San Francisco Fed earlier this month it doesn’t matter much anyway. The Fed economists who wrote the study estimate that a QE2-sized programme ($600bn of US Treasuries purchased over two years) without accompanying dovish guidance on interest rates would have added only 0.04% to GDP growth and 0.02% to inflation. Even with this guidance they assessed the impact at a meagre +0.13% on GDP and +0.03% on inflation. As they conclude:
Asset purchase programs like QE2 appear to have, at best, moderate effects on economic growth and inflation … those effects are weaker and more uncertain than conventional interest rate policy. This suggests that communication about the beginning of federal funds rate increases will have stronger effects than guidance about the end of asset purchases.
Moreover, one of their key model assumptions was that QE would lead holders of longer-dated Treasuries to reallocate capital to other asset classes or the wider economy (they assume no impact on holders who are indifferent to bond maturities):
If long-term yields fall, these investors have less incentive to save and may allocate more money to consumption or investment in nonfinancial assets. This boosts aggregate demand and puts upward pressure on inflation.
This analysis will be familiar to readers who remember the numbers involved in our own programme of QE here in the UK. As this blog observed some time ago, however, with the government issuing at least as much debt into the bond market as the Bank of England is taking out, this “helicopter drop” monetary model simply doesn’t fly:
Imagine that you were in the crowd underneath the helicopter and had managed to scramble successfully for £50. Then, as the helicopter flies away and you are about to put the money into your wallet, you feel a tap on your shoulder. You turn to see a man standing in front of you with a knife, who mugs you for it. Would you feel like the beneficiary of a windfall and embark on an inflationary spending bonanza, or would you put your wallet away in bewilderment, feeling as if the whole exercise had been an elaborate distraction?
Unsurprisingly for an economy which has seen the level of public debt to GDP rise from a little over 60% at the start of the Great Recession to over 100% today, the same logic applies over the Atlantic. Since the Fed started QE it has bought $2,196bn of Treasuries. Over the same period, BoA Merrill Lynch data on the Treasury and TIPS markets shows that the face value of the US government bond market has increased by $5,251bn – almost two and a half times as much.
So the numbers suggest US QE has been a monetary sideshow, as does a study made by the Fed’s own specialists. The same is also true if we look at other possible transmission mechanisms which the study ignores, such as the weekly Fed data on loans and leases made by US commercial banks for example, which after a prolonged decline only exceeded their previous (2008) peak towards the middle of last month.
This is not to denigrate the Fed’s whole programme of unconventional policy measures. The purchase of mortgage-backed securities alongside government bonds for instance might well have helped repair bank balance sheets – as well as contribute to lower mortgage rates, and alongside the effect of initial emergency measures such as the Troubled Asset Relief Programme, the Federal takeover and capitalisation of Fannie Mae and Freddie Mac, etc. In fact the speed of the banking sector recovery in the US – as opposed to in Europe (including the UK) – has been one of the great relative strengths of the American economy. The Fed’s activities during the subprime crisis and its devastating aftermath are not to be sniffed at.
Nonetheless, some participants are betting that ending, or merely reducing, a programme whose actual monetary effects are likely to have been trivial will destabilise economic recovery in the US and across the globe.
This appears to betoken an unreasonably heightened level of concern.
On Wednesday, Fed Chairman Bernanke held a press conference. Making it clear that (in his phrase) the Fed would be “letting up a bit on the gas pedal” rather than hitting the brake, he announced that asset purchases conducted under the quantitative easing programme would likely start tapering off this year if the US economic recovery continued to show strength.
So far, so reasonable. QE is an emergency monetary measure designed to stimulate growth in desperate times. If the times no longer look desperate emergency measures are no longer required. Mr Bernanke’s announcement was a signal that the Fed’s view on the recovery has grown more positive. Some might describe that as good news.
Markets, however, did not see things that way. For them the story was the oncoming shrinkage of central bank stimulus. Since QE involves bond buying, bond markets sold off with the 10 year US treasury yield up about 30bp since the end of last week. Since some participants in the rather confused rush into owning gold had bought the metal out of fear that the QE programme would usher in hyperinflation and dollar collapse, gold continued its fall, closing below $1,300 an ounce for the first time in almost three years. And equity spiked lower again: the S&P 500 dropped by 2.5%, its biggest one-day fall in percentage terms since November 2011 (when Italy was thought to be on the edge of default), and losses in Europe were even worse.
Much of this behaviour is defensible in logic. But the reaction is also interesting for what it tells us about sentiment.
Back in the panic of H2 2011 the Fed got a similar bashing from markets when it announced a change to its QE programme. It wouldn’t be buying a greater quantity of bonds outright; it would simply be lengthening the maturity of the programme to move longer as well as shorter term interest rates lower. Dubbed “Operation Twist”, readers may remember that the market lurched lower – not because it didn’t like the idea but because the economic view put forward by the Fed as justification for the move was surprisingly negative.
In other words, just the opposite happened in 2011 as happened this week. Then, the market ignored the Fed’s intention to increase monetary stimulus and focused on its gloomy assessment of the economy. Now, the market is ignoring the more constructive economic view and focusing on the intention to reduce monetary stimulus.
This week’s stock market reaction has been bearish. Not as bearish as it was in September 2011: then, the fall after the Operation Twist announcement was 6%, not 2.5%. But it is bearish nonetheless. An American stock market which rallied on the back of the most consistently positive economic data period for some years has now fallen as the chairman of the central bank expressed a cautious view that this period would continue.
It is foolish to be dismissive of sentiment. Operation Twist succeeded in driving US mortgage rates to new lows, and housing market activity has picked up ever since. If bond market fears deepen and long term rates continue to go higher, some of that shine could be taken off over the next few months. But it is undeniable that fear is more rational at some times than at others.
During 2011 the US labour market was stalling, the Greek crisis brought fears of catastrophe in Europe and China was tightening monetary policy to contain an inflation problem. Today the US economic picture is so much more obviously confident as to be almost unrecognisable, the “European crisis” has not been remotely as bad as feared and the Chinese are keener to promote growth than stifle it.
Markets are equally in a much happier condition than they were two years ago. As a result, the opportunities are not quite so obvious as they were back then. But episodes like the current period of bearishness can still create them – with or without the help of press conferences from central banks.