Market Thinking

making sense of the narrative

The Fed is being asked to keep the punchbowl topped up.

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Once again the market is focussed on a small move in short term interest rates by the US Federal Reserve and once again the narrative is all about how the US economy ‘needs’ this. The reality is that it doesn’t need it, well the real economy doesn’t at least. The question is, does the Financial system need it? If it does, the outlook is not good. If it doesn’t, then arguably the situation is even worse.

Ever since I started writing about markets there has been an obsession with the behaviour of the US Federal Reserve and to be fair, back in 1989 (yes it really was that long ago), the then Fed Chairman Paul Volker was pursuing a very determined policy to collapse inflation by forcing short term US rates up as high as was deemed necessary. The impact that this dramatic inversion of the yield curve had on both the economy and the markets was obviously profound, especially in fixed income markets and not surprisingly ‘Fed watching’ became a huge industry, not to mention a great employer of economists.

The expression about the role of the Fed being to take away the punchbowl just when the party is in full swing was originated by William McChesney Martin, who was Chairman of the US Federal Reserve from 1951 to 1970 and was very much focussed on the idea of restoring interest rates to their ‘neutral’ or natural level once an economy had recovered from a recession. This tied in to an economic notion of ‘the output gap’, the idea that when economic output was at a level consistent with the ability of the economy to grow without causing undue inflation then interest rates should be at a neutral level. Too big an output gap meant rates were coming down and vice versa. Post the Volker shock and awe period, the Fed watchers actively tried to predict the path of interest rates based using the concept of the output gap and utilising a model that became known as the Taylor Rule. Developed by economist John Taylor and seeking to capture the economic variables on inflation and output that were consistent with price stability, the Taylor rule showed a close fit with various economic indicators and subsequent Fed policy which was very exciting for all the economists then trying to predict those indicators and thus the direction of rates. Unfortunately, as with seemingly all models of the economy, the minute the model was codified it ceased to work.

Not however that this deterred the prediction industry, which by then had reduced the Taylor Rule components to little more than a short cut of ‘predicting’ the monthly non farm payrolls data. The reality is that the (still) hordes of economists dedicated to analysing high frequency economic data are essentially there to provide ‘noise’ for the noise traders in FX, commodity and short dated fixed income markets. Thus every months we have the theatre of ‘the non farm payroll” numbers, where the pundits compete to wager (and it is a wager) whether the data will be higher or lower than market consensus. Market consensus by the way tends to be variously plus or minus one standard deviation from the trend. This is a classic case of a variable becoming important simply because everybody believes it to be so. However, the last few years has seen this become even more of a short term market as QE has established a clear break between interest rates and the needs of the real US economy. To play with the economic variables for a moment, with US economic growth at 2.1%, unemployment at 3.6%, wages growing 3% and core inflation below 2% and yet interest rates already way below neutral, it is extremely difficult to argue on these numbers against higher rates, let alone justify a rate cut.

So what is going on? To be honest I am not sure, but none of the possible answers are good. Variously, 1) and to stay in the realm of economic fundamentals for a moment (I know), it could be that the Fed is looking at indicators such as the state of credit markets in the real economy. Housing and autos are both struggling as consumers continue a steady process of deleveraging, but its hard to see how making finance that nobody wants to take on 25bp more attractive is going to achieve much, nor is the slight reduction in repayments on floating rate debt going to boost disposable income very much. They might, 2) generously, be considering the plight of overseas borrowers of $s, a higher US rate of interest usually presents a double hit of higher interest costs and a higher dollar making local currency costs even higher. Certainly it seems likely that one of the reasons the Trump administration want lower rates is because they think it will lower the dollar exchange rate. It’s worth noting that for the first time since 2013, no central banks are considering tightening and that this is then really about relative exchange rates and a round of competitive devaluation. More nuanced, but probably getting closer to the reality, 4) the Fed are worried about international capital markets. Certainly, the seeming fragility of international capital markets when the Fed was discussing the end of QE (remember the taper tantrum in May 2013) has a better fit with Fed policy than any domestic variables. More cynical would be 5) that the Fed has been captured by equity markets to such an extent that it believes its role is simply to keep supplying the proverbial punch and ignore the longer term consequences. Certainly talk of tightening last autumn coincided with a swoon in the US stock market and a smaller sell off in May followed an absence of ‘good news’ on a rate cut, the rally seeming to follow hints since June of just such a move. If all the Fed is doing is providing liquidity for leverage and carry trades then we risk a nasty market top and an sharp unwind of leverage when rates do finally go some way towards normal. Finally and more worryingly is the idea that 6) the Fed realises that the US corporate sector simply can’t cope with higher rates or any deleveraging. The US corporate sector under QE has taken on enormous amounts of debt either to buy other companies or, mainly, to buy back its own equity. Ironically much of this cash has then been recycled into the private equity space by yield hungry investors, providing yet more scope to leverage up existing balance sheets rather than make productive investment. Higher rates would simultaneously hit profitability in the corporate sector and the ‘alternatives’ sector and by offering a ‘sensible’ return on cash expose the fragility of the high yield (formerly and more accurately termed ‘junk’) bond markets.

The markets think they want lower interest rates because of the dopamine hit, but its difficult to see how this ends well.