Usually IMF Head Christine Lagarde is too busy hobnobbing with the financial elite to take time out to issue warnings about the financial markets, but yesterday she cautioned US rate increases could trigger instability in emerging markets:
The head of the International Monetary Fund warned on Tuesday that emerging markets are set to face a renewed period of economic instability when US interest rates rise this year, forecasting a repeat of 2013’s damaging “taper tantrum” episode of capital flight and rapid currency depreciation.
The IMF chief said she feared that negative “spillover” effects from these increases would lead to a re-run of the crisis that hit developing economies such as India and Turkey nearly two years ago, following hints from then Fed chair Ben Bernanke about an early end to the institution’s bond purchasing programme known as quantitative easing.
“I am afraid this may not be a one-off episode,” Ms Lagarde said. “The timing of interest rate lift-off and the pace of subsequent rate increases can still surprise markets. The danger is that vulnerabilities that build up during a period of very accommodative monetary policy can unwind suddenly when such policy is reversed, creating substantial market volatility.”
I am not one to worry about government officials’ concerns as by the time they have admitted there is a problem, it is often almost over.
But at the same time that Christine was warning about the potential negative effects from the US rate increases, BridgeWater’s Ray Dalio was releasing his latest research piece that echoed the same concerns. I might not listen to IMF heads, but I certainly take notice when Dalio speaks. His firm is the largest and most successful hedge fund out there. More importantly, his analysis since the start of the 2007/8 credit crisis has been spot on. He has understood the policies of financial repression and what he calls the “beautiful de-leveraging” better than anyone.
Dalio is worried that the Fed might be about to make a 1937 style mistake in tightening. From his latest piece:
…we think it would be best for the Fed to err on the side of being later and more delicate than normal. To be clear, we don’t know – nor does the Fed know – exactly how much tightening will knock over the apple cart. What we do hope the Fed knows, which we don’t know, is how exactly it will fix things if it knocks it over. We hope that they know that before they make a move that could knock over the apple cart.
Clearly the Fed has created expectations that it will tighten in either June or September, and such expectations are difficult to deviate from. For those reasons, we expect a Fed tightening and are cautious about our exposures.
In his portfolio, Dalio is playing defence and encouraging the Fed to have their backup plan ready when the shit hits the fan. In the rest of the piece he takes you on a history lesson outlining the mistakes made during the 1937 period. “BridgeWater Daily Observations” are private letters for his staff and clients, but the FT posted a link to this piece. I took a copy, and given that FT was distributing the research, I figure it must be good for public consumption. So here is a link to the BridgeWater piece. It is well worth the read.
So we have lots of high profile figures giving public warnings about the dangers of tightening too quickly. Doesn’t it seem like a slam dunk that Yellen will err on the side of being overly accommodative for even longer?
Whose on the tightening side anyway? What is the logic in tightening before inflation even shows up?
To answer that question, you need to think about how we got into this mess in the first place. During the past two cycles the after-the-fact analysis has been that rates were left too loose for too long. Whether it was Greenspan’s failure to raise rates to head off the DotCom bubble or the Greenspan/Bernanke team’s easy money policy that fuelled the real estate mania – in hindsight the anecdotal promises have always vowed never again. In the clean up from the aftermath of the bursting of the bubble, economists always claim that the bust was not worth the boom.
Yet here we are; with easy money once again fuelling another boom (in financial assets at least). The hawks who want to raise rates are the economists who haven’t forgotten the earlier promise. Former Federal Reserve Bob McTeer Governor’s recent blog post sums up this attitude perfectly:
“Let ‘er rip, let it fly;
Come on baby, say it, do you think I’m going to cry?
. . .
Why the drama? We don’t have to drag out this situation.”
Natalie Maines of the Dixie Chicks was anticipating her boyfriend’s breaking up with her, but she could have been referring to the end of Janet Yellen’s patience. She figured, if it’s going to happen, let’s get it over with. I say, we don’t have to drag out this situation. How many more Fridays like yesterday can we take?
I don’t know how long ago zero interest rates ceased being a good idea, but I’m sure it was some time in the past. Six years and counting is too long even if some slack does remain in the labor force and inflation is not a clear and present danger. But when 295,000 net new establishment jobs and 5.5 percent unemployment rates are treated as bad news and costs 278.94 Dow points in one day, that’s another reason to just get it over with. What is it they say about a brave man dying only once while cowards die a thousand deaths? It’s time to cowboy up!
I really enjoy Bob McTeer’s blog. Too many writers are busy writing in the most dramatic fashion possible – but not Bob. He presents his no-nonsense pragmatic Texas views in a straightforward logical manner. When he speaks about his time at the Federal Reserve you get a deep understanding of the issues facing the people assigned with conducting monetary policy. Bob has not been one of those critics that has been hawkish for the past few years. Therefore when he says it is high time to start to raise rates, I view this as indicative of the reasoning for many of the more conservative Federal Reserve Governors.
They worry that the Federal Reserve has already left rates for too low for long. The Fed policy is already running more easy than most economic models would dictate.
According to the classic Taylor model the Fed Funds should be 2.25%. Many economists are looking at these indicators and concluding we are making the same mistake that we vowed to never make again.
To which I would counter – of course we are! There is no doubt we are sowing the seeds for the next bubble. In fact, we are already experiencing the bubble – we just don’t know how it will manifest itself yet. It won’t be obvious until it has burst.
Given the high debt levels, we can’t afford to put rates to proper levels. It simply isn’t going to happen. It would crush our economy. We are not about to get religion and run prudent monetary policy until the market finally takes control and forces Central Banks’ hand. So until then, all we can expect is more of the same. Easy monetary policy which blows bubbles, which eventually burst, which is then followed by even easier monetary policy, rinse and repeat.
We have levered the system to the point where even the threat of raising sends rates and the US dollar shooting up. Actually I take that back, not even the threat of raising rates, but merely the removal of the word “patient” sends the markets in a tizzy.
The markets remember the 2004 tightening cycle, and the removal of the word “patient” was the first step in a series of hikes that sent the Fed Funds from 1% to 5.25%.
From that point on, the Federal Reserve raised rates by 0.25% at every meeting for the next two years.
So when the markets see the Federal Reserve warming up to raising rates, all they can do is imagine the worst.
Which is why the US dollar is going like this:
Which is causing commodities to do this:
Which means that inflation looks like this:
Even though the market is doing a huge amount of tightening for the Fed, will they go ahead and raise rates anyway? Or will the Federal Reserve listen to the warnings from the likes of Ray Dalio and Christine Lagarde?
This morning Bloomberg Briefs had a great chart highlighting economists predictions about the Federal Reserve’s direction:
90% of economists think they will drop the word patient and 92% think the Federal Reserve will hike by September.
Personally I think that Yellen has already set us up for the removal for the word patient, so that is a done deal. But I reiterate that this will be all that the hawks get. Everything else will be as dovish as possible. When serious people like Dalio and Lagarde are sticking their necks out, the Federal Reserve committee members will take that advice to heart.
I see there are zero economists predicting a December date for the first hike. Given my belief that the consensus is often wrong, I will take the outlier and make a December hike my call. But in the mean time, expect the Fed to surprise on the dovish side… that is apart from removing the word “patient.”