We are currently mired in a strange period for the markets. The Federal Reserve would like to get on with the removal of their zero interest rate policy. Nothing would make them happier than if the economy showed enough strength to necessitate a rate hike. The problem is that although there are some signs of encouragement, there is precious little evidence the economy is strong enough to justify raising rates.
Some have made the argument zero is not a natural rate and that it was supposed to be an “emergency” temporary level. They believe the emergency is long past, and the Fed should immediately raise rates.
Although I am sympathetic to this argument, I do not believe the members of the Federal Reserve committee feel the same way. Yellen’s speech last Friday made it crystal clear there would need to be an economic uptick before the Fed hikes rates.
For this reason, if the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy. To support taking this step, however, I will need to see continued improvement in labor market conditions, and I will need to be reasonably confident that inflation will move back to 2 percent over the medium term.
Yellen spelled out the two conditions needed for rates to be raised. The first is “continued improvement in labour market conditions.” Note how she said “continued improvement.” That means the current labour market conditions are not sufficient to necessitate a tightening. The second condition is a ““reasonable confidence that inflation will move back to 2 percent over the medium term.” What is really interesting is that she used the word “and” when describing the conditions needed for a hike. She didn’t say “or”, she said “and.” That means we could get continued labour improvements but if inflation stays below target, then Yellen would not be in favour of raising rates. At the same time, if inflation perks up, but we don’t get an improvement in the employment picture, she would again not be eager to hike. No wonder the market is so convinced the Fed doesn’t have the guts to follow through with a rate increase.
What if I am wrong?
Yet even though the Fed is signalling they will be patient with rate hikes, they are optimistic those conditions are right around the corner. Look at the first sentence of Yellen’s quote – “for this reason, if the economy continues to improve as I expect…” The members of the Federal Reserve believe we are in the midst of our typical first quarter slowdown, coupled with the lingering effects of the brutal East coast winter, and that the economic snapback is quickly approaching.
I want to believe they are correct. I too see all sorts of positive signs in the economy. But even though I am not about to change my opinion because the rebound is slow in arriving, I am willing to entertain the possibility I am wrong.
I am a little concerned with the market action over the past couple of weeks. The yield curve, the US dollar and other risk assets are not behaving like the American economy is about to take off.
Let’s start with the yield curve. Nothing screams economic slowdown more than a flattening yield curve. The current US yield curve is by no means flat, yet the direction of the change in slope still gives important clues as to what is happening in the economy. During most of 2014 the yield curve was flattening, but during the first quarter of 2015 the trend stopped, and then during most of April, the curve steepened. This was a positive development as it meant there was demand for credit. Corporations, individuals and governments were all collectively creating credit (taking out loans) which pushed the curve steeper. Obviously the analysis is not quite this easy. There are dozens of different factors which affect the shape of the yield curve. Everything from market participants’ expectations of Fed policy to foreign Central Bank monetary operations all influence the shape of the curve. Despite this, the curve still gives reliable signals about the overall demand for credit. However, this credit expansion seems to have slowed.
The spread between the 2 and 10 year US treasury curve was showing encouraging signs of the demand for credit increasing, but this trend recently reversed. Now maybe this is just a pause, but I would prefer to see the curve steepening, not flattening to be optimistic about economic future economic growth.
The US dollar is also showing worrying signs of economic weakness. Again, it is difficult to make generalizations about the reason for an asset price movement. There are tons of different reasons the US dollar can move up or down.
Recently the US dollar has been rising, but I do not believe this is the result of increased investment demand. I think the US dollar is going up because the supply of dollars is not increasing fast enough. Currencies are just like any other commodity – they are priced at the point where the supply and demand curve meet. When the US economy is creating credit, the supply of US dollars is increasing. If credit is being destroyed, then the supply of US dollars is decreasing. Therefore it is possible an increasing US dollar is actually a sign of economic weakness. We saw this occur with the credit crisis of 2007/8 when the US dollar soared.
We also saw the same phenomenon when the Japanese tsunami hit. The Yen rallied on the initial news of the terrible tragedy.
It then sold off as capital fled Japan in the days after the disaster. But as the Japanese economy contracted, credit was destroyed and the supply of Yen shrunk. Even though it was perverse, the Yen actually rallied hard as the Japanese economy stumbled into a severe economic slump.
Over the past year the US dollar has been rising. I am not suggesting the reason for this rise is solely the result of credit destruction. However, I do believe that tightening credit conditions slowed down the creation of US dollars, and this contributed to the rally.
It is no surprise the US stock market hit new highs as the dollar rally tailed off in late April. And it is also not unusual for the stock market to be stumbling as the US dollar rally has resumed over the past week. The US dollar rally is yet another sign that credit might be too tight.
The other worrisome signal is the recent decline in risk and hard assets. Have a look at the CRB Spot Industrial index:
This is not the kind of action you would expect from an economy about to explode to the upside.
What does it all mean?
I really want to believe the recent pause in the economy is a temporary affair. In the past, economic expansions didn’t die from old age, they had to be put down with higher rates.
But what if the sheer amount of debt overhanging our economy means the nature of economic cycles has changed? What if last year’s taper of the QE program was in fact a tightening (we can probably agree it was at least a reduction in the rate of monetary expansion), and this recent economic slowdown is the result of the withdrawal of monetary stimulus?
I believe the odds still favour the US economy exploding upwards in the coming quarters. Yet I can’t deny the signals the market is sending us.
I would feel a lot better if the yield curve went back to steepening, the US dollar stopped rallying and commodity and other risk assets started rising. I am not going to abandon my base case for an economic uptick in the coming months, but I hear the message the market is sending loud and clear.
Covering my Yen
I was fortunate enough to short Yen last week. Since then, the Yen has plunged to new lows for this move. Although I might be getting a little too cute, I am covering all my position. This ended up being a great trade, but I get the sense with the lack of any real obvious trades out there in macro land, too many momentum monkeys have climbed aboard the breakout. I will therefore ring the register and watch from the sidelines.
If this is the big one that spirals out of control, then I guess I will miss it. But I sure hope that isn’t the case…
Thanks for reading,