The other day I was chatting with my co-coach for my oldest daughter’s soccer team. We have been coaching our daughters together for years, and have gotten to know each well enough to talk about a little more than just soccer strategy. He’s a pretty interesting guy. He used to fly planes for the military, but he now hauls around passengers for a big Canadian airline. When I am bored, I usually quiz him about all the pilot stuff the twelve year boy in me always wanted to know.
“You ever get hit by lightning?” I ask, a little too eagerly.
“Yup, all time.”
“What’s it like? Is it scary?”
“Not really,” my co-coach responds. “Sometimes it will knock out off the autopilot and you need to reboot the electronic systems, but it’s not that big of a deal.”
“Do you fly the big planes? Do you need certification on each different type of plane? Do you have regular co-pilots or do you just show up and fly with a different person each time?”
I try to make sure I don’t pepper him with too many questions, but I find it fascinating doing something productive for a living instead of just banging futures back and forth all day.
The other day we had more time than usual because there had been a lightning strike near the field, and the soccer league rules are the girls are not allowed to play for at least a half an hour after lightning. So I continued with my questions about being a pilot.
“Thunderstorms – can you go through them?” I asked.
“Not a chance – you go around them. They’d toss you around like a pinball.”
“What about above? Can you climb over them?”
“Well, yeah… You can… but it’s not a good idea. The other day some yahoo pilots for Singapore airlines decided to take their A330 over the top of a big storm. They climbed to 39,000 when they ran out of oxygen for their engines. They had dual engine failure…”
“Holy shit. You’re kidding. What happened?”
“Well, they started gliding. They were lucky because the A330 has a great glide ratio, if you are going to do a stupid stunt like that, that is the plane you want to do it in.”
“You mean the plane just starts gliding down? Do you think they told the passengers? What would have it been like as a passenger?” I asked.
“I am not sure what it would be like as a passenger, except quiet. There would be no engine noise at all. But I sure know what it would be like for the pilots – white knuckle intense. They couldn’t get their engines restarted until they hit 12,000 feet. They glided down 27,000 feet before they could finally power up again.”
“Wow. That’s insane. Were they pissed at the tower for taking them that high?” I asked.
“Naw, it was the pilot’s call. Bloody idiot. He really should have known better than to try going over the top of the storm.”
There are no shortcuts
When I heard this story, I couldn’t help but think about the similarities to the Fed’s current predicament. Most of the Fed Presidents desperately wants to raise rates. The FOMC committee members hate being stuck at zero for so long. Yet economic conditions refuse to cooperate. It is tempting for the Fed to take a shortcut and raise rates anyway, just get it over with. Just like was tempting for the pilots of the Singapore airline to go over the top of the storm. Why not save the hassle of going all the way around the system? I am sure the storm didn’t look that bad, and their wives and husbands were waiting for them at home (I say wives and husbands, but let’s face it, these pilots were probably men – women are too smart to do some jackass move like this). I am sure the Fed is tempted to just get it over with and take the shortcut as well.
There is a big contingent within the Fed who desperately want to remove the zero rate. This camp thinks the time for the emergency rate of zero is long past, and want to get about normalizing rates. These FOMC committee members understand inflation is not running at levels that would normally mandate a rise in Fed Funds, but they don’t view monetary policy as being in a neutral state. Their argument is that monetary policy need not be made tight with a series of hikes, but neither does it need to be pinned to the super loose zero rate.
The opposing group of FOMC committee members are focused on the fact the economy has consistently not achieved its target inflation rate. It has been three years since the Fed’s preferred inflation measure has been at their 2% target.
We had one uptick in the heyday of the QE programs where inflation hit the Fed’s target, but inflation has since slumped and refuses to get up off the mat.
Preparing the market for higher rates
Over the past couple of months, I had believed the US economy was stronger than the economic statistics were suggesting. I figured the tough East coast winter would soon be in the rear view mirror, and the much anticipated self sustaining expansionary economic cycle would be in full bloom.
And many FOMC committee members felt the same way. Figuring they should prepare the market for the first interest rate hike in what feels like decades, they increased the hawkish rhetoric and started the process of having the market price in interest rate increases.
The trouble is the economy is not taking off as hoped. In fact, it is slumping. I could show a bunch of the recent poor economic releases, but the CitiBank Economic surprise index does a decent job at demonstrating the overall state of economic releases versus expectations.
This index is firmly stuck on the lows. This means economic releases continue to be below expectations.
The much anticipated US economic uptick refuses to show itself. I had thought it was simply a matter of being patient, but I am starting to doubt that call. The US economy is refusing to ignite as hoped. It’s like a car engine that is flooded (to those younger readers who have never had an engine without electronic fuel injection, it used be that if you pressed down too much on the gas while starting a car, you could flood the engine with too much gas, and it wouldn’t start for a while). For whatever reason, the US economy is refusing to start, and it is stuttering.
What is the cause of this stutter?
Now here is where it gets a little tricky. Is the economy underperforming because monetary policy is too easy? David Einhorn and Stanley Drukenmiller would argue that zero interest rates are hurting the economy. They would argue the last six years of zero interest rate is not working as hoped, and the Fed should immediately normalize monetary policy.
On the other hand, there are equally wise and thoughtful market veterans like Ray Dalio who warn about a 1937 type mistake if the Fed were to hike rates prematurely. Dalio would argue the economy is in a period of deleveraging and that raising rates too early would cause the deflationary vicious circle to resume.
No one knows
I think if someone tells you they know for sure what is going to happen with the economy, you should immediately stop listening to them. The reality is we are in uncharted territory. We have negative interest rates in much of Europe, a Bank of Japan that is expanding their balance sheet at a furious pace, and a US economy that is trying to deal with the aftermath of one of the biggest credit crises in history. How all these variables are going to mesh together to affect the global economy is a wickedly complex puzzle.
No one knows how much monetary expansion is too much. Nor do they know how much is too little. The best thing to do is to watch how the economy is reacting to the various forces being applied.
US economic downtick
There can be no denying the US economy seems to be struggling over the past few months. The hope the economy would be strong enough to withstand a rate hike is fading.
I believe the US economy is being more negatively affected by the strength of the dollar as opposed to the threat of higher rates. If the Fed raises rates by 25 basis points; consumers, corporations and the government would probably be largely unaffected by the increased borrowing cost. This 25 basis points would not be the straw that broke the camels back.
But, the ensuing US dollar rally might be. The global economy has precious little growth. Most Central Bankers are lowering rates, not raising them. As the Fed embarks on a tightening policy, it makes the US dollar relatively more attractive. This causes a disproportionate rise in today’s zero interest rate world. Even the simple act of the Fed preparing the market for higher rates has caused one of the biggest US dollar rallies in history.
This is the real problem with the US economy. No one, including the United States, can afford to have a strong currency.
The US dollar is up more than 20% over the past year. Have a look at this chart of the Fed’s estimate of the drag on the economy from currency strength:
That graph shows the estimates for a 10% increase in the currency rate. But we have rallied more than 20%!
US dollar strength is killing the economy
The US economy is not having trouble dealing with the threat of slightly higher interest rates, but it is stumbling from the ensuing foreign exchange reaction to this threat.
It used to be the Fed would never even mention the US dollar, leaving that up to the Treasury department. But increasingly the Fed is focused on the US dollar and the effect the global economy is having on the US. From Bloomberg:
Federal Reserve Vice Chairman Stanley Fischer said policy makers will consider global growth as they begin to raise interest rates, and that they could increase borrowing costs more gradually should the world economy falter. “If foreign growth is weaker than anticipated, the consequences for the U.S. economy could lead the Fed to remove accommodation more slowly than otherwise,” Fischer said in a speech Tuesday at Tel Aviv University.
The FOMC committee members are desperate to temper down any expectations for monetary tightening. Again from Bloomberg:
When it comes to describing how the Federal Reserve will exit the zero-rate era, “liftoff” is all wrong, says Vice Chairman Stanley Fischer.
The term, dear to investors and headline writers, “is the most misleading word you can imagine,” he said on Monday in Toronto.
“Liftoff says we’re going straight up with the interest rate,” Fischer said during a question-and-answer session after a speech on financial crises. “Well, we’re going up with the interest rate, then along, and then another little jump. That’s not liftoff, that’s crawling.”
Can’t even raise once
The Fed cannot even get out the first rise without the market tightening conditions so much the rise is not even needed. This would be consistent with Dalio’s belief the US economy is not strong enough to withstand a normalization of interest rates.
Recently other economists are arriving at this same conclusion. Goldman Sach’s economic team just downgraded their estimate of the US economy’s long run potential. From ZeroHedge:
Having recently cut its estimate of US trend productivity growth to 1.5%, in a shocking move earlier today, Goldman admitted US trend growth is far less than previously speculated (or, “secularly stagnating”) and moments ago lowered its long-term potential GDP. The bank says: “after adjusting for a drag from government sector productivity and incorporating an updated assessment of trend labor force growth, we now see long-run potential GDP growth at 1¾%, half a percentage point below our prior estimate.”
It’s not just the vampire squid that is pessimistic about the US economy. Deutsche Bank issued a report that sounded more like a ZeroHedge piece:
Truth be told, we think the Fed is obliged to talk up the economy because if they were brutally honest, the economy what vestiges of optimism remain in the domestic sectors could quickly evaporate.
At issue is whether or not the Fed in particular but the market in general has properly understood the nature of the economic problem. The more we dig into this, the more we are afraid that they do not. So aside from a data revision tsunami, we would suggest that the Fed has the outlook not just horribly wrong, but completely misunderstood.
… the idea that the economy is “ready” for a removal of accommodation and that there is any sense in it from the perspective of rising inflation expectations and a stronger real growth outlook is nonsense.
Giving up hope
I used to be optimistic the US economy would come shooting out of the gate this spring. But I have given up hope. For those economic bulls still standing, my throwing in the towel might be the all clear signal you were waiting for. But when economic signals continue to disappoint, and the US dollar resumes its rally, I don’t see any reason to cling to the hope things will improve dramatically in the coming weeks.
And what worries me the most is that Ray Dalio’s warning will prove too prescient. I worry the Fed is so eager to get off the zero rate, they will do so at the first available moment. I worry they will take the shortcut just like those Singapore airline pilots who tried to go over the top of the storm. I suspect if the Fed is premature with their hike, the US economy will quickly stall out just like the A330’s engines. It will then be a sickening plunge as markets are nowhere ready to deal with the prospects of an even stronger US dollar. The 27,000 feet the market will fall will be a frightening nightmare.
I really hope I am wrong. I really hope the US economy explodes higher in a pent up ignition of all the monetary fuel we have thrown on the fire. If that is the case, I won’t be afraid to climb aboard later. But in the mean time, I am going to assume Dalio is correct in assuming the mistake will be to hike too early, not the other way around.
Thanks for reading