The members of the Federal Reserve committee are living in a dream land. They have somehow deluded themselves into believing the ending of quantitative easing and their subsequent relatively hawkish rhetoric, has not yet tightened monetary conditions. Convinced they have to follow through with a move off of zero, they have backed themselves into a corner. With all the previous aborted lift offs, the Federal Reserve is all too aware that another last minute change will further damage their already shaky credibility. Not only that, the market has now priced in a December rate hike, so failing to follow through will cause more market volatility.
The January 2016 Fed Funds future (the first clean future after a mid December FOMC meeting), is trading at 99.69. This equates to an implied average Fed Funds rate of 0.31% for the first month of next year. Given that Fed Funds are trading at approximately 0.12%, this means a 25 basis point rise is almost fully baked into the market.
Barring an absolutely stunning reversal of the employment picture or some geopolitical event, the Federal Reserve will raise rates this December 16th. I don’t think it is the right move, but the Fed doesn’t really have a choice. They have already committed to moving off zero, and failure to do would cause unproductive market volatility. Yellen understands this, and during yesterday’s speech, she took the opportunity to solidify market expectations:
…we must also take into account the well-documented lags in the effects of monetary policy. Were the FOMC to delay the start of policy normalization for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession. Moreover, holding the federal funds rate at its current level for too long could also encourage excessive risk-taking and thus undermine financial stability.
On balance, economic and financial information received since our October meeting has been consistent with our expectations of continued improvement in the labor market. And, as I have noted, continuing improvement in the labor market helps strengthen confidence that inflation will move back to our 2 percent objective over the medium term.
There was no ambiguity in these comments. Yellen is steering the committee towards a December lift off. The “zero was an emergency rate and the emergency is long past” crowd seems to have finally won the day.
Tightening right into the next recession
The Federal Reserve is tightening right into the next recession. Of course we all know another one is coming eventually. Central Bankers have not figured out how to repeal the business cycle. The only question is the timing.
Many market players are assuming this cycle will look like previous cycles. They are mistakenly applying the old playbook to an economy playing by new rules. To these old school pundits, the first Fed hike is nothing to worry about. It has previously taken many hikes before the economy rolls over. However I believe the global financial system is mired in a massive balance sheet recession. The enormous amount of debt means the slightest increase in rates sets off a deflationary vicious credit contraction cycle.
The Fed has already started this self reinforcing feedback loop in motion, they just refuse to acknowledge it. On Tuesday the ISM Manufacturing PMI was released, and much to the optimists surprise, it slipped below 50 which indicates this sector is actually contracting.
The last time we approached this stall speed, Bernanke ushered in QE3 (dubbed QE infinity). Maybe you think the myriad of QE programs was unnecessary. You certainly would not be alone. Maybe you think the Fed should raise rates as zero is not a proper level for an economy with 5% unemployment. That is a valid argument.
But make no mistake, the economy is about to roll over, and raising rates in this environment will only speed this process along. All the economic indicators (except for employment) are shouting slow down. The Federal Reserve is tightening right into the next recession.
And in terms of trades, I think a great risk reward out there right now is to buy the long end of the US bond market. If I am right about the global economy being more sensitive to monetary tightening than the Fed and most market participants believe, then as the US economy rolls over convincingly, treasuries will be a screaming buy.
Thanks for reading,