The other day I wrote a piece that highlighted the risks from an increasingly hawkish Fed (Trump and Yellen’s collision course). One of my buddies emailed me to tell me I was overly concerned about the Fed’s hawkish rhetoric. He reasoned that we had seen this movie before. And not just once, but a few times. Over the past couple of years the Federal Reserve has talked a tough game, but when push came to shove, regularly fallen down.
At the beginning of last year the Fed had communicated an expectation to raise rates four times in the coming twelve months. Well, we all know how that turned out. The Federal Reserve was barely able to get one hike under its belt.
So yeah, I get it. The winning side of the trade has been to bet on the Fed wimping out. Their rhetoric about higher rates has not matched the Fed’s actions. For all the tough talk about normalizing monetary policy, over the past two years the Federal Reserve has raised rates a whopping 50 basis points.
Lending credence to my buddy’s theory is the fact that speculators are leaning heavily short the front end of the yield curve. Three month Eurodollar futures have a record net speculative position.
The contrarian in me is screaming out warnings about climbing aboard this crowded trade. Surely with this massive short speculative position, the market has already priced in hawkish Fed rhetoric, and any surprise will be with a Fed that hikes rates more slowly than expected.
But here is the rub. Although I agree eventually this short position at the front end of the curve will be covered in a dramatic panic, it will only occur once the Fed tightens to the point of breaking something. So it comes down to a question of timing.
Will something break quickly enough to send the Fed scurrying back down its coward hole? A week ago I would have said probably not as the Trumphoria was still glowing strongly. But Trump’s actions over the weekend, and more importantly, the associated turmoil they have created, has created the worry it might undermine economic growth. Will it be enough to derail the Fed? I am not sure.
It is easy to remember all the times the Fed chickened out of raising rates, but often forgotten are the events leading up to the Fed whiffs. The Fed didn’t just panic at the first bad economic number. Usually the US dollar was screaming higher, commodities collapsing, or emerging markets tanking. As the Fed tried to tighten, stuff started breaking in the global financial system, and ultimately this pressure translated into pressure in US markets.
Have a look at the stock market over the past couple of years:
There are a couple of large breaks of more than 10% that coincided with attempts from the Federal Reserve to tighten policy. And of course the subsequent scream higher is when they blinked.
But does the current situation really resemble the previous times when the Fed fell down?
Let’s start with the Fed’s favourite market based inflation indicator - the five year five year forward breakeven inflation swap:
From the start of 2014 to mid 2016, market based inflation expectations were headed only one way - down! I attribute this to a Yellen Fed that was too tight, but regardless of the reason, there is no disputing the overwhelming trend.
In an environment of falling inflation expectations it makes sense for the Fed to err on easier monetary policy when stresses appear in the financial system. But have a look at the last 9 months. Inflation expectations are rising, not falling.
And how about the US dollar? Last time the Fed tried to tighten the US dollar exploded higher. This repricing caused monster problems for emerging market companies and economies. Yet even with all the recent Fed hawkish rhetoric, the US dollar has been falling, not rising.
During the past couple of years, the Federal Reserve attempted to tighten into a globally weak economic environment. Not only that, but fiscal policy was firmly stuck in neutral.
Contrast that to today. Instead of the global economy tottering on the edge, the last half year has seen a firm upswing.
Finally, let’s address the elephant in the room. Although the Fed is supposed to be apolitical, I doubt there are many Trump supporters on the FOMC board. The Fed was already concerned the window of opportunity for effective fiscal stimulus had passed, and I very much doubt they will take kindly to Trump’s aggressive tax cuts and spending. When you combine that with the disruption of Trump’s trade policies, it will be difficult for the Federal Reserve members to interpret any of Trump’s actions as anything other than inflationary.
There are some smart people who think Trump’s bumbling this weekend has introduced economic uncertainty, which will keep the Fed on the sidelines. Have a look at this article from Business Insider:
Refugee bans, looming trade wars, and worldwide protests. Investors can be forgiven for forgetting the Federal Reserve is meeting this week to set US interest-rate policy.
It wasn’t hard to see that Donald Trump’s ascent to the White House, with all the whirlwind volatility it entailed, would quickly obfuscate Fed policy as a driver of financial-market activity.
Still, the force with which Trump’s first week in office has upset global affairs is worse than even pessimists had foreseen.
As for how this affects the Fed, recent turmoil is most likely tilting the argument in favor of those officials who saw Trump’s policies as a potential retardant of economic growth, as opposed to the camp counting on promised fiscal policies to boost activity. Minutes from the Fed’s December meeting suggested the Fed was evenly split on that count.
This means the already extremely gradual pace of interest-rate hikes — just one in each of the past two years as opposed to initial hints from top officials of many more — will remain snail-like, almost imperceptible.
Although I understand Pedro Nicolaci da Costa’s opinion, I respectfully take the other side of the trade.
Yes, there is some turmoil from Trump’s recent actions, but let’s face it, there is precious little market stress. Stocks are still near the highs, spreads are acting well. There are little signs of panic.
I suspect the Fed will err on being more hawkish than anyone expects. They will want to send a signal to the Trump team.
I am not sure of how to best play this rising tension between the Fed and Trump. Eventually the Fed will tighten enough to break something, but the problem with that strategy is that we could scream much higher in the mean time.
I am throwing out the idea the Fed will be as wimpy as they were over the past two years. After all, they only blinked once markets moved hard against them (which has not yet happened), and economic conditions were dramatically different back then. Until these conditions change, I will assume the Fed will surprise on the hawkish side.
Thanks for reading,