Remember a few years back, in the midst of the U.S. QE programs, all the negative talk about how “the Fed would never be able to taper their bond buying?” When Yellen & Co. successfully navigated that hurdle, the doomsayers moved over to, “raising rates will be a disaster for the U.S. economy.” Well, a year and a half later (and after two hikes), the world has not ended. Faced with these two defeats, the chicken little crowd has adopted a new motto. “The Federal Reserve will never be able to reduce their balance sheet,” has now become the war cry for those of bearish persuasion.
At times during Yellen’s tenure, I have become concerned when the Federal Reserve tightened too quickly. When the Fed’s rhetoric pushed the U.S. dollar higher at a destabilizing rate, or when the tighter American policy caused oil to crash, I warned the Federal Reserve did not seem to realize their policies’ effect on the rest of the global financial system. I know the U.S. dollar is the world’s reserve currency, and yet the Federal Reserve tunes monetary policy for American economic conditions, but there can be no denying the Fed’s relatively hawkish path (especially when compared to other Central Banks), has caused a great degree of stress throughout the world.
But here we are; two hikes under the Fed’s belt, the front end of the yield curve pricing in another two for the remainder of the year, and FOMC members introducing plans for a balance sheet wind down. Who’d thunk the S&P 500 would be within spitting distance of all time highs after all of that?
If I didn’t know better, I would say the Federal Reserve is accomplishing their goal of withdrawing accommodation without having the whole financial system come crashing down. In a creeping fashion, the Fed is doing what the naysayers said couldn’t be done.
I must admit, I am a little surprised it has gone so smoothly. But I wonder if the Federal Reserve isn’t pushing their luck.
Last FOMC meeting Minneapolis Fed President Neel Kashkari dissented against the rate hike in part because he felt the Federal Reserve should concentrate on winding down their balance sheet. Given that during the 2008 credit crisis the Fed argued bond purchases during Quantitative Easing was accommodative, it follows that unwinding their balance sheet would be restrictive. Instead of raising rates, Neel felt the Fed should substitute rate hikes with portfolio unwind. Makes sense, and in the week after the meeting, many Fed officials came right out and acknowledged this was a path they were preparing for. Then last week, the third most important person at the Fed (right behind Yellen and Fischer), NY Fed President Bill Dudley said the following:
“It wouldn’t surprise me if sometime later this year or sometime in 2018, should the economy perform in line with our expectations, that we’ll start to gradually let securities mature rather than reinvesting them.”
“If we start to normalize the balance sheet, that’s a substitute for short-term rate hikes because it would also work in the direction of tightening financial conditions.”
“If and when we decide to begin to normalize the balance sheet we might actually decide at the same time to take a little pause in terms of raising short-term interest rates.”
I (and many others) wrote a piece about how the Fed was shifting from rate hikes to balance sheet wind down. I argued the Fed would most likely raise two more times (since that was pretty much all baked in) and then proceed to focus on withdrawing accommodation by letting their balance sheet run off.
This sort of prudence seemed logical. After all, there has never been a successful winding down of a balance sheet by a Central Bank. We are in uncharted territory. Gently taking their foot off the brake during this dangerous period makes complete sense for the Federal Reserve. No one knows how markets and the economy will react. Better to err on the side of doing no harm, than instead slamming the economy with too much braking.
Dudley’s remarks made perfect sense to me, and obviously to the rest of the market as the yield curve steepened and priced in this new reality. Yet for some reason, Dudley did not like the way they were interpreted.
In an absolute harebrained move, on Friday Dudley redirected the market. From Bloomberg:
Dudley said his March 31 comments that caused bonds to rally and steepened the curve were “misconstrued” by some. A pause “at the time you make the decision on the balance sheet” would be to make sure it “doesn’t turn out to be a bigger decision than you thought you were making. So, I would emphasize the words ‘little pause,”’ Dudley said
Talk about sending the market scurrying back. Suddenly the market was no longer just worrying about Fed rate hikes, but the added burden of rate hikes along with balance sheet wind down loom large.
So far it seems as if financial markets are taking it in stride, but I wonder how long before the U.S. economy reels from the pressure.
Right now we are in an environment where all news, is good news. I understand that the markets make the news, but I was perplexed by Friday’s reaction to the employment report. Even in the face of a terrible number, market participants found ways to spin it bullishly. But famed ex-Merrill Lynch strategist David Rosenberg’s interpretation seems more credible. From Business Insider:
The warmest February on record boosted construction jobs two months ago, but hiring cooled again in March, reducing overall employment by 10,000, according to Rosenberg. Winter Storm Stella, which blasted through the Northeast in mid-March, also shaved up to 20,000 jobs off the headline on Friday.
“So strip out all the weather impacts, and the payroll figure still would have ended up being well short of the consensus at a mere +128,000,” Rosenberg said. Economists had forecast 180,000 nonfarm payrolls.
“Then tack on the downward revisions of 38,000 to the first two months of the year, and the bottom line is that there is no possible way to put lipstick on this pig of a report,” Rosenberg said. “Full stop.”
Rosenberg also noted that some of the weaker sectors were those that catered to final consumer demand. Retail lost 29,700 jobs in March after a loss of 34,700 in February. Hiring has declined amid a wave of store closures — about 3,500 stores are expected to close over the next few months.
“It may well be that retailing accounts for barely more than 10% of the total employment pie, but keep in mind that it is a sector that caters to 70% of the overall economy known as the American consumer,” Rosenberg said.
Heck, even the Fed’s own GDP modeling tool “GDP Now” has been trending lower over the past month.
It is now predicting a mere 0.6% growth rate for the 1st quarter.
And it’s easy to see why. Loan growth is rolling over. I found this great chart on Twitter from HansMrkts:
That’s what raising rates will do. The Fed’s policies are having their effect, but the members of the FOMC are ignoring the data staring them in their face about the actual economy.
Instead, they are fretting over the price of stocks and other financial instruments. Yeah, I get it. They let a bubble brew out of control last time, so now they are determined to not let it happen again.
So much so, that when Dudley insinuates that the Fed will take a pause in hiking to allow the balance sheet to run down, and instead of the stock market selling off on that news, it rallies, Dudley rushes out to take back the portion of the plan that involves reducing the tightening.
Do you really think that if spooz gave up 50 handles on that announcement, Dudley would have bothered to “clarify” his comments about a “little” pause on Friday? Not a f’ng chance.
Over the past few years, many market participants have complained that the Federal Reserve changed policy too quickly based on the stock market reaction. I would agree that they seem way too focused on that one aspect of the economy.
But if they were too quick to ease on an S&P dip, it’s not unrealistic to expect them to be too quick to tighten on an S&P rip. It’s a ridiculous policy, yet why should we expect anything different from these knobs?
We are in the process of the stock market diverging from the economy. Given the Fed’s over eagerness to set monetary policy based on the S&P 500 level, they are pushing too hard on the brake right now.
The Fed is once again making a policy error. They are tightening too hard, taking every little bit the market will give them. This occurred in March when they realized they could speed up the tightening pace without upsetting markets. And now it is happening again with Dudley backtracking because he understood the markets could withstand tighter policy.
Yet, even though financial markets are rocketing higher, this Fed tightening will hurt the real economy. And it’s only a matter of time before the two converge.
Just remember, eventually the alligator got Chubbs… You can’t outrun your destiny.
Thanks for reading,