The MacroTourist sure picked a heck of a week to head off on vacation. I was expecting a nice quiet affair at last week’s FOMC meeting, with the Federal Reserve setting the market up for a June tightening, but ultimately trying to do their best to not derail the risk-on rally. After all, they had been consistently signaling everything was on pace for four tightenings in the next year. There had been absolutely no signs the interest rate path was about to be altered.
In fact, due to the ripping rally of the past few weeks, a few economists were even forecasting a interest rate rise at last week’s FOMC meeting. Although I did not think this was probable, I definitely thought it was possible. After all, even though I felt the Fed was making a colossal mistake, there were zero signs they were about to change tack. I even wrote a piece about how Yellen might pull a Trichet and tighten twice in succession just to prove the first rate rise was not a mistake.
Man, was I wrong. Not only did Yellen & Co. skip any tightening, they guided down rate hike expectations for the coming quarters. The infamous “dot plots” which show FOMC members’ expected interest rate levels were reduced by 50 basis points for 2016. Instead of ending the year at 1.375%, the mean consensus Fed Funds level was lowered to 0.875%. Just like that, with absolutely no warning at all, the FOMC reduced forward guidance by 50 basis points.
According to Goldman, this was one of the biggest Fed surprises in the past 15 years. From Bloomberg:
According to economists at Goldman Sachs Group Inc., the Federal Reserve just delivered one of its most dovish decisions of the new millennium.
Excluding two meetings during the depths of the financial crisis in late 2008 and early 2009, the shock of Wednesday’s slash to the so-called “dot plot” was only exceeded by introduction of calendar-based forward guidance in 2011, the decision to forego “Septaper” in 2013, and last March’s markdown, according to Goldman:
“Markets had little doubt that the FOMC would leave the funds rate unchanged at yesterday’s meeting—futures markets implied only about a 5 percent chance of an increase before the announcement,” wrote Pandl and Struyven. “Yet the decision was clearly a major dovish surprise for markets, with interest rates declining across the curve and the dollar falling against other developed market currencies.”
The economists judge how big a surprise a Fed announcement is by the extent to which a variety of asset classes—from stocks, to gold, to inflation-protected Treasuries, to the Chicago Board Options Exchange Volatility Index—move together in the wake of these communiques, and the direction in which they go.
There is not much to be gained by debating whether the move was justified. I happen to think the last six months of economic and market turmoil was self inflicted by an overly enthusiastic Federal Reserve, but I understand those who argue the longer we delay the tightening, the worse the eventual crisis. Regardless of how one feels about the change in policy, it is what it is, so we are better off accepting it and deciding how to profit from the Federal Reserve’s change of stance.
Two different possibilities
The timing of the FOMC’s shift was peculiar. There were plenty of opportunities for Yellen to signal a shift toward a less hawkish stance over the past few weeks. Why wait until stocks have rallied more than 200 S&P 500 handles off the lows and financial conditions have loosened appreciably?
It was only a month ago the world was coming unglued. The Fed was stubbornly sticking to their hawkish rhetoric, forcing up the dollar, putting tremendous strain on oil and other commodities, not to mention the incessant capital flight from the overpriced pegged Chinese Yuan. It was into this stress that a little easing off the brake from the Federal Reserve would have been extremely helpful. Yet none came.
So what changed? As far as I see it, there are two likely possibilities. The first is that over the past couple of weeks the Federal Reserve has become aware of a large systemic risk to the global financial system. Maybe Deutsche Bank is closer to failing than anyone suspects. Or the Chinese banking system is teetering closer to running out of reserves than the market realizes. The Federal Reserve might have loosened because they are afraid continued hawkish guidance would tip a dire situation over the edge.
Although I am not discounting this possibility, I am more inclined to believe there is no pressing disaster-in-the-making, but that the Federal Reserve finally woke up to their asinine policy. I suspect the United States got an earful about their monetary policy at the G20 meeting. Maybe there was an explicit agreement, but I doubt it. The Central Bankers agreed the financial stresses has gone too far, and that something needed to be done.
On February 9th I wrote an article titled “Central Banks get ready to strike back.” I am not taking any sort of victory lap as even though my prediction was spot on, Yellen, Fischer and Lew’s hawkish talk convinced me that the Federal Reserve was tone deaf to the role they were playing in the crisis. After I wrote that article one of my buddies emailed me and asked what form the Central Bank action would take. I told him I didn’t know, and then like a mope, I got shaken off the idea by all the bearishness and US officials’ steadfastness. I didn’t have to guts to stick with my prediction.
From the article:
I suspect there is already a plan, and it will be a coordinated affair with even the Fed doing their part. The Central Bankers will strike back - the one thing they are desperately afraid of is a repeat of 2008. They will do everything in their power to prevent that outcome.
If I am wrong, and Yellen stays on her path of normalizing rates, then another financial credit crisis is almost guaranteed. The longer she refuses to acknowledge this reality, the greater the risk it reaches a point where Central Bankers are powerless to stop it.
It just goes to show you how hard trading is. Even when you are right, it often only becomes obvious in hindsight.
There was obviously a plan
The Federal Reserve didn’t panic into the February lows because they didn’t want to be seen reacting to market events. But I firmly believe the Central Bankers and government officials made some sort of deal in those dark dreary days. Whether it was formalized at the G20 meeting, or whether it was done at one of their bi-monthly BIS meetings doesn’t matter. The important part to understand is the Federal Reserve finally succumbed to the pleas from the rest of the world to ease up on the rate of tightening.
Although many market pundits blame China or the bursting of the crude oil production bubble for the pain of the past six months, those were just symptoms of the withdrawal of global liquidity. When the tide goes out you find out who has been swimming naked, but those skinny dippers did not cause the tide to retreat. The real cause of the market’s decline has been a self inflicted wound from the Fed’s foolish “a zero rate was an emergency rate and the emergency is long past” crowd’s desire to normalize rates.
As the Fed has tightened financial conditions, it has caused many serious stresses on the global financial system.
Have a look at the relationship between Brent crude oil and the inverted US dollar index:
Although there is no doubt energy companies made their problems infinitely worse, one cannot deny the Federal Reserve’s tightening campaign, along with accompanied rise in the US dollar, was a large factor in the crude bear market of the past couple of years.
And the even bigger problem has been the Chinese peg to the US dollar. This relationship, which worked so well when America had the easiest monetary policy on the planet after 2008, suddenly became a huge liability when the Fed started to withdraw all of that liquidity.
Although the Chinese made a half hearted attempt to disentangle themselves from the US currency peg, this proved much more difficult than they envisioned. While they have grappled for a solution, the pain the Chinese have endured from the US dollar rally (and by extension also the Chinese Yuan rise) has been immense. No wonder the world economy has sputtered. The second biggest economy, and the one the world has counted on for the vast majority of growth, has been saddled with a 30%+ increase in the value of its currency, all the while China’s competitors have enjoyed the reciprocal decline.
Stuck with a currency much too valuable given the underlying fundamentals, capital has exited China at an amazing rate. There was absolutely no way the Yuan could remain pegged to the US dollar for much longer in the current environment.
This left the Chinese with two different solutions. Either they break their peg to the US dollar, or (and this is the part too many hedgies have ignored) the US dollar has to go down.
Before the FOMC’s recent about face, this second option seemed like a non-starter. Yet if you think about it, isn’t a Fed easing a much easier answer to everyone’s problems? Let’s face it, the US was the only major country in the world hiking, and being the reserve currency, it was causing an undue amount of problems. It forced other countries like Japan and the European nations to ease even more aggressively, which only caused the US dollar to rally further. It was a terrible feedback loop.
In essence, America’s insistence on withdrawing liquidity caused the currency wars to flame up more than necessary.
Don’t believe there was a deal?
Think back to the dark days of last month’s market decline. Even though it appeared nothing changed at the G20 meeting, the market has since risen steadily for the past few weeks. Although nothing officially was agreed on, there is no doubt in my mind the US signaled to the other Central Bankers that their foot would come off the brake. And this market rally on “no news” was simply the plugged in crowd getting the early wink and nod.
One of Mario Draghi’s answers at his recent Q&A session was especially interesting:
Question: Some people have called it currency wars.
Answer: …Also, let’s not forget that in the G20 in Shanghai all countries took a solemn agreement that basically they would avoid such war.
Why would all countries agree to this “solemn agreement” when US policy was choking off economic growth and worsening the currency wars? The answer is now obvious. The countries all agreed because the US relented.
A month ago my buddy asked me what Central Banks striking back would look like… Well we now know, this is exactly what it looks like (too bad I wasn’t smart enough to realize it).
What does it mean?
This post is getting long, but I wanted to highlight this move by the Federal Reserve is a game changer. Although I am not rushing out to buy stocks at these elevated levels, the dangers from leaning short have risen astronomically. The Fed has been holding back all risk assets, but without a US dollar anchor around their necks, risk assets might be buoyed from the insane BoJ and ECB quantitative easing.
My best guess is that if the Fed does not foolishly revert back to their hawkish ways (something I am not entirely certain of because their communication has been so bad), the risk-on rally might have more legs than market participants expect. I would suggest not buying US assets to take advantage of this rally, but instead look at emerging markets, commodities and inflation protected securities.
I will have more to say in the coming days, but my main message is that there was a deal amongst Central Bankers, and it will have profound repercussions in the coming quarters.
Bill Ackman in trouble again
Long time readers will know the MacroTourist has precious little time for Bill Ackman (Baby Buffett? I doubt it). Good ole’ Bill is a blow hard whose pompousness is only rivaled by my other favourite hedge fund “titan” Carl Icahn. Yet maybe we should all take a moment to feel sorry for Ackman who lately has been having some trouble with one of his holdings (hint the symbol starts with a V).
But there might be some good news on the horizon for Bill. Although Valeant is in hot water for accounting irregularities, the other company Ackman has aggressively shorted due to alleged rampant fraud has so far been immune to Ackman’s accusations.
Until now… I don’t know about you, but I think this latest Herbalife ad might have been photoshopped, and the claims seem a little dubious.
Don’t you worry about Bill - he will be back in the money in no time!
Thanks for reading,
Would you prefer to receive the MacroTourist delivered to your email inbox automatically every day? Or did you receive the MacroTourist email from a friend and want to sign up? Simply click on the email icon. Your email address will never be used for solicitation of any kind and you can unsubscribe at any time.