I have long held the view that contrary to popular opinion, since taking over as Fed chair, Yellen’s actions have erred on the hawkish side. Most pundits portray her as some sort of easy money villain, but it is not backed up by any hard facts.
Under her watch, the FOMC has tapered and ended Bernanke’s QE program, and then raised rates. In the process, they have flattened the yield curve as much as during the previous 2002-2007 cycle. The market is screaming out that the Fed is too tight.
And in case you don’t believe the message the yield curve is sending, last week at a BIS conference, Hyun Song Shin presented a paper titled “Global liquidity and procyclicality” (click link to read paper) that outlined what the FT described as a “Textbook defying global dollar shortage.”
The gist of Hyun’s argument is that there is an acute shortage of US dollar liquidity. In fact, the FT deduces the situation is as dire as 2008:
We’re inclined to suggest it’s one of the most important charts in the world right now. And that’s not widely appreciated. What it shows is how dollar strength and the availability of dollars via the FX swap market go hand-in-hand in the market atm. What it implies is that the global “dollar shortage” is matching if not surpassing 2008 levels.
The Federal Reserve has thoroughly failed to realize how their hawkish actions and rhetoric has sapped the global economy of much needed liquidity. Like it or not, the US dollar is the world’s reserve currency, and the global economy has not able to handle Yellen’s tightening cycle.
Even the WSJ has figured it out. In article titled the “World isn’t ready for a Fed increase” Greg Ip outlines the problems with the hawkish Fed policy:
But it’s not just the trajectory of the U.S. economy that should guide their decision. While the Fed is the U.S. central bank, the dollar’s central role in the international financial system means it also is the world’s central bank and the world may not be ready for another rate increase.
In theory, the influence of the Fed on the world economy should be receding, not growing. The U.S.’s share of global output has shrunk, as has the number of countries pegging their currencies to the dollar (China is a notable exception).
Yet the dollar is now more influential than ever. It accounts for 87% of currency transactions, 60% of global reserves and 62% of cross-border debts, according to Ruchir Sharma, chief global strategist at Morgan Stanley Investment Management. Oil prices are supposed to respond to supply and demand but nowadays they also respond to the dollar, he says, because trading of oil far exceeds actual consumption, and trading is conducted in dollars.
Finally figuring it out
Yet yesterday’s FOMC meeting shows the Federal Reserve might finally be figuring out the disastrous role their hawkish policy has had on the world (and US) economy. The stupid dots which show the FOMC members’ projected path for interest rates have consistently being miles above the rate priced by the market. The Fed’s pipe dreams about how far they intend to raise rates has not been confirmed by market participants. The market knows better. It knows the Fed will never be able to get anywhere close to the absurdly optimistic levels projected by the FOMC. I will go one step further and claim the very act of projecting that sort of increase, ensures it will never happen. In a balance sheet constrained economy, the only way a Central Bank can create inflation is to be “responsibly irresponsible.” The Fed does not get this. Their actions and guidance act contrary to what they are trying to achieve.
But what happened yesterday? The Fed’s dot projections were lowered closer to market expectations:
The Fed is still well above the actual market projected path, but this lowering represented an admission they have got it wrong.
Have a closer look at the change in the dots:
Whereas in March there was only one FOMC member looking for only one increase in the Fed Funds rate in 2016, now there are six! And then look at the new outlier dot projection. One of the FOMC members thinks there will be no increases in 2017 or 2018!
The Federal Reserve has cried Uncle. All the FOMC members might not be on board, but there has been a dramatic shift from believing “they must raise rates” to a realization they have just tightened into a global economic slowdown (and in fact, might have actually caused the slowdown).
Let’s see if my theory is correct
It has been my theory that the long end of the bond market has rallied because the Federal Reserve has been too tight. Remember, the long end loves an overly tight Central Bank because it ensures there will be no inflation.
Although I admit, there is a chance the Fed’s hawkish policies have pushed the global economy into a recession that will cause the long end to rally even further.
But if I am correct, regardless of whether there is a recession or if the Fed eased up on the brake in time, the yield curve should steepen. Either way, the short end which has been unduly punished by the Fed’s withdrawal of liquidity, should rally more than the long end.
And the market interpreted yesterday’s FOMC change the same way:
This morning the curve is once again flattening, but I think that has more to do with Brexit and all the other global worries consuming the market. As we get through Brexit and things hopefully settle down in the coming weeks, I expect the US yield curve to steepen.
I am still long the 2/10 spread, and given the recent FOMC shift, I will add to the position. I might even venture out into the 5/30 part of the curve. The end game is for Central Banks to keep printing until the bond market takes away the keys. This recent attempt by the Federal Reserve to raise rates is coming to an end. They are realizing there is simply no way to conduct prudent monetary policy in this balance sheet constrained world. It is inflate or die. And that means a much steeper yield curve…
Thanks for reading,