I was traveling in the South Eastern part of the U.S. on
business last week and made a few observations. One evening while frequenting a
local watering hole enjoying the New England vs. Pittsburgh game, there was a
group of non-professional investors that started talking about the market. As I
listened to their views with great interest, it struck me that a level of panic
that I was expecting to hear wasn’t present. In our blog
last week we pointed to several sentiment indicators that are falling to levels
usually consistent with a near-term bounce. Indeed as a follow-up to that
analysis the CNN Money Fear
& Greed Index is signifying extreme fear in the market place and should
be considered a contrarian bullish indicator.
So where was the panic in the discussion with this specific
group of people? I understand small sample size and geographic concentration
so there isn’t much to draw upon to form a conclusion but I definitely thought
it was quite curious. Then as I picked up the Wall Street Journal to read on
the plane I came across the title, “On Stock Slide, Investors Say, “What, Me
Worry?”. I attached the online version of the article here.
The article states, “U.S. investors
stayed cool in August despite a wild stock-market rout. Outflows from mutual
funds and exchange-traded funds that invest in U.S. stocks dropped to their
lowest level in six months, according to new data from research firm
Morningstar Inc. Investors withdrew a net total of $4.9 billion from these
funds last month, but that was down from $9.6 billion in July, according to
Morningstar. The largest so far this year is a withdrawal of $25.9 billion in
April. “The panic wasn’t that great,” said
Alina Lamy, a senior markets analyst at Morningstar. “There is still
some confidence in the U.S. market.””
Perhaps there is a slight disconnect between these
traditional sentiment indicators and actual investor behavior. Perhaps the side
effects of unorthodox monetary policy (QE and Operation Twist) have had a
profound impact of investor psychology in ways we cannot quite understand yet.
As I try to think back in time and ask myself, does the market have a feel of
despair to it? In 2008 and 2011 there was “blood in the streets” and true wide
spread panic. Even in early 2000, before the major market damage was done,
there was a feeling of inevitability that there was something bad coming. In
early 2000, when the market caps of all these dot.com companies were astronomically
high even though profitability was decades off in some cases one couldn’t help
but feel worried. I wrote an article in early June 2000 entitled Reality
Check.com and said 90% of the dot.com companies listed will be out of business
in a year, and of the remaining 10%, 90% of those remaining will never show
profitability. I listed a group of companies that I thought were in danger of
failing. It was a good piece. I found a version of it in the Los Angeles
Times for review.
I did some digging on further evidence that investor
sentiment hasn’t quite washed out and found a few interesting tidbits on the
subject. According to StockCharts.com
DecisionPoint Rydex Ratio, “A great
measure of sentiment is the DecisionPoint Rydex Ratio. Sentiment has
traditionally been measured by taking polls of selected groups of investors,
advisors, investing professionals, etc. Rydex is an unusual mutual fund company
in that it publishes the total dollar amount of assets in each of its funds on
a daily basis. This makes it possible for us to analyze sentiment based upon
what investors are actually doing with real money. We do this by calculating a
daily bear/bull asset ratio and monitoring the relationship between assets in
the two types of funds. The first chart measures what the total assets are in
each class. Currently total assets in bear funds has still not reached previous
highs experienced in 2009/2011. The Rydex Asset Ratio is about .50 which tells
us that there is more money in bull funds currently. When the reading is
greater than 1, that tells us there are more assets in bear funds and money
markets. Previous readings at 2009/2011 bottoms were nearly 2, meaning in a
general sense that for every dollar in a bull fund there were two dollars in a
bear fund.”
They also point out, “NAAIM
stands for the National Association of Active Investment Managers. This
professional group reports its exposure to US stocks on a weekly basis. The
exposure index reflects the average exposure of NAAIM members. At previous
market bottoms, they were not nearly as exposed as they are now.”
They go on to conclude, “Yes,
sentiment indicators are contrarian, and although readings are sufficiently
bearish to normally indicate a market bottom, we saw that these indicators can
get even more one-sided or deeply oversold, especially at major market reversals.
Observations at previous major market bottoms tell us people aren't bearish
enough right now.”
In the latest Duke
University/CFO Global Business Outlook, it appears the world’s leading
Chief Financial Officers, presumably the people that have their finger on the
pulse of corporate activity and productivity clearly view the market with a
skeptical but confident eye. “CFO
optimism about the U.S. economy has weakened but remains the strongest in the
world. On a scale from zero to 100, financial executives rate the outlook at
60, down from 65 in the spring and 63 last quarter. As a result, business plans
will soften somewhat. Capital spending is expected to increase only 2.4 percent
at U.S. companies and earnings will rise only 3 percent. Merger and acquisition
activity will continue, with the deals funded primarily by cash and debt.
"Finance executives are eager to help their companies start building
again," said David W. Owens, editorial director for CFO Research,
"but they feel some drag from continuing uncertainties about government
actions and consumer reluctance at home, and about economic conditions overseas,
especially in China."”
Fifty-five percent of these CFO’s believe the market is
still overvalued even after the current sell-off. So it appears that this group
of individuals are taking a cautiously optimistic stance. There is some
trepidation in the report but nothing that screams to me extreme panic. I would
find that comforting if not for the unreliable benefits of heeding the advice
of such groups.
In a white paper entitled MANAGERIAL MISCALIBRATION by Itzhak Ben-David, John R. Graham and
Campbell R. Harvey they go on to conclude, “Over
the past 10 years, we collected more than 13,300 S&P 500 forecasts,
including 80% confidence intervals, from CFOs. We study the abilities of CFOs
to estimate probabilities over time and in the cross-section and examine how
these abilities affect the corporate policies at the CFOs’ firms.
We use several methods
to show that CFOs are, on average, severely miscalibrated: their confidence
intervals are far too narrow. For example, the 80% confidence interval for
their one year forecasts contains only 36.6% of the realized returns. We find
that confidence intervals are wider in periods of high market-wide uncertainty,
but during these periods, CFOs are even more miscalibrated. We also show that
the size of the confidence intervals is related to the dispersion of forecasts
across CFOs.”
This last article I thought was fabulous and ties well into
these observations. According to the blog Acting Man, Pater Tenebrarum
released a piece entitled Oblivious to
Risk – Investors in LaLa-Land. In it he writes, “Given current market volatility and the increasing amount of evidence
showing that the global central bank money printing orgy of recent years has
utterly failed to produce a so-called “self-sustaining” recovery, it is quite
odd how nonchalant investors remain about the outlook for “risk assets” such as
stocks.”
“This chart depicts
the MSCI Global Index and contrasts it with a “macro confidence” indicator
(“global risk sentiment”). This indicator does not take sentiment surveys into
account – instead it is purely based on a variety of market prices and
positioning data that are held to reflect investor sentiment. Not surprisingly,
this indicator often has contrarian implications. It is quite stunning to what
extent it is currently diverging from stock prices. Apparently, investor
confidence not only hasn’t suffered, it has actually soared to a new high for
the year:”
He goes on to summarize,
“It is perhaps not surprising that investors have such faith in central banks
saving their bacon – after all, it is common knowledge that unbridled money
printing has been the main driving force behind asset price inflation. When central
banks (or commercial banks with central bank assistance) are expanding the
money supply, it is an apodictic certainty that some prices in the economy will
rise. Given the manner in which new money enters the economy, it is quite
normal that securities prices are among the first prices to rise, and clearly
they are also among the prices affected the most by an expansion of the money
supply…The market has delivered a warning shot in August, but it seems
investors aren’t taking it seriously yet. This could turn out to be a costly
mistake. If (or rather when) faith in the omnipotence of central banks
crumbles, we could see an unusually severe market dislocation.”
He also points out an article in his blog entitled Attention: Investors lacking risk awareness
on equities! This analysis is
provided by behavioral finance firm sentix. They report, “The latest sentix data set reveals an alarming discrepancy: investors’
fundamental belief in equity prices is still rising despite falling economic
expectations. Potential risks are especially lurking in the US market.
Investors are turning a blind eye on possible adverse effects for equities as economic
optimism fades.
The sentix Economic
Index for September drops significantly for all major markets and regions.
Notably expectations of economic acceleration are on the decline. Such drops in
investors’ expectations are usually early warning signs for declining equity
markets. By itself, economic expectations convey an alarming message. However,
in combination with results shown by the sentix Strategic Bias for equities,
which aims at capturing investors’ fundamental belief in equities, the signal is
even more puzzling. Strategic Bias rises, especially for US markets (see
figure).”
“Discrepancies of such
magnitude reflect serious risks. Though, rising skepticism about economic
expectations has not raised investors’ awareness regarding equity price
developments – investors still perceive an engagement in equities as an
investment without alternative. Moreover, investors’ blind trust in the power
of central bank interventionism is threatening. Would behavior be consistent
with expectations should reactions follow suit – with negative consequences for
equity price developments.”
Bottom Line: While
the sentiment indicators that we highlighted last week are indicating extreme
deterioration in investor sentiment we find from actions of investors that sentiment
hasn’t washed out to levels of extreme panic. We adhere to our conclusion from
last week, “We expect continued market
volatility with a near-term rally followed by market weakness into the end of
3Q and into 4Q before stabilizing and heading higher again. Intermediate and
long-term momentum remains negative and we will be preparing to use overbought
situations to protect and/or monetize further weakness. Should the global and
U.S. economic picture continue to deteriorate, then we will readdress our
thesis.”
Double Bottom Line: We
are on alert for another potential downturn in the market. The technical
picture makes the case for further weakness and a disappointing Fed release
this week could make or break the current trading cycle.
Shackling the
Invisible Hand
Speaking about this insane Pavlovian relationship between
investor sentiment and central bank monetary policy, it got me thinking of the
free market system. There have been quite a few examples lately of institutions
of power trying to mold or manipulate markets. This battle against the free
forces of “the market” can’t end well.
Example #1: The powers that be in China attempting to stem
the falling Chinese stock market. In early July we
wrote, “The near-term prospects may
provide a bounce in the ETF but ultimately we believe there is little
centralized regulation can do to stem a market correction. More importantly is
the long-term concerns on the economic and financial stability in China. As
such a key driver of global economic growth, a major economic, financial and
social upheaval in China is enough to start the correction in U.S. equities
that so many are talking about.”
We pointed out the enormous efforts by China to throw
everything they had to stop the market decline at the time and in the end it
seems their desired outcome has yet to be determined. Indeed from the time of
that last post, the iShares MSCI China Index Fund (MCHI) is down an additional
15% on top of the 17% decline it suffered at the time of the writing.
This type of free
market intervention has a low probability of success in our opinion.
Example #2: OPEC’s (Saudi Arabia’s) strategy of flooding the
market with oil to drive prices lower and retain market share while hurting
competitors. Admittedly at first I thought this strategy would work in the
near-term but it is becoming increasingly clear that Saudi Arabia may have
gotten out ahead of their skis. As we
wrote in early August, “The Saudi
Strategy calls for lowering the price of oil to cripple those producers at a
higher cost point in order to maintain market share. The near-term manageable
pain felt by the Saudi producers would be well worth the destruction of the
U.S. shale boom and preservation as a leading producer. This is how I imagine
the argument goes. The question arises if the Saudi’s miscalculated the
ingenuity and efficiency of the American capital machine. It is true that U.S.
rig counts have been in a free fall. That said, U.S. production has not as of
yet witnessed a significant drop in reduction. True many of these drillers need
to maintain production levels in order to meet interest payments on their debt
and keep the operations going. The hope is for survival through a temporary
depression in the underlying commodity. This also forces these companies to
extract higher levels of productivity than in the past and a favorable turn in
the supply – demand dynamic will have an exponential effect on operations and
profitability. If it is found that these companies are unable to withstand the
weakened business climate, there will certainly be bankruptcies. That said,
it’s our opinion that the money behind many of these entities is fairly
intelligent and there will also be restructurings, mergers and acquisitions
that will make the overall industry that much more efficient and productive.”
It is our opinion now that this price war strategy is doing
more harm to OPEC and is actually making our energy industry that much
stronger. When we look at investing, we have our shorter term tactical
positioning (we own XLE puts and are doing well) and our longer term strategic
positioning (Why
We're Investing in the Energy Sector). Our strategic investment position
resides with the U.S. large cap energy sector offering value and allowing us to
build positions while protecting our build from market weakness by putting in
place portfolio protection. If all goes as planned, we will have had the opportunity
to build our energy position without significant losses while doing so. Once
investor sentiment in the sector aligns more closely to the favorable
fundamental picture then we can unwind the protection investments while
enjoying the upside of our accumulated positions while the market was weak.
That is our strategy and we are executing it as best to our ability.
In our view, it is conceivable that Saudi Arabia will
realize that their level of market control is deteriorating and they may shift
gears as it relates to their current pricing strategy. According to OilPrice.com,
“The IEA is of the opinion that prices
may need to fall further in order to slow production enough to really reduce
supplies, but perhaps that misses the point. Supply is a function of price, and
if OPEC forces U.S. producers to become more effective in their own operations,
then in the end that simply hurts OPEC’s own ability to control prices. There
is nothing worse for a lumbering cartel than a nimble firm that can jump in and
take profits whenever an opportunity presents itself. With that in mind,
perhaps OPEC should spend less time waiting and more time figuring out how to
optimize its own operations in response to prices.”
This type of free
market intervention has a low probability of success in our opinion.
Example #3: The Fed’s unconventional monetary policy actions
since the great recession. It is my belief that the Fed set out to stabilize
our economy when things went south in 2008 and 2009. At the time QE and later
Operation Twist were justified to provide confidence and liquidity to an
economic system that was under extreme stress. The chart below highlighted in Business
Insider shows the impact of QE on stock prices.
They write, “In a note
to clients on Thursday, Morgan Stanley's Adam Parker sent around an updated
version of his chart showing stock market declines since the financial crisis.
Earlier this year, it looked like the stock market was getting over its
addiction to QE, illustrated by the fact that the first stock market sell-off
in a post-QE era saw a quick rebound. But with the recent 12% drawdown in the
S&P 500, it looks like the market hasn't gotten used to going it alone. Or
said another way, the market hasn't gotten used to not having what Parker
called in June, "the stabilizing presence of QE."”
It is for this reason that we may be seeing unusual market
sentiment activity and why we could be in for additional downside in the
market. The unfortunate effects of the Fed’s monetary policy is the danger that
the tail starts wagging the dog. The removal of their accommodation may cause
just as much havoc as their reason for implementing it.
I have no idea what the Fed will do this week, but to
prevent this moral hazard, loss of credibility and the perception of loss of
control, I feel there is no choice for the Fed. They must raise rates sooner rather than later (September) to avoid
looking weak and inconsequential at this point.
Being the most transparent Fed is a double edged sword and
they need to remain vigilant as it relates to their core mandates and not be
perceived as the market trader of last resort. Perhaps a visit to the good ol’
days when Alan Greenspan would testify to Congress and leave the rest of us
asking, “what the hell did he just say?”
This type of free
market intervention has a low probability of success in our opinion.
The Good (case for a
Fed hike)
It's
never taken longer for US businesses to fill a job opening – Business
Insider: “Not only is the number of job
openings in America the highest it's ever been, but it's also taking businesses
a record amount of time to fill those openings. According to Dice Holdings'
DHI-DFH Mean Vacancy Duration measure, it took US businesses an average of 29
days to fill a job opening in July. Dice bases the number using data from the
the BLS's Job Openings & Labor Turnover Survey (JOLTS). A job is filled
when someone accepts an offer to take an open position. "Longer vacancy
durations and falling unemployment rates point to a considerable tightening of
labor markets in recent months,” said University of Chicago's Steven
Davis. “Wage pressures are likely to
intensify if the economy continues along this path." This is another piece
of good news for the labor market, which is big considering the Fed's rate hike
decision next week will have a lot to do with American jobs.”
“GDP is far from the
rather exact number most people think. There are lots of ways to measure GDP;
and recently, what is not measured has been the cause for some controversy, at
least among economists who care about such things. Given that second-quarter
GDP was revised up substantially on Thursday to a surprisingly high 3.7%, it is
even more appropriate to look at how that number is created. Bloomberg ran a
short article pointing out that if you took the oil slump out, it was much
higher still:
The U.S. clocked its
fastest rate of economic growth in nine years. Well, at least if you strip out
the effects of a battered energy sector.
Oil and exploration
companies this year have cut back on investment in response to a plunge in
crude prices that gathered steam as 2014 drew to a close. If it weren't for
such a dramatic reversal in demand for drilling rigs and wells, the economy
would have posted its strongest pace of growth since the start of 2006.
Weapons
of Economic Misdirection – Mauldin Economics: “Gross domestic product, which includes what consumers, companies and
governments spend and invest, increased at a 4.5 percent annualized rate in the
second quarter when outlays for exploration, shafts and wells are excluded. Can
that really be true? Even without taking out the oil industry, GDP growth this
quarter was about as good as it gets these days. It gets even better when you
realize that nominal GDP was 5.85%, with a 2.09% implicit price deflator. Let’s
review that for a second. Well above 3% growth, 2% inflation, the most popular
measure of unemployment is down to 5%, and interest rates are still held to 0%?
What is wrong with this picture? How in the name of holy righteous monetary
policy can the Federal Reserve not raise rates at its next meeting? If they use
the recent market turbulence as an excuse, they will lose all credibility as to
being focused on monetary policy rather than looking at the stock market to
determine what policy should be. They told us they wanted two percent
inflation? Bingo – got it. Unemployment is moving in the right direction; and
unless we get some disaster of an employment number in September (which doesn’t
appear very likely), we have to be as close to the sweet spot for an interest
rate hike as the Fed has been in seven years. Truly, I can see no reason for a
delay other than some very misguided understanding of how the economy works.
This zero interest rate policy is creating all sorts of malinvestment and
inappropriate financial behavior, and we need to begin to move towards
normalization.”
The
Employment Report–Not Bad Enough To Derail Fed Action – Bob McTeer’s
Economic Blog: “Like Wagner’s music, the
August jobs report is better than it sounds. Not great, but good enough to
permit a long-overdue tiny adjustment in the Federal Funds rate. Yes, 173,000
more establishment payroll jobs could have been better, but the farther we go
in taking up the slack in a labor market with increasing mismatches between
skills demanded and supplied, the harder it is to stay above the 200,000 rate.
Besides, we should also count the 44,000 jobs added to the June and July
estimates. And, given labor force shrinkage, an impressive 237,000 fewer people
counted as unemployed, thus bringing the unemployment rate down to 5.1 percent.
Five-percent unemployment here we come. Of course, the big question on people’s
minds is what is the impact of this report likely to be on the FOMC’s decision
on rates. Coming in the midst of all the financial turmoil recently, this
report is probably a small argument for delay. However, if I were still a
member of the FOMC—and remember I was known as the Lonesome Dove—I’d vote for a
September increase anyway. Not so much because the jobs report was not as bad
as it sounds, but because normalization is long overdue. Too bad opportunities
were missed prior to August 11 when China made a sensible and modest adjustment
in its currency management. But, even so, it looks like markets will continue
to obsess over timing until the band aid is ripped off. I’ve been a victim, I
think, of the frog in boiling water syndrome. I don’t know exactly when the
prolonged emergency monetary policy became overdue for change, but I do believe
it has. There is no emergency in the U.S. economy anymore. We aren’t doing well,
but we are doing better than almost everyone else. And, don’t forget, we don’t
measure our output on a per-person or per-worker basis, but on an aggregate
growth basis. We can’t expect such a shrunken work force—some of it voluntary,
by normal retirement, rather than involuntary because of cyclical weakness—to
put up aggregate numbers to match those of a larger work force relative to
population.”
The Bad (case against
a Fed hike)
TOP
BANKER: It is basic 'common sense' that the Fed should delay lifting rates
– Business Insider: “It is the question
of the hour: should the Federal Reserve lift interest rates this month, or
delay? According to Laurent Bouvier, the head of the global industrials group
at UBS, the answer is really pretty obvious… He sets out two key arguments
against a 2015 rate hike: broken econometrics, and unexplained levels of
inflation. He said in a note to clients: "The Great Financial Crisis
followed by black magic-infused monetary policies have broken macro-economic
models, preventing economists and central bankers from predicting future macro
developments with much accuracy, if any, even in the short term." He
provides a number of examples, such as the stronger-than-expected second
quarter US GDP growth, and the weaker-than-expected first quarter US GDP
contraction as evidence. "In that context, expectations cannot possibly be
relied upon to guide the Fed’s decisions. Waiting for tangible and explainable
evidence of a sustained rebound in economic activity is the only way
forward." On a related note, the unexpected low levels of inflation
support the idea that economists are no longer able to predict the future. The
inflation index ex-food and energy is up 1.2% over the past year, according to
Bouvier, below the 2% inflation rate targeted by the Federal Reserve. And that
2% target may be too low anyway, according to Bouvier. He said: "To
effectively break away from the Great Financial Crisis and enter wholeheartedly
into a new economic cycle, a higher inflation rate is not only welcome, but
required as one of the lessons learnt from Japan."
Global
Economy Nearing a “Structural Recession” – Wolf Street: “To the never-ending astonishment of our
economists, global growth has been much weaker since the Financial Crisis than
before it, despite enormous global stimulus from years of extreme central-bank
monetary policies and record amounts of government deficit spending. This
should not have happened, according to our economists. Fiscal stimulus and
expansionary monetary policies beget economic growth, which beget even more
economic growth. That’s the theory. And that’s precisely what hasn’t happened.
All it did was inflate asset prices. But the global economy has been a dud.”
Fed
Up with the Fed – Project Syndicate: “Even
now, seven years after the global financial crisis triggered the Great
Recession, “official” unemployment among African-Americans is more than 9%.
According to a broader (and more appropriate) definition, which includes
part-time employees seeking full-time jobs and marginally employed workers, the
unemployment rate for the United States as a whole is 10.3%. But, for
African-Americans – especially the young – the rate is much higher. For
example, for African-Americans aged 17-20 who have graduated high school but
not enrolled in college, the unemployment rate is over 50%. The “jobs gap” –
the difference between today’s employment and what it should be – is some three
million. With so many people out of work, downward pressure on wages is showing
up in official statistics as well. So far this year, real wages for
non-supervisory workers fell by nearly 0.5%. This is part of a long-term trend
that explains why household incomes in the middle of the distribution are lower
than they were a quarter-century ago. Wage stagnation also helps to explain why
statements from Fed officials that the economy has virtually returned to normal
are met with derision. Perhaps that is true in the neighborhoods where the
officials live. But, with the bulk of the increase in incomes since the US
“recovery” began going to the top 1% of earners, it is not true for most
communities. The young people at Jackson Hole, representing a national movement
called, naturally, “Fed Up,” could attest to that.”
There
is no Defensible Argument for Raising Rates at Present – Pragmatic
Capitalism: “I am a little stunned by the
Fed’s insistence on leaving a rate hike on the table in September. What is the purpose of this? Worse, I have yet to hear a strong argument
justifying this view. So far the “logic”
appears to amount to “we’ve been at 0% for too long”, “the Fed wants to raise
rates so they can lower them later”, “we need to fend off financial
instability” or “we just need to get that first hike out of the way”. These arguments display a total lack of
risk/reward analysis. First, the natural overnight rate is 0% because a banking
system with excess reserves will bid the overnight rate down to 0%
naturally. People who argue that
overnight rates have been “mispriced” or “manipulated” flat out don’t
understand how reserve banking works. Second, raising rates 25 bps does not
provide ammo for later on. If cutting
rates by 500 bps over the last few years didn’t spark a recovery then why would
cutting from 25 bps? Third, the Fed is
contributing to global financial instability by watching the dollar climb ever
higher so that argument doesn’t hold much water. Let’s look at things from a
practical perspective here. The last few
months have been a game changer. We know
that global economies are teetering on the edge and that US financial
conditions are tightening (as seen in break-even rates). We know that a rising dollar is hurting
corporate America. We know that the
commodity crash is being exacerbated by the dollar’s rise which is subsequently
feeding through to the global economy. But more importantly, we know that
raising rates by 25 bps will do virtually nothing for the US economy. So, what we have here is a situation where
the upside is literally nothing. And the
downside is the potential that the Fed will exacerbate turmoil in the global
economy and potentially create a positive feedback loop where the foreign
weakness actually bleeds into the US economy.”
3 Things: Fed
Hike, Now Or Never, Claims – Street Talk with Lance Roberts: “The most anticipated, discussed and fretted
about meeting of the Federal Reserve Open Market Committee (FOMC) is rapidly
approaching. That meeting will answer the one singular question on every
investors mind – will the Fed hike interest rates? The chart below shows that
the Fed has maintained near zero overnight lending rates for a period longer
than any other in history.”
“The consequence of
extremely accommodative monetary policy has been a blistering run-up in
financial asset prices as "savers" were forced to chase yield in
higher risk areas. However, there has been little translation through the real
economy that has continued to limp along. It is worth remembering that the
Federal Reserve uses monetary policy tools in an attempt to foster full
employment and maintain price stability. In other words, the Fed lowers
interest rates to stimulate economic activity and spark some inflationary
pressures. The raises interest rates when the economy begins to accelerate too
quickly, and inflationary pressures are building to a point that it becomes a
detraction to economic growth. The chart below shows the Fed Funds rate as
compared to CPI.”
“In the late 90's Alan
Greenspan began an interest-rate hiking campaign as inflationary pressures were
building in the economy. The sharp increase in rates beginning in early 1999
ultimately led to a suppression of inflation as asset prices plunged, and the
economy fell into recession. Then, starting in 2006, then Fed Chairman Ben
Bernanke also launched a rate hiking campaign as housing prices, commodity
prices (oil) and asset prices were rising sharply. The inflationary pressure
build in the economy became a concern, and ultimately, increases in Fed
interest rates once again quelled those concerns. Unfortunately, the quelling
of inflation was combined with an unprecedented global financial crisis. In the
next few days, Fed Chairman Janet Yellen will announce whether or not she will
begin further restricting monetary accommodation by lifting the overnight
lending rate. She will do so with both inflation and economic growth at levels
lower than at any other time in history.”
The Ugly (The Fed is
ruled by the Financial Markets at this point)
Deutsche
Bank's top economist says the Fed won't make a move until markets give the all
clear – Business Insider: “Deutsche Bank's chief US economist Joe LaVorgna
doesn't think the Federal Reserve will raise interest rates until the market
says it's okay. In a note to clients on Thursday, LaVorgna said that basically,
the Fed is on hold until markets make clear that they are ready to handle a
change in the Fed's posture. LaVorgna wrote on Thursday (emphasis his): Most importantly, the financial markets
have to be discounting a reasonably high probability of an interest rate hike.
In other words, the Fed will not surprise the financial markets with a
tightening in policy. (Unfortunately, this is how monetary policymakers have
conditioned the financial markets over the years.) The difficult part for the
Fed will be convincing the markets that the funds rate can go up next month.
Tantrums –
Macro Man: “As readers are no doubt very
much aware, the Yellen Fed has gone through extraordinary pains to reassure
markets that the lift-off and subsequent cycle will be transparent and as
painless as possible; if the whole QE/ZIRP policies have been monetary heroin,
it seems as if the Fed wishes lift-off to be monetary methadone. As such, to engage in lift-off at a meeting
in which the market is not fully priced would appear to endanger the Fed's
intention to make it as painless as possible; after all, this is supposed to be
a removal of an emergency policy, not a legit monetary tightening. However,
there is a downside to letting the inmates run the asylum. If the market throws a tantrum every time
that it senses that lift-off is imminent, normalization can and will be delayed
unnecessarily if the Fed slams on the brakes when it sees the toys flying out
of the pram. Moreover, market pricing is
also a captive of conditional probability. The market is currently pricing in a
75% chance that the Fed will go by the end of the year. Using the logic of "meeting market
expectations", that should naturally imply that they will indeed raise
rates by the December meeting. However,
if (or perhaps when?) the Fed stands pat this month, some portion of that 75%
will vanish into the ether- that represented by the chance of a September
tightening. Perhaps the market will then
price December as a 50/50 proposition.
From that point, it would only take a little more stock market
indigestion, coupled with apparent hand-wringing from the usual sources, to
nudge that percentage lower again, and then voila! The market will be priced at a 1/3 shot
again, "too risky" for lift-off to commence. Lather, rinse, repeat.”
VIX Spikes
and Easy Money: Volatility Dependent Fed Policy – Pension Partners: “If the Fed isn’t focusing on economic data,
what exactly are they “looking at?” It is becoming increasingly obvious that
when they say they are “data dependent” what they really mean is they are
“S&P 500 and market volatility dependent.” As I illustrated last December,
it is the stock market tail that has been wagging the Fed dog in recent years.
In 2010 and 2011 when the Fed was expected to begin “normalizing” interest
rates, sharp stock market declines (17% and 21%) and spikes in volatility
(above 40) derailed those plans and new rounds of easing (QE1/Twist/QE2) were
initiated instead. With the recent 12% correction in the S&P 500, similar
talk has begun. Ray Dalio predicted last week that the next major Fed move will
be an easing (QE4) rather than a tightening. Few market participants are
expecting the Fed to follow through with plans of a rate hike in September
given the recent market volatility. William Dudley (NY Fed President) confirmed
this last week in saying a September hike was “less compelling” given
“financial-market developments.””
Joseph S. Kalinowski, CFA
Additional Reading:
On Oil Prices
GOLDMAN:
Oil is on the verge of plunging to $20 – Business Insider
On The Economy
The
US job market has found an old sweet spot – Business Insider
America's
small businesses are optimistic – Business Insider
The
US economy looks like it's getting even stronger – Dr. Ed’s Blog (Via
Business Insider)
Is a
Recession Coming? – The BlackRock Blog
On the Fed
Will
Fed Be Spooked by Specter of Chinese Recession? – The Street
You
Deserve a Raise Today. Interest Rates Don’t. – New York Times
DEUTSCHE
BANK: Here's our advice to the Fed – Business Insider
IMF:
It's too soon to raise interest rates – CNN Money
Fischer
Keeps Rate Hike Door Open, But Shouldn't – Street Talk with Lance Roberts
This
is the worst argument for the Fed to raise rates – The Washington Post
The
Fed and the Jobs Report - Bloomberg
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