It seems nearly every day now
Some Fed members make the same vow
First buying will stop
Next Fed funds will pop
Then asset run-off we’ll allow
Thus far markets have been subdued
Though some players now have construed
That buying the dip
Has lost all its zip
While selling all rallies is shrewd
Another day, another series of Fed speakers explaining that inflation is the primary focus, that when QE stops in March it may (read will) be appropriate to raise the Fed Funds rate by 0.25% and that the Fed has powerful tools to prevent inflation from getting out of hand. While it is encouraging that they have finally figured out inflation is a problem, the fact that they still don’t understand it is a problem of their own making is somewhat disconcerting. However, moving in the right direction is clearly a positive.
So, after Brainerd, Waller, Barkin and Evans all basically said the same thing, here is what we know. It seems a virtual certainty that the Fed Funds rate will be raised at the March meeting with a very high likelihood of at least two more hikes as the year progresses. Mr Waller even suggested more than four total this year, although that is clearly a minority view, right now, on the FOMC. The problem is that 25 basis point increments every 12 weeks is not going to make much of a dent in inflation running at 7.0%. And, even if inflation falls back down to 4.0%, it will still take more than three years for the Fed to even reach a point where real yields are back to 0.0%. Not only that, when Waller was asked about 0.50% increments, he dismissed the idea as being destabilizing for markets. (Yet again we can read between the lines and recognize that preventing an equity market decline remains the Fed’s primary focus regardless of recent comments on inflation.)
But back to the real yield story. It is important to understand that negative real yields are not a bug in their plans, they are the feature. Negative real yields are the only way for the US (and every overly indebted nation) to reduce the value of their debt without a technical default. The Fed knows this playbook from their actions in the wake of WWII, where they capped yields at 2.50% and inflation ran at 10.0%. A few years later, the debt/GDP ratio had fallen from 125% to 35% and the country’s finances were back in order. That process worked then because the US economy dominated the global economy and essentially everything was manufactured here. Given the dramatic changes that have taken place in the ensuing 80 years, it is not clear that the citizenry in the US will be quite as patient this time, but that is almost certainly the Fed’s plan.
If we assume that real yields are set to remain negative for a long time into the future, what are the likely impacts going to be? First and foremost, real assets like commodities and real estate should perform well and maintain their value if not appreciate. Bonds, on the other hand, will have a tougher time, although there are many things which may help support them, not least of which would be a reversal of policy by central banks. Equities are going to find themselves segregated into companies that have businesses and are profitable and those that have benefitted from the ongoing monetary largesse of the central banks and may find that funding their businesses will get more difficult. In other words, credit is going to matter going forward in this environment. Finally, the dollar’s behavior will be contingent on just how other nations approach the real yield question. For those countries that follow sound money policies, and seek to end financial repression, their currencies should benefit. However, all signs are pointing, at this time, to the fact the US will not be considering sound money policies as they are short-term politically unpalatable, and the dollar will underperform going forward. I apologize for the dour message on a Friday, but the constant Fed blather becomes difficult to tune out after a while.
Ok, here’s what we have seen overnight. Yesterday’s tech rout in the US took equity markets lower across the board and that was followed in Asia as well (Nikkei -1.3%, Hang Seng -0.2%, Shanghai -1.0%). Europe, too, is in the red with fairly solid declines in the DAX (-0.6%) and CAC (-0.6%) although the FTSE 100 (-0.1%) is outperforming after November GDP data showed surprisingly strong growth in the UK across both manufacturing and services. Meanwhile, US futures are hovering either side of unchanged although NASDAQ futures have recently turned down a bit more aggressively.
An interesting feature of today’s price action is that not only are stocks being sold, but so are bonds, and everywhere. Treasury yields are higher by 3.0bps, although that is simply unwinding yesterday’s rally where yields fell a similar amount. European sovereigns are also selling off with yields higher across the board (Bunds +2.4bps, OATs +2.4bps, Gilts +2.8bps). While the positive news from the UK seems a rationale for the Gilt market, German GDP actually fell in Q4 bringing their Y/Y number down to 2.7% and one would have thought that might support Bunds.
Where, you may ask, are investors hiding if they are selling both stocks and bonds? Commodities are looking better this morning with oil (+0.7%) continuing its recent rally although NatGas (-2.6%) remains beholden to the winter weather. A warmer day here in the Northeast is undermining the price. Precious metals (Au +0.1%, Ag +0.2%) are both on the right side of unchanged and most industrial metals are doing well (Cu -0.7%, Zn +1.9%, Sn +2.3%). Agricultural prices are also beholden to the weather so are seeing a mixed bag this morning.
Finally, the dollar is mixed this morning, with an equal set of gainers and losers in both the G10 and EMG blocs. JPY (+0.3%) is the leader in the clubhouse as the very obvious risk-off sentiment is encouraging repatriation of funds while AUD (-0.3%) is the laggard, seemingly on the back of the hawkish Fed comments (or perhaps on the fact that Novak Djokovic will not be playing in the Australian Open after all!) In the emerging markets RUB (-0.6%) is the worst performer on the back of fears of further sanctions as the Ukraine situation continues to escalate, while INR (-0.35%) has also suffered overnight, this more on the talk of Fed hawkishness. However, after those two, decliners have moved very little, certainly not enough to make a case about anything in particular. On the plus side, CLP (+0.5%) and ZAR (+0.4%) are the leaders. The peso is following yesterday’s strength with more as traders anticipate more hawkishness from the central bank while the rand is trading on the back of some key technical levels having been breached and pointing to yet more strength short-term.
Data this morning brings Retail Sales (exp -0.1%, +0.1% ex autos) as well as IP (0.2%), Capacity Utilization (77.0%) and Michigan Sentiment (70.0). Yesterday’s PPI data did nothing to dispel the idea that inflation is well entrenched in the US economy regardless of what Fed members say in testimony or commentary.
Using the dollar index (DXY) as a proxy, the dollar has fallen 1.5% since this time last week. Heading into this year, dollar bullishness was rampant as expectations for much tighter Fed policy were seen as likely to push the dollar higher. However, the early price action is beginning to dispel that notion. I have a feeling that we are going to see investors sell dollar rallies at the same time they sell equity rallies. This is a huge sentiment change from the previous “buy the dip” mentality that had been prevalent since Ben Bernanke first introduced QE all those years ago. Caveat emptor is the new watchword, for both stocks and the dollar.
Good luck, good weekend and stay safe