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Why The Fed's Credibility Is Crashing: The Market's Three Biggest Worries

Early this week, when evaluating the likelihood of a Fed rate hike, we cited RBS' Alberto Gallo who said the "real reason to hike is another one: preventing the debt $-denominated overhangs from building up further – the burst of which would be, in turn, even more deflationary (and the same imbalances resulting from a financial boom can also reduce productivity, as discussed by the IMF). So if the Fed’s mandate is to worry about the medium-term and to target structural issues vs today’s asset prices, the right thing to do would be to hike. This is also what the majority of institutional investors think. But the Fed won’t."

Why not? Because the Fed itself realizes its credibility is fading fast and as RBS also showed as per a recent survey of its clients, a whopping 63% replied that the Fed is losing credibility. In other words, it has little to lose by doing what will erode its credibility that much more.

Yesterday the Fed confirmed this was the case when it once again chickened out of its first rate hike in 9 years and took the easy way out, one which however confirmed to everyone that the Fed is increasingly gambling with what precious little credibility it still has left. As a reminder, if and when the Fed loses all trust, its only recourse will be to print boxes of cash and paradrop them on the population. Pardon, boxes of paper because at that point the US reserve will be worthless.

We are not there yet, but as RBS notes in its follow up note today, "the price action in market today is negative, suggesting  increasing worries."

According to Alberto Gallo, the biggest worries are the following:

  1. The first is that by keeping rates lower for even longer, the EM imbalances the Fed is worrying about will grow even larger, making it harder to exit stimulus
  2. The second is a question on the value of forward guidance, after the Fed has repeatedly called for a hike and then backed out
  3. The third is that the Fed may have limited, or no ammunition to react to the next potential shock, and that financial booms and busts may grow even larger over time

Gallo's conclusion:

And as the IMF wrote recently in its World Economic Outlook, these booms and busts have structural – not cyclical – consequences on productivity, following misallocation of capital and human resources to leverage-heavy sectors (real estate, infrastructure), which following the bust create a drag on banks’ balance sheets and in the workforce.

 

Our US trading desk economist Michelle Girard says the Fed has missed its window, and now expects a first hike in March 2016. Together with our rates colleagues, we expect the ECB to react with more easing, increasing lengthening its QE programme, by year-end.

 

The world we are heading into is one of increasingly market-dependent central bank policy, and of decreasing returns for bondholders. The investor reaction function has clearly changed from QE-positive to worries about too much easing and its collateral effects.

Back in 2009 - when we commented on the arrival of global central planning -  we warned this was coming. 6 years later, after the biggest transfer of wealth known to man with virtually no objections by those being pillaged blind, the cracks in the centrally-planned facade are finally appearing.

Additional thoughts from Gallo in the BBG TV clip below: