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Reflexivity Wrecks Fed Credibility, Crushes 2016 Rate Hike Hopes

With Janet Yellen choking back the vomit as she shifted The Fed's stance to a "hawkish hold," markets remain just as confused (and disconnected) as they were after The FOMC's "dovish hold." The problem, as Deutsche explains, is The Fed's reliance on 'conventional' inflation dynamics (and its mean-reversion - higher in this case) as opposed to actual market expectations (which are collapsing), leaving them open to a major Type II policy error -  the risk of rejecting something that is, in actuality, true. The Fed's credibility is teetering on the brink as inflation 'reflexivity' - that is, Fed expectations strengthen the dollar, depress risk in general and commodities in particular, with lower commodities driving headline inflation lower - raises the prospect that the Fed fails to raise rates at all in 2016.

For many asset classes there has been nothing but a roundtrip, risk on before the Fed, replaced by risk off. However the momentum especially in say high yield, some dollar pairs (especially vs. EM) and to some extent equities appears to be headed towards revisiting what had been earlier sell-off lows in the China devaluation panic.

 

For some investors the Fed’s failure to raise rates is viewed as the culprit in the risk reversal, even though for many investors the Fed was viewed as being in a “dovish hold”, reflecting a more sanguine outlook for inflation as well as global growth concerns. The former view suggests that the Fed is still very much on track for hikes later this year and all will therefore be well as the start to normalization will instill confidence in the economic outlook and “remove” uncertainty that might otherwise be plaguing risk assets. And consistent with this it is the official view of our economist colleagues that the Fed will raise rates in December and then again twice more in 2016.

 

Yellen, in her speech late last week, specifically included herself in the group of FOMC members that expect to raise rates later this year and as such seemed to redirect the market’s perception of the September decision toward a “hawkish hold” rather than a “malign” dovish hold. The malign dovish hold is one in which the Fed delays lift-off because it is concerned about the vigor of activity domestically and abroad. The hawkish hold, in contrast, leaves rate hikes on the table for 2015, and is likely to keep downward pressure on inflation, risk assets, the general level of yields, and the slope of the curve.

 

The potential issue with Yellen’s position is that it is based largely on an entirely conventional view of inflation dynamics, whereby headline inflation over time is expected to revert to the more stable core measure. This entails assigning a greater “weight” to inflation survey data rather than traded market inflation compensation, posits that the long-run inflation trend is unchanged, and assumes no changes in the relationship between core and headline inflation. This is all conventional stuff, but remains exposed to risks that inflation dynamics have changed. For example, we have highlighted statistical evidence that suggests that headline inflation “Granger causes” core inflation rather than vice versa since the crisis in the US, with a similar and somewhat more robust effect evident in the European HICP data.

 

This result could be deceptively important in that, if it persists, it suggests that expectations of Fed hikes could be having a negative effect on the inflation metric that drives them. That is, Fed expectations strengthen the dollar, depress risk in general and commodities in particular, with lower commodities driving headline inflation lower.

 

This would be less problematic if headline inflation did not feed back into the core measure, as base effects would lead the decline in headline inflation to dissipate over time. The problem is that there is demonstrable pass through into core, with the risk being that “transitory” influences could in fact be depressing the longer-run trend. Even if this statistical behavior is a transitory cyclical effect stemming from the financial crisis, the reality is that 1) the dollar linkage demonstrates the relevance of the global economy, and 2) other major economies are in worse shape than the US economy.

Ultimately the issue remains Type 2 error risk – the risk of rejecting something that is, in actuality, true.

Risk assets remain negatively correlated with real yields – a signal distinct from pre-crisis behavior that we interpret as reflecting market concerns over a policy error. While it is possible that risk-off dynamics will be limited in scope and hence acceptable if not desirable, it is also possible that risk off could overly tighten financial conditions in a fashion that precludes, rather than reflects, a more balanced recovery domestically and abroad.

We think there are scenarios for the next few months that might allow the Fed to raise rates, even this year. However we continue to believe these scenarios are unlikely to materialize and the market is therefore prone to dismiss them.

 

In our view they do not represent good risk/reward for investors. On the contrary we think the path of least resistance for market pricing is to continue to deflate Fed expectations through 2016.

 

The prospect that the Fed fails to raise rates at all in 2016 is rising. Almost by its very nature we think the market needs to ease financial conditions for the Fed first, if the Fed is going to be able to achieve lift off.

Morgan Stanley confirms this "paradox" as they note...

We see an unusual discrepancy in real yields vs. inflation breakevens in the US and the Eurozone. Forward real yields imply the Fed will tighten monetary policy above our estimate of the real terminal rate, even though inflation breakevens price a large and persistent inflation undershoot.

 

In our view, either real rates are too high or breakevens are too low. If inflation breakevens are right about persistently low inflation, the Fed will not be able to normalize real rates, let alone take them into restrictive territory. Nevertheless, the market is pricing this scenario when viewed through the lens of 5-year forward 5-year (5y5y) and 10y20y real yields and inflation breakevens.

 

 

Could the Fed embark on a hiking cycle that, in its totality, would amount to a policy mistake? Could the Fed tighten monetary conditions to the extent that inflation never returns to its own 2 percent inflation target? This seems implausible to us, especially in light of the cautious nature of the Fed’s recent decision to delay liftoff at the September FOMC meeting. For the Fed to make one policy mistake is human. For the Fed to make a series of policy mistakes over a multi-year period is unthinkable.

The TIPS market appears to be pricing in a lengthy policy mistake.

 

We give the last word to Deutsche Bank who raise considerable doubts about risk assets in either a "dovish" or "hawkish" Fed world... Much has been discussed around why the market seems so divided on whether the Fed should be hiking or delaying amidst what on paper looks like a tight labor market.

  • The argument for hiking is that inflation risks are around the corner and it is unlikely that global woes alone can derail the US economy, even if they temporarily weaken inflation.
  • The argument for delaying is that even if you accept the underlying strength of the US economy (secular stagnation fears aside, etc.), balance sheet economics dominates the business cycle and may be a leading indicator of future economic weakness, while the cycle itself is a lagging indicator of prior financial conditions.

The easiest way to appreciate balance sheet concerns is in terms of (risk) asset price returns, reflecting deleveraging in various sectors, especially energy and commodities, which shows up in emerging market currency stress, high yield and to some extent equities. Real yields (on Treasuries) are essentially “too high” for these asset prices to stabilize and the danger is that financial conditions continue to tighten.

In turn this raises the risk that the domestic corporate sector, facing weaker pricing power at home and abroad, curtails the expansion to defend profits and manage an otherwise deteriorating debt burden.

*  *  *

So to sum up...

  • It was a hawkish hold after all. Yellen dispelled any uncertainty in her speech late last week. That leaves us bearish risk and looking for sub-2 percent in 10y yields with a flattening of the curve.
  • We think the risk of Type 2 error should dominate the Fed’s thinking because the balance sheet leads the business cycle. While some sectors are still enjoying what were less restrictive conditions a year or two ago, the effect of deleveraging is evident in energy and commodities more generally, high yield and equities. Rising real rates have been negative for asset prices, and pre-crisis dynamics suggest that this negative correlation reflects market concerns over a policy error. Rate hikes are likely to cause further tightening of financial conditions, ultimately hindering growth.
  • The path of least resistance for market pricing is to continue to depress rate hike expectations, to the extent that the Fed might not be able to raise rates at all through the end of 2016.

Once again The Fed falls foul of linear-thinking as reflexivity leaves them wishing to appear dovishly hawkish... is it any wonder Yellen is sick of it.

Or put another way, the more (potentially erroneously) economically-confident "hawkish" The Fed talks, the less and less likely 'markets' are to price in long-run economic growth, thus defeating The Fed's hope not to surprise the market... get back to work Mr. Yellen.