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The Fed Post-Mortem: Here Is The $64 Trillion Question

While on the surface, there was something in it for both hawks and doves, with the Fed admitting, and adding, that "the pace of job gains slowed" boosting the domestic economic dovish camp (the language about business fixed investment increasing "at solid rates in recent months" will be promptly removed as the recent re-plunge in oil flows through the energy sector's cash flow statement), it was the hawkishness about the global environment that appears to have been the primary catalyst for today's rally as it gave the market the impression that the global economic jitters from the past three months are now well in the rear view mirror.

Specifically, it was the complete removal of the line that "recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term" and the addition that the fed is "monitoring global economic and financial developments" which were the kicker.

This is how Bank of America's Michael Hanson explained this change:

The October statement removed the notice that “recent global and financial developments” had posed some risks to economic activity and inflation “in the near term.” During the September press conference and in subsequent speeches, Fed officials stressed that they wanted to be prudent in the face of these risks, but had not fundamentally altered their outlook. The FOMC was concerned that downside risks could intensify into a significant global shock, which warranted their caution. But that did not happen, and other central banks have since stepped in to ease and support their domestic economies. Equivalently, the FOMC has indicated that September was an event that got their attention, rather than a shift toward systemic concern about global growth.

In other words, now that first the PBOC cut rates, the Riksbank boosted its QE, and the ECB (and possibly the BOJ) are about to ease as well, the Fed no longer had the leisurely option of being prevented from not raising rates due to its recently expanded mandate of being global financial regulator, and instead was forced to admit that it is the other central banks' jobs to police their own financial conditions.

BofA's take on this is as follows:

Today’s statement suggests the FOMC would need to see more bad news globally to not hike — in contrast with the market belief going into today’s meeting that the global outlook would have to improve in order for the Fed to hike.

This is not entirely correct: a far more accurate way of saying the above is that having suffered the September swoon, Fed is now betting that the recently expanded easing by other central banks should be sufficient to offset the tightened monetary conditions that would accompany a Fed rate hike.

This also changes the Fed's baseline assumption that the rest of the world is somehow fixed when it was the soaring dollar strength that unleashed the Chinese devaluation and the Emerging Market debt crisis in the past few months. Today's surge in the dollar only reminds us f the Fed's reflexive trap: as long as the Fed postures that a rate hike may come, the dollar will keep rising. And that alone puts us right back on square one.

The rest of the Fed statement was very much in line, and had to do with domestic economic conditions. On these issues, Bank of America's assessment was more accurate:

First, the gradual slowdown in the job market:

Jobs: soft, but no reversal


... the Fed acknowledged that job growth “slowed” and the unemployment “held steady” since December. But they still stressed the cumulative improvement in labor market conditions, suggesting that may be enough — or nearly enough — to allow them to hike in December. Obviously the markets will be watching the October employment report extremely closely. A number of Fed officials have recently suggested that 100,000 may be the forward-looking equilibrium pace of employment growth. Thus, a jobs report similar to the August and September140,000-range would still be a net improvement in the eyes of many Fed officials. Any further decline in the unemployment rate — as well as the U6 under-employment rate — would give further reason to think about starting to move away from zero in a gradual manner come December.

Then, the overall economy, where the Fed is also tempering its ambitions:

Moderate outlook may be enough


The FOMC also maintained that activity is expanding “moderately,” despite the widespread anticipation of a weak 3Q GDP print. In fact, they strengthened the assessment of domestic demand, noting that consumer spending and business investment “have been increasing at solid rates in recent months,” while housing “has improved further.” That suggests the Committee is likely to look past a  soft 3Q GDP growth report; we are tracking 1.5% for GDP but 3.5% for domestic demand in 3Q.

As noted earlier, the business spending, especially in light of the latest dismal durable goods report, will be struck down, but that will only reinforce the Fed's gradual admission that the economy is officially fading.

As for the market's reaction, first there was the bond market, where the biggest variable was the jump in implied rate hike odds. Remember: the Fed will not hike unless the Fed Fund futures at least modestly expects it, so today's jump to ~50% December odds, may be all it takes:

Rates: repricing the liftoff date


US rates increased up to 9 basis points led by the 5y sector, which is most sensitive to the path of near- to medium-term Fed expectations.... We believe the market will continue to focus on the possibility that December will be a live meeting and that a tightening cycle could materialize in coming months, steepening out the implied path of the hiking cycle currently priced in for 2016 and 2017. Indeed, the market-implied probability of a December rate hike shifted higher by around 10 to 15 percent following the statement and may now be in the range where the Fed would be comfortable moving without fear of surprising the market. Should the Fed increase rates in December, we believe they will be cognizant of strained year-end liquidity conditions, but this alone will not be sufficient to dissuade them if they believe a move is warranted.

This brings up a whole different issue, namely whether the Fed will be able to raise the short-end via reverse repos, but that's a whole new topic for a different day, as only afterwards will the Fed realize that it is not nearly equipped to push up the trillions parked on the short-end.

We will be closely watching any communications from the Fed regarding how it will deploy its interest rate management tools and expect the size of overnight and term reverse repo offerings to be increased at the time of the first rate move.

Last, and even more important than the "global" issue - because they are reflexively related - is the question how the Fed will handle the soaring dollar.

The USD rallied broadly following the FOMC statement. Against market expectations, the Fed maintained its outlook for “moderate” growth, focusing on the economy’s cumulative improvement since early this year, and removed the risks posed by overseas developments. This suggests a much lower bar for hiking than FX markets had anticipated amidst recently slowing data momentum. Clearly the Fed is data dependent, but with the Fed explicitly signalling December is a “live” meeting the USD will be supported not only as the probability of a hike rises, but also if the market prices a faster pace of hikes thereafter. Combined with the ECB’s strong signal for an expansion and/or extension of QE (and potential depo rate cut) in December last week, rate differentials will once again play be an important FX driver into year-end. With our analysis suggesting much of the USD rally since 2014 driven by overseas developments (not the Fed), a significant shift in Fed expectations has room to propel the USD higher, particularly with positioning at its lowest level since the USD rally began. While Fed hikes could take some pressure off of G10 central banks from easing, it also suggest higher beta currencies could struggle if risk sentiment takes a hit or commodity demand comes down amidst USD strength. 

The $64 trillion dollar question: "The key question is if the US economy is strong enough to handle a stronger USD."

We'll find out very soon. If the answer is no, the Fed may succeed in pushing the economy into a recession by simply talking the dollar up and without ever having raised rates at all.