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The Fed - Hawk, Dove, Or Chicken?

Submitted by Joseph Calhoun via Alhambra Investment Partners,

Janet Yellen threaded the needle last week with a masterfully worded statement following the FOMC meeting. The word “patient”, the removal of which had produced so much angst in markets recently, was excised to appease the hawks while the rest of the statement cooed dovishly to appease the stock market bulls. The Fed finally acknowledged reality and downgraded their economic outlook, now expecting growth to continue along the 2 to 2.5% path it has been on for several years now. They could have saved themselves some embarrassment by merely reading my weekly missives. I’ve been saying for almost two years now that the economy’s growth trajectory hasn’t changed much. We’ve had some better quarters and some weaker ones, but year over year growth has been stubbornly stuck with a two handle since 2011.

Considering the Fed’s over optimism of the last few years though, one can’t help but worry that their current forecast will end up being so again. They’ve forecast every year that growth would accelerate and spent the second half of the year backtracking as reality refused to conform to their hopes and dreams. This year they didn’t even wait until the second half and with their track record I am left wondering how they’ll be wrong this time. Will their estimate of growth be too high or too low? For investors the bigger fear should, of course, be the former as anything lower than here will probably be hard to distinguish from a recession. And a recession with valuations this high is not a pleasant prospect for anyone with exposure to the stock market.

Based on the incoming data so far this year, the Fed had little choice but to acknowledge the obvious which is that, like last year, the first half is not shaping up too well.

Last week the only report that was better than the consensus – which has been falling in any case – was jobless claims. The manufacturing surveys (Empire State and Philly Fed) were both less than expected and the Philly version was particularly worrisome. New orders were less than the headline activity number, unfilled orders collapsed to -13.8 from last month’s +7.3. Shipments were also below 0 (indicating contraction) at -7.8 and employment was also weaker than the headline at 3.5. Margins are also a concern with input prices falling to -3.0 and finished goods down more at -6.4. All in all, a weak report that is hard to blame on weather and the port strike on the West coast.

 

The industrial production numbers reflected the recent survey data, coming in at a less than expected 0.1% with last month getting a revision into negative territory. The manufacturing part of the report showed a decline of 0.2%. It is obvious – to even the Fed now – that the industrial/manufacturing side of the economy is slowing. Part of that is due to the rest of the world slowing down but with data in Europe and Asia starting to improve that excuse is getting a little dated. Part of it is also due to the energy sector which continues to struggle with low oil and natural gas prices amidst a glut of fuel. We’re starting to see some defaults in energy high yield now and the WSJ reported that several banks have had trouble finding buyers for energy loans they had intended to syndicate. Losses are modest so far but I suspect we’re only seeing the tip of the iceberg now.

 

Housing is still struggling – something else the Fed acknowledged – with the Housing Market Index, housing starts and mortgage applications all disappointing. The Leading Economic Indicators seemed to confirm the budding slowdown coming in at a less than expected 0.2. Last week’s data was not an aberration but rather the continuation of a trend that started a few months ago.

But back to Ms. Yellen and her word-smithing. The immediate effect of the statement was that everything, with the notable exception of the dollar, got bought. Stocks, bonds, gold, oil and everything else that wasn’t nailed down found an immediate bid. In other words, the market acted more as if the Fed had eased rather then opening the door to a rate hike later this year. And in a sense that is exactly what they did. They have spent months preparing the market for a rate hike based on an improving US economy and with their nod to economic reality made it a lot less likely. In fact, I’ve said before and still believe that we will not see a rate hike this year and maybe not even next. The Fed’s shift to forward guidance as their essential policy tool means that changes in expectations are the equivalent of actual changes in policy.

So it appears we will be getting more of the same from the monetary side of the economic growth equation, a mix of zero interest rates (negative real rates) and the hope that the wealth effect is greater than all the research says it is. Not that either policy has worked to date. The euthanasia of the rentier, that Keynesian disdain for those lay about savers, has failed so miserably that one wonders how long it will be before monetary policy takes a Logan’s Run turn and shifts to the real thing. Surely if we just kill all the seniors trying to live off their savings we can get down to the business of spending our way out of this lousy economy. The Fed’s policy of lowering interest rates at any sign of economic weakness over the last few decades has distorted capital allocation so badly that a new theory – secular stagnation – had to be invented to explain the poor performance of the economy.

Secular stagnation is not a discussion topic because we’ve run out of ideas – except maybe at the Fed – but because low interest rates in this cycle accomplished nothing more than allowing corporate insiders to borrow against company assets to line their own pockets and governments to continue avoiding structural reforms that are the real impediment to better growth. Yes, some of the easy money leaked into student and auto loans here in the US and certainly it boosted borrowing outside the US as the weak dollar enticed borrowers from Beijing to Rio, but that has only made the problem worse as the global debt pile has grown even larger in the years since the Great Recession. The now rising dollar has exacerbated the problem for all those non-US borrowers and the Fed can’t get off the zero bound for fear they will prick the debt bubble for which they provided the air.

QE and ZIRP were supposed to work through the two channels of the portfolio balance effect. The twin policies would force investors into riskier securities in a reach for yield, allowing lower rated borrowers to gain funding. In this cycle, that was primarily lending to shale oil and gas producers. The rise in the price of risky assets would also produce a wealth effect as those with the means to participate in financial markets go out and spend their new found, Fed induced wealth. Now the energy loans are coming a cropper and the Fed is left with the wealth effect as the sole remaining prop under a weakening economy.

We often hear various Fed officials described as hawks or doves but Janet Yellen’s Fed brings to mind another avian metaphor. They are afraid to raise rates for fear that doing so would upset the asset market inflation process and derail what is left of their theory. In her press conference last week Yellen said that stock market valuations were on the high side of historical norms, an appellation that only works if one includes the stock bubble of the late 90s. It seems that she and the other members of the FOMC have decided that another epic stock market bubble is better than admitting they were wrong. This FOMC doesn’t have any hawks or doves, only chickens.