Jun 16/15 – Raising rates will always be scary

2015-06-16 9am EDT  |  #Bob McTeer #bonds #economy #Fed #Yellen

Let’s face it, there will never be a great time to raise rates. We have stuffed our economy full of so much debt and leverage, relied too much on financial repression to boost the value of long dated financial assets, and in general created such a Frankenstein economy addicted to cheap credit that raising rates will from now on always be scary. When guys like Leon Cooperman argue we shouldn’t worry about the first hike they are mistakenly assuming the markets will behave like previous cycles.

"On average, after the first Fed tightening one year later, the market is higher by an average of a little under 10%. And I think the initial stage of rising interest rates are indicative of an improving economy, rising earnings, rising dividends and the market likes that," he said.

The economy has been distorted through three different Quantitative Easing programs. Looking at past cycles has become less and less helpful as the fundamental nature of the economy has changed. Almost all of the developed world is mired in a balance sheet recession. I couldn’t help but laugh when one of China’s largest newspapers took a dig at the countries that attended the recent G7 conference:

Yet countries such as the US and Japan can hardly accept the rising international status of emerging economies and are reluctant to give up their hegemony. When the financial crisis eased slightly, Western media vigorously propagated the “revival” of the G7. But the economic performance of G7 members meant the summit was a gathering of debtors.

“A gathering of debtors” – what a great line. And to a large degree, this description is bang on correct.

Remember Jim Bianco’s recent reminder that no country has ever normalized rates after lowering them to zero? None. Think about that for a second. Raising rates at this point is uncharted waters.

If Leon Cooperman and guys like him are sure they know how the markets and the economy will react, they must be even smarter than their reputations. I, on the other hand, don’t have a clue what this economic monstrosity will spit out.

All I know is that the financial system is much more unstable than almost everyone believes.

Now don’t misunderstand me to think I am suggesting rushing out and shorting everything with both fists. I am just as scared of a melt up as I am of a crash. This market is dominated by Central Banks tossing around financial assets like they are kids trading marbles at recess. The Swiss National Bank is one of Apple’s largest holders. The Bank of Japan buys stocks anytime they decline more than 1% in the morning. The CME has a Central Bank rebate program for S&P 500 futures! The world has gone bat shit crazy. The markets have become complete and utter farces.

To think you can have the world’s largest Central Bank benignly raise rates into this complicated house of cards is just naive. And it is made even worse with the fact many market participants refuse to believe the Fed will follow through with a hike. Jeff Gundlach, the newly appointed “Bond King”, said flat out on National TV the Fed will not raise rates in 2015. This lack of Fed credibility will make the market reaction to a hike even more uncertain.

But will they hike or not?

As uncertain as I am about the consequences of a hike, I am equally uncertain about whether the Fed will raise rates in 2015. Jeff Gundlach is sure they won’t raise rates in 2015, yet I don’t have the same conviction. And in fact, if forced to make a prediction, I would err on the Fed making a mistake and assuming the economy can handle higher rates. The Fed does not appreciate how much the economy has changed.

There is a big contingent on the FOMC committee who believe “ZIRP was supposed to be a emergency measure, and the emergency is long past.” This group wants to get on with the rate rise. They believe monetary policy acts with a long lag, and leaving rates at zero today is risking significant overheating a year down the road.

To better understand what is going through the minds of the FOMC committee members, I often turn to former Texas Fed President Bob McTeer. He writes a great blog that often clarifies their thought process in setting monetary policy.

I agree with the consensus view that September 17 is the most likely date for the FOMC to make its first tweak in the Federal Funds rate in a long, long time. I also agree that this week (June 17 to be precise) is probably not on their agenda because of their promise to be "data dependent." While they no doubt believe the first quarter's negative GDP number was a one-off affair and that growth will rebound from that beginning in the second quarter, it would still look bad to "tighten" monetary policy while the latest growth measure was negative. I also agree that the September 16-17 meeting is the most likely, my purpose here is to ask "What's wrong with the July 28-29 meeting?"

I watch more financial TV than I should, and I don't believe I've even heard the FOMC's July meeting even mentioned as a possibility. The guessing game jumps from June to September as if there was no July meeting. So much so that I just looked it up to make sure it was there.

At the end of July we will be getting the first estimate of the second quarter GDP number, which looks to be positive enough at this point to count as a "rebound" from the weak first quarter. Furthermore, the weak March employment report, which was recently revised up substantially will be another month old and fading from memory. If they are becoming eager to begin the process, they will likely have the cover to do it. In addition, I think they should do it earlier rather than later.

It's getting harder for me to remember how we got to the point where employment growth averaging over 200,000 net new jobs per month with strong follow-up JOLT surveys, an unemployment rate at 5.5 percent and growth other than first quarters getting more nearly reasonable while we have a near zero Federal Funds rate. I feel like the frog experiencing deadly, but gradual and unnoticeable, increases in water temperature.

While I don't think the economy will meet the frog's fate if we wait until September, I see no reason to wait. It's not just that the economy needs to normalize and is ready for it; it's also that we are experiencing unnecessary volatility in financial markets as we play the guessing game. What are we afraid of: A Federal Funds rate of 25 basis points, or even 50 basis points. They've already promised to go slow and watch market reactionbaby stepsand maybe even one and done for a while. The fear in the markets seems irrational to me. But, I may be wrong.

Bob’s arguments sum up the “let’s get it over with it” camp’s views perfectly. He thinks raising rates is not a big deal. Bob doesn’t buy the argument that this cycle is different. He makes the case for raising rates at the first possible meeting, which isn’t September, but could be as early as July.

Will this view win over the day at the FOMC meeting? Are there enough hawks to push through a hike? Do they even want to speed up the timeline?

Contrast that to Chairwomen Yellen’s recent comments.

For this reason, if the economy continues to improve as I expect, I think it will be appropriate at some point this year to take the initial step to raise the federal funds rate target and begin the process of normalizing monetary policy. To support taking this step, however, I will need to see continued improvement in labor market conditions, and I will need to be reasonably confident that inflation will move back to 2 percent over the medium term.

Although the labour market continues to improve, the inflation part of this equation is notably absent.

It is difficult to argue that the conditions are there to be “reasonably confident that inflation will move back to 2 percent over the medium term.”

The real question is whether Yellen will insist on both employment and inflation to justify raising rates, or whether just one of those conditions will be enough.

My guess is that the FOMC statement will try to solidify the September rate hike certainty. Although Bob McTeer believes a September hike is consensus, the market is far from fully priced in for that outcome. The front month Fed Fund future is trading at 99.87 and the October contract is trading 99.74 (we shouldn’t use September contract because the settlement method for Fed Funds future is the average Fed Funds level over the course of the entire delivery month and the FOMC September meeting is mid month – September 17th). This means the market is pricing in 13 basis points of tightening by October, which is roughly half the typical 25 basis point the Fed hikes. Now maybe the Fed chooses to not raise by 25 basis points this time. I argued there is a real possibility the Fed will move to 10 basis points increments in a previous post (Mar 2315 - The next Fed move is going to be only 10 basis points). If that ends up being the case, then the market might end up being more efficient than is usually the case. But I think that is an outside possibility. The more likely outcome is the Fed sticks to 25 basis point moves, and they use today and tomorrow’s FOMC meeting to set the stage for a more certain September hike.

The market is not expecting the Fed to get more hawkish, and I don’t think it will be taken well. Bob McTeer asked what are we afraid of? Well, all I can tell him is what I am afraid of. And that answer is quite easy. I am afraid the financial system is teetering on a delicate house of cards that is interconnected in a multitude of ways no one understands. Maybe a Fed hike turns out to be no big deal. I am fully prepared to accept that possibility. I am just not willing to accept the opposing view. I don’t buy the guarantee that everything will be fine with a Fed hike. This is exactly the sort of misplaced certainty that gets you in trouble. The last time I heard a Fed official express this sort of confidence was when Ben Bernanke told us “we’ve never had a decline in house prices on a nationwide basis…”

Thanks for reading,

Kevin Muir

the MacroTourist