Heard on the Street    

Fed’s Bearhug Won’t Be So Tight

The market is bracing for a tightening cycle, but it isn’t likely to look like past rate increases

By David Reilly

March 11, 2015 1:46 p.m. ET



So the Fed’s thinking will be shaped by its perception not of whether the economy is too strong, but whether it is strong enough to dispense with extraordinary support. The Fed isn’t trying to put on the brakes.

That flies in the face of how investors usually think about tightening cycles, so prior ones may not provide useful guidance on what follows.

For the Fed, this presents a unique communications challenge: It needs to convince markets that what is typically a bad thing can actually reflect improving economic conditions.

This won’t be easy. Markets have become accustomed, even addicted, to supereasy monetary policy. The Fed and Chairwoman Janet Yellen have already grappled with how to guide market expectations in terms of how they even prepare to consider raising rates.

An imminent Fed move is doubly confusing because there doesn’t appear to be a threat of rising inflation. The core measure that the Fed looks to was most recently at 1.3%, well below its 2% target.

Meanwhile, inflation globally is worryingly low, prompting central banks elsewhere to undertake their own extraordinary easing campaigns.

That inflation expectations remain subdued argues for the Fed, when it does decide to begin raising rates, to do so at a far more cautious pace than in the past. And policy makers will want to take special care to gauge market reactions because no one has experience of a true shift from such extraordinary policy to a normalized rate environment.

At the same time, the soaring dollar poses a rising economic headwind. The U.S. Dollar Index is at its highest level in 12 years.

So, looming Fed rate increases aren’t likely to be abrupt or persistent, in the way they were in the middle of the last decade or in 1994. Instead, Fed moves may be separated by long pauses, and interest rates’ eventual resting place may be well below what markets would normally expect.

Until the Fed can convince investors of that, U.S. stocks and other risk assets will be in for a rough time. But, longer term, the ride may not prove as jarring as investors would expect.

Why Deflation is Good News for Europe

Daniel Gros
MAR 11, 2015

 Petrol station oil prices BRUSSELS – In today's global economy, there is no price as important as that of crude oil. More than 80 million barrels are produced (and consumed) daily, and a large part of that output is traded internationally. Thus, the sharp fall in the crude-oil price – from about $110 last year to around $60 today – is yielding hundreds of billions of dollars in savings for oil importers. For the European Union and the United States, the gain from that decline is worth about 2-3% of GDP.
For Europe, the benefits of cheap oil might grow over time, because long-term gas-supply contracts are to a significant degree indexed to the oil price. This represents another advantage for Europe, where prices for natural gas were, until recently, several times higher than in the US, which had been benefiting from lower-cost shale energy.
But many observers have argued that cheap oil also has a downside, because it exacerbates deflationary tendencies in the advanced countries, which already seem to be mired in a low-growth trap. The sharp fall in oil prices, according to this view, will make it even harder for these countries' central banks to achieve the 2% annual inflation rate that most have targeted in fulfilling their price-stability mandate.
The eurozone, in particular, seems to be in danger, as prices are now falling for the first time since 2009. This deflation is bad, it is argued, because it makes it harder for debtors, especially in the troubled economies of the eurozone's periphery (Greece, Ireland, Italy, Portugal, and Spain), to pay what they owe.
But this fear is unfounded, because it is based on a misunderstanding. What matters for debt-service capacity is the debtors' income, not the general price level.
As oil prices fall, households' real (inflation-adjusted) income should rise, because they do not have to spend as much on fuel and heating. Lower oil prices make life easier, not harder, for highly indebted households in the US or the eurozone periphery. Falling consumer prices should thus be viewed as a good sign.
Most manufacturing enterprises will also benefit from lower energy costs, improving their ability to service their debts. This, too, is particularly relevant in the eurozone periphery, where the non-financial sector accumulated too much debt during the credit boom that preceded the 2008 global financial crisis. Moreover, though most of the savings implied by lower energy costs might initially show up in higher profits, over time, competition will force companies to pass on some of these windfall gains in the form of lower prices or higher wages.
This is another important consequence of cheap oil: lower prices make it more difficult to judge the point at which wage pressure becomes inflationary. Because wages can increase to a greater extent without fueling inflation, the US Federal Reserve Board might be inclined to delay hiking interest rates, which it is now widely expected to do this summer.
Public finances should also benefit from the deflation engendered by lower oil prices. Government revenues depend on the value of domestic output, not only consumption. Though lower oil prices depress consumer prices, they should boost production and overall GDP.
Absent large price changes for raw materials, the consumer price index evolves along with the GDP deflator (the price deflator for the entire economy). But that will not be true this year, because consumer prices are falling, whereas the GDP deflator (and nominal GDP) is still increasing. This should lead to solid government revenues, which is good news for highly indebted governments throughout the industrialized world, but particularly for the eurozone periphery.
The fall in (consumer) prices that the eurozone currently is experiencing should thus be seen as a positive development for all energy importers. The eurozone periphery, in particular, can look forward to an ideal combination of low interest rates, a favorable euro exchange rate, and a boost in real incomes as a result of cheap oil. In a deflationary environment, lower oil prices appear to make it more difficult for the European Central Bank to achieve its target of an inflation rate close to 2%. In reality, lower oil prices represent a boon for Europe – especially for its most beleaguered nations.
Read more at http://www.project-syndicate.org/commentary/europe-deflation-good-news-by-daniel-gros-2015-03#QuEQxDoW1wlh5tbo.99

A Patient Fed Considers Losing Patience

by: Peter Schiff

  • The Fed's misguided policies are becoming dangerous.
  • Their talk about raising rates is only talk.
  • Their credibility is being stretched to its limits.
I have always argued that quantitative easing and zero percent interest rates were misguided policies to combat economic weakness. But as the years went on, misguided turned into irresponsible, which led to ridiculous, and then turned into dangerous. But lately, the only word that comes to mind is "surreal." How should we react when central bankers begin to speak like Willie Wonka?

Contained in the latest release of the Minutes of the Federal Reserve's Open Market Committee (Jan. 27-28, 2015) was a lively discussion of how to say something without anyone understanding what is being said. Although I have been critical of the Fed for many years, I never imagined that it would provide me with material that bordered on the metaphysical.

As Fed policies have become ever more critical to our economic health and stock market performance (see our 2015 Outlook piece in our latest newsletter), the degree to which investors and journalists dissect every public statement and utterance by Fed officials has increased remarkably. At present, one of the biggest points of contention is to find the true meaning and significance of the word "patient."

Last year, as market watchers grew nervous with the Fed's withdrawal of its quantitative easing purchases, many began to wonder how long it would be, after the program came to an end, for the Fed to actually raise interest rates, which had remained at zero since 2008. After all, this would shift the bank into a second, potentially more consequential, phase of monetary tightening. Investors wanted to know what to expect.

Initially the Fed let market participants know that it would hold rates at zero for a "considerable time" after the end of QE (9/13/12 press release), thereby creating a buffer zone between the end of QE and the beginning of rate increases. But, after a while, this also became too amorphous and static for investors who crave actionable information. So in December of 2014, in a bid to increase "transparency" (which is the central banking buzzword for "no surprises"), and to signal that the day of tightening had moved closer, the Fed replaced "considerable time" with the word "patient." But this only deepened the mystery. Investors began to wonder what "patient" actually meant to the Fed.

With potential fortunes riding on every word, the discussion was anything but academic.

When pressed for an answer at a Fed press conference, Yellen explained that the word "patient" in the FOMC statement indicated that it would be unlikely that the Fed would raise rates for at least "a couple" of meetings. She then conceded that "a couple" could be interpreted as "two." Since the FOMC meets every six weeks, that seems to mean that a rate hike would not happen for at least three months after the word "patient" is removed from its statements. But she was also careful to say that removal of the word "patient" does not necessarily mean that the Fed would raise rates after two meetings, just that it's possible. But this much transparency may have become too much for the Fed to handle.

With the economy now clearly losing steam, based on the drop in GDP from 3rd to 4th quarters, and general macro data coming in very weak (Zero Hedge, 2/18/15), I believe the Fed wants desperately to move those goalposts. But after a series of seemingly strong jobs reports, culminating with a strong 295,000 jobs in February, the market expects that "patient" will soon disappear from the statement.

The Fed wants to comply, thereby signaling that everything is fine. But at the same time it doesn't want the markets to conclude that rate hikes are imminent when it does.

In other words, they are searching for a way to drop the word "patient" without communicating a loss of patience. What? This is like a driver telling other drivers that she plans on engaging her turn signal before making a left, but then wonders how to hit the blinker without actually creating an expectation that a turn is imminent. This seems to be a question for psychologists not bankers. Perhaps it is looking for a new word to replace "patient"?

Something that implies a slightly less patient outlook, but that certainly does not imply imminence. "Casual" or "nonchalance" may fit the bill. How would the markets react to a "nonchalant" Fed? Time for a focus group.

The recently released Minutes of the January 27-28 FOMC Meeting frames the difficulty:

"Many participants regarded dropping the "patient" language in the statement, whenever that might occur, as risking a shift in market expectations for the beginning of policy firming toward an unduly narrow range of dates. As a result, some expressed the concern that financial markets might overreact, resulting in undesirably tight financial conditions."

Translated into English this means, "We hope the markets don't actually believe what we tell them." The Minutes continue:

"A number of participants noted that while forward guidance had been a very useful tool under the extraordinary conditions of recent years, as the start of normalization approaches, there would be limits to the specificity that the Committee could provide about its timing."

To me this translates as "Transparency was great while we were loosening policy, or doing nothing, but it isn't useful now that the markets expect us to tighten." If you believe as I do, that the Fed has no intention of tightening anytime soon, its sudden aversion to clarity is understandable. Not surprisingly, the Committee appears to be in favor of shifting to a "data dependent" stance:

"...it was suggested that the Committee should communicate clearly that policy decisions will be data dependent, and that unanticipated economic developments could therefore warrant a path of the federal funds rate different from that currently expected by investors or policymakers."

Of course the Fed won't actually define exactly what type of data movements will translate into what specific policy actions. In that sense, a "data dependent" policy stance puts the Fed back into a "goalpost-free" environment where no one knows what it will do or when it will do it.

To underscore the absurdity of the situation, Chairman Yellen, at her semi-annual Senate testimony in February, offered this "full-throated" warning about pending policy normalization, saying that the Fed "will at some point begin considering an increase in the target range for the federal funds rate."

So this means that after some unspecified time of not even thinking about rate increases, the Fed will "begin" the process of getting itself to the point where it may "consider" (which is in itself an open-ended deliberation) an increase in its rate target (which does not even in itself imply an actual increase in rates). Yet despite this squishy language, the lead front page article on February 24th in the Wall Street Journal (that contained that quote), ran under the bold headline "Yellen Puts Fed on Path to Lift Rates." Leave it to the media to carry the water that the Fed refuses to pick up.

So are we expected to believe that the Fed hasn't even begun considering rate increases yet? Really?

 Isn't that the biggest, most urgent, issue before it? The Fed is a central bank, what else is it supposed to consider? This is like a 16-year old boy saying that "at some point in the future I may begin thinking about girls." Till then, should we expect him to think solely about homework and household chores?

Fed officials have warned that they are concerned about raising rates too quickly. Perhaps that fear may have been plausible a few years ago, before unemployment plummeted and the stock market soared. But how would a 25 basis point increase in rates seriously slow an economy that most people believe has fully recovered? And if the Fed is concerned now, why would it not be concerned next year? If anything, the longer it waits, the more vulnerable the recovery will be to higher rates.

The business cycle tells us that recoveries do lose momentum over time. The current recovery is already five years old, and is, statistically speaking, already well past its prime. And since low rates encourage the economy to take on more debt, the longer the Fed waits to raise rates, the more debt we will have when it does. This means that the debt will be more costly to service when rates rise, which will throw even more cold water on the "recovery."

The Fed's real predicament is not how to raise rates, but how to talk about raising interest rates without ever having to actually raise them. If we had a real recovery, the Fed would not need to couch its language so delicately. It would have just pulled the trigger already. But when its communications and its intentions are different, credibility becomes a very delicate asset.

Last updated: March 11, 2015 4:09 pm

Bloated valuations arrest US bull run

Michael Mackenzie

Entering its seventh year, the ageing US equity bull market looks vulnerable.

Rising concerns about the outlook for US equities reflect their lofty valuations and expectations of higher interest rates. In the past, the combination of rich share prices during periods of tighter monetary policy has proved challenging for the market.

Now, as investors increasingly believe the Federal Reserve may start raising official borrowing costs as early as the summer, equity prices have come under pressure. The S&P 500 erased its 2015 gains on Tuesday as investors have focused on sharp downward profit revisions led by energy stocks and concerns over rising bond yields and the strengthening dollar.
Uncertainly over how asset prices will react once borrowing costs rise for the first time since 2006, looms large over Wall Street. Years of low interest rates and aggressive easing from the central bank have encouraged investors to seek equity exposure, while US companies have taken advantage of cheap borrowing costs to help fund huge buybacks and dividend payouts to shareholders.
“We have been relatively bullish on the market in recent years and believe the bias for stocks remains to the upside, but investors should be concerned,” says Dan Greenhaus, chief strategist at BTIG.

“One thing is clear, whenever the Fed has raised rates at times when equities are richly valued, it has been problematic for investors.”

No matter the S&P 500 setting a record close earlier this month, as the Nasdaq Composite briefly rose above the 5,000 point threshold for the first time since the internet bubble, investors entered 2015 worried about high valuations and a mature-looking bull run.
Vadim Zlotnikov, chief market strategist at AllianceBernstein, says: “I’m always concerned about environments like this, as there are not a lot of opportunities for value.”

Among the clouds massing on the equity market horizon is the prospect of two straight quarters of negative earnings growth, led by energy companies being hammered by a sliding oil price, and dubbed by some as a “profits recession” during the first half of this year.

Mr Greenhaus says the forecast declines in earnings mainly reflect the energy sector. “We don’t think this is a good development per se, but we do not think it portends the start of a bear market.”

Michael Stanes, investment director at Heartwood Investment Management says: “At some point earnings do have to come through to support higher valuation multiples,” adding that ‘’valuations are moving back up to levels last seen in 2007”.

To some extent, Wall Street is looking beyond the slide in consensus earnings, due to lower energy prices and those for imported goods boosting the economy. Greater spending power for consumers is seen outweighing the looming hit for company bottom lines. Not surprisingly, analysts are forecasting a rebound for earnings growth during the second half.

But as the dollar continues ascending, global revenues for US multinationals face continued downward pressure, while Treasury yields have risen sharply of late, weighing down the performance of bond-like share market proxies such as utilities and real estate investment trusts.

Jack Ablin, chief investment officer at BMO Private Bank, says US valuations do not compare well with global equities and that buybacks have been a key source of strength for the domestic share market.

“Buybacks are keeping the market afloat and the buyback yield is higher than the dividend yield as the amount of shares outstanding declines,” says Mr Ablin.

Bull runs

With equities on the defensive, uppermost in the minds of some observers is how the current US bull run, at 72 months — and counting, ranks as the fourth longest winning streak since the 1930s, according to S&P Dow Jones Indices. In terms of performance, the S&P 500’s rise of more than 200 per cent since the nadir of the financial crisis in March 2009 pales beside that of the bull run of the 1990s, but is approaching the gain recorded during the 1980s.

Unlike those bull market runs, the current interest rate backdrop is much lower, in part reflecting muted expectations for inflation.

As such, modest tightening from the Fed this year is not seen pushing long-term interest rates substantially higher. A contained rise in 10-year Treasury yields from about 2.1 per cent is likely to sustain the appeal of owning equities even with the S&P trading at 17 times future earnings.

In turn, the current weakness in US equities may well represent another buying opportunity for a bull market that can run a lot further.

“With rates so low, stocks could grow more expensive before they finally reach peak valuations,” says Nicholas Colas, chief market strategist at ConvergEx.