Fed “Policy Mistakes”
– a View from Across the Pond
I have talked at length in recent
months about the well-proven limitations of Federal Reserve modeling of the
economy. (See for instance “Data-Dependent ... on Imaginary Data.”) And come to think
of it, I’ve been on their case for years. The Fed’s predictive capacities are
demonstrably abysmal. In today’s Outside
the Box, Ambrose Evans-Pritchard, the intrepid international
business editor of the Daily Telegraph of London, joins the fray.
Ambrose’s criticism of the Fed’s
current posture on policy rates and the drawing down of the Fed’s balance sheet
center on three areas of concern:
- The forward curve for the
one-month Overnight Index Swap rate (OIS), which is a market proxy
for the Fed policy rate, has flattened and inverted two years
ahead. Ambrose notes that Fed officials like to rely on a different
signal: the point where the 10-year US Treasury yield drops below the
two-year yield. Problem is, this tends to happen several months after the
OIS rate curve has already inverted. By then it’s often too late.
- The Fed’s tightening is putting
the squeeze on the money supply.
- On the global front US rate
rises are in effect being magnified, through the mechanism of LIBOR (the
London Interbank Offered Rate). Three-month LIBOR – used to set the
cost of borrowing on $9 trillion of US and global loans, and $200 trillion
of derivatives – has surged 60 basis points since January, and the
LIBOR-OIS spread (or LOIS) has widened. The last time that happened – to
disastrous effect – was 2007.
To add to what Ambrose is saying,
it is just not the last 90 days that LIBOR has surged. It was only a few years
ago that LIBOR was under 0.25%. Today it is 2.3%. That is a 2% jump since the
Fed’s tightening cycle began. That increase has raised rates on an enormous
number of adjustable-rate mortgages and all manner of loans pegged to LIBOR.
Note the graph below:
Source: St. Louis Fed
Ambrose concludes by placing these
developments in the context of evidence that US, European, and Chinese growth
may all be slowing. Yet, he wryly observes,
There is no sign
yet that the Fed is having second thoughts about the wisdom of charging ahead
with sabers drawn. The new chairman, Jay Powell, was strikingly
hawkish in a recent speech, making it clear that he has no intention of bailing
out Wall Street if equities tumble or credit spreads widen. He dismissed
short-term shifts in the economy as meaningless noise.
Poor Chairman Powell. Janet Yellen
rides off into the sunset and leaves him with a true upside-down mess. Fed
rates are 1.625% and inflation is at 2.1%. Essentially we have 50 basis points
of negative real interest rates. Jay knows he has to continue to tighten under
these circumstances. But he also knows exactly what he’s risking. As the saying
goes, he’s in between the devil and the deep blue sea. The heavily
Democratically biased Yellen Fed simply did not step up and do their job when
the economy was doing well, out of fear of going too far. The moment Trump was
elected they got religion about rates – at least three years too late. And
Powell get stuck with the Old Maid. (For non-US readers, Old Maid is a
children’s card game with one card, the Old Maid, that you don’t want to have
in your hand at the end of the game, so you try to pass it off to your fellow
players. If you get stuck with the Old Maid, you lose. I think Powell could
lose.)
This is important stuff. We’re
marching straight into the jaws of what, in last week’s Thoughts
from the Frontline,
I called the Great Reset. It’s one thing to boldly charge ahead on the policy
front but quite another to head off the next global recession, born of chronic
monetary and fiscal malfeasance.
By the way, as I was reviewing my
information sources the other day, something interesting occurred to me: Some
of the best US economic analysis comes from outside the US. In theory, we
should have a better grip on our own central bank and government, right? But in
fact, my friends in Canada, Europe, Asia and elsewhere deliver consistently
cogent thoughts as well. I haven’t done a formal tally, but I suspect I rely on
them at least as much as I do on US sources.
Why is that? Maybe it’s because distance
gives you a different perspective. Non-Americans aren’t burdened with our
cultural assumptions and can look just at the facts. They see things we
Americans miss because to us they’re just part of the landscape.
This underscores the importance of
having both many
information sources and the right
sources. And you still have to prioritize, because none of us can read
everything that competes for our views. I’ve figured out ways to deal with
these issues, and I’ll be sharing them with you. Details soon.
I find myself in Charlotte, North
Carolina, where I’m speaking for the S&P Forum. Semi-randomly, good friend
Rory Riggs is in town, and we will have lunch in a few minutes. You’re going to
hear that name a lot from me over the next few years. He is getting ready to
set the investment industry on its ear. Stay tuned…
Your worried about monetary policy
mistakes analyst,
John Mauldin, Editor
Outside the Box
JP Morgan fears Fed “policy mistake” as
US yield curve inverts
By Ambrose Evans-Pritchard,
The Telegraph
The US credit markets are flashing
a rare warning of economic trouble ahead, signalling that
the Federal Reserve risks blundering into another recession without a deft
change of course.
A blizzard of surprisingly poor
data across the world suggests that the Fed’s liquidity squeeze is taking
a greater toll than widely assumed, and that the institution’s staff model has
so far failed to pick up the danger signs.
US jobs growth fizzled to stall-speed levels of 103,000 in March. The
worldwide PMI gauge of manufacturing and services has dropped to a 14-month
low. The average “Nowcast” tracker of global growth has slid suddenly to a
quarterly rate of 3.2pc from 4.1pc as recently as early February.
Analysts at JP Morgan say the
forward curve for the one-month Overnight Index Swap rate (OIS) – a market
proxy for the Fed policy rate – has flattened and “inverted” two
years ahead. This is a collective bet by big institutional investors and fund
managers that interest rates may be falling by then.
It is a market verdict that Fed officials have lost touch with reality in thinking that
they can safely raise rates another seven times to 3.5pc by late 2019, as
implied by the “dot plot” forecast. It is tantamount to a recession
warning.
“An inversion at the front end of
the US curve is a significant market development, not least because it occurs
rather rarely. It is generally perceived as a bad omen for risky markets,” said
Nikolaos Panigirtzoglou, JP Morgan’s market strategist.
“Markets have started pricing in a
Fed policy mistake or have started pricing in end-of-cycle dynamics,” he said.
Both possibilities are disturbing.
The OIS yield curve has inverted
three times over the last two decades. In 1998 it proved to be a false alarm
because the Greenspan Fed did a pirouette and flooded the system with
liquidity. In 2000 it was a clear precursor of recession. In 2005 it signaled
that the US housing boom was already starting to deflate.
Fed officials tend to watch a
different signal – the moment when the 10-year US Treasury yield drops
below the two-year yield – deeming this the best single predictor of
recessions in a study last month by the San Francisco Fed.
This has not yet been triggered.
The problem is that this tends to happen several months after the OIS rate
curve has already inverted. By then it is often too late. Trouble is already
baked into the pie.
“We think that the current
expansion will begin to fizzle out before long. US equities are likely to
suffer once the US economy stalls, and a weaker US stock market would almost
certainly be contagious, especially if growth in the rest of the world also
faltered,” said Finn McLaughlin from Capital Economics.
The Fed’s monetary tightening is
now biting hard. Growth of the “broad” M3 money supply in the US has
slowed to a 2pc rate over the last three months (annualised) as the Fed shrinks
its $4.4 trillion (£3.1 trillion) balance sheet, close to stall speed and
pointing to a “growth recession” by early 2019. Narrow real M1 money has
actually contracted slightly since November.
This suggests that the reversal of quantitative easing may matter more than
generally appreciated. The Fed’s bond sales have been running at a pace of
$20bn a month. This rises to $30bn this month, reaching $50bn by the
fourth quarter. RBC Capital Markets says this will drain M3 money by roughly
$300bn a year, ceteris paribus.
What worries monetarists is that
the Fed intends to step up the pace of quantitative tightening (QT) regardless
of the monetary slowdown. The institution adheres closely to a New Keynesian
“creditist” model and pays little attention to monetary aggregates. This
proved a costly mistake in 2008.
US rate rises are having a parallel
effect, but through a different mechanism. Three-month Libor rates
– used to set the cost of borrowing on $9 trillion of US and global loans,
and $200 trillion of derivatives – have surged 60 basis points since
January.
There is no sign yet that the Fed
is having second thoughts about the wisdom of charging ahead with sabers
drawn. The new chairman, Jay Powell, was strikingly hawkish in a recent
speech, making it clear that he has no intention of bailing out Wall Street if
equities tumble or credit spreads widen. He dismissed short-term shifts in the
economy as meaningless noise.
The Fed view is that Donald Trump’s
unwarranted fiscal stimulus – lifting the budget deficit to 5pc of GDP at
the top of the cycle – is inflationary and increases the risk of
over-heating.
The signs of a slowdown are even
clearer in Europe where the low-hanging fruit of post-depression recovery has
largely been picked and the boom is fizzling out, exposing the underlying
fragilities of a banking system with €1 trillion of lingering bad debts.
Citigroup’s economic surprise index
for the region has seen the worst four-month deterioration since 2008. A
reduction in the pace of QE from $80bn to $30bn a month has removed a key prop.
The European Central Bank’s bond purchase programme expires altogether in September.
What is surprising is that Germany
is slowing hard despite a seriously undervalued currency (for Germany, not for
France or Italy). Industrial output has contracted over the last three months
and exports suffered the steepest dive for three years in February.
Germany is highly leveraged to the
Chinese industrial cycle so this may be a sign that Chinese growth has slowed
more than the authorities admit – as indicated by plummeting yields on
Chinese bonds, and rates on three-month Shibor and certificates of deposit.
The world economy was coming off
the boil even before President Trump launched an escalating trade war against
China. The global money supply has been slowing since last September. The
Baltic Dry Index measuring freight rates for dry goods peaked in mid-December
and has since dropped 45pc.
The Fed, the ECB, and the global
authorities insist that this is a temporary “air pocket”, and that synchronized
world growth is alive and well. The bond markets do not entirely believe them.
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