Fed looks at the long run, won't wait for hike until inflation actually hits 2%

Outlook:

The big data today is the first revision of US Q4 GDP. The initial is 2.6% and many expect a downward revision. But never mind. San Francisco Fed Williams told the WSJ that the economy is going very well indeed and on track to meet the criteria for a hike to be considered starting at the June 16-17 policy meeting. “I don’t see any reason at all that we should raise rates before June. That’s out. Maybe in June it would be the time to contemplate raising rates. Maybe we’ll want to wait longer, but at least it will be an option to decide on.” The Fed does not have to wait until inflation actually hits 2%. The Fed looks at the long run and inflation will hit 2% by end-2016.
Williams doesn’t like the disconnect between Fed ideas and market expectations. Better communications are needed. Golly, what is it about California air that makes the San Francisco Fed president a straight-talker? Ms. Yellen should make a trip home.

Wall Street in Advance guru Lynn found someone (and not just anyone) who agrees with us that the Street is getting the Fed wrong. Evercore ISI’s De Busschere thinks the street has misheard Yellen, and that could mean rate hikes sooner than later. He says “Krishna Guha, ISI's head of policy, has made the point that Yellen was misunderstood in her testimony and her tone was sneaky hawkish on Tuesday despite the markets dovish take. Krishna noted specifically that ‘the time-frame for returning inflation to target is the medium term (typically a three year forecast horizon) and the test is reasonable confidence in that forecast. This is not a particularly dovish formulation.’ If correct, the stronger than expected inflation data today could be an even bigger deal from a market point of view going forward.”

The reaction to yesterday’s stories on negative yields was much delayed. As noted above, we had negative yields in Swiss paper up to 10 years in January. In early Feb, the WSJ reported that JP Morgan estimated as much as €1.5 trillion of euro area debt maturing in more than a year was paying a negative yield. “That compares to none whatsoever a year ago.”

What do negative bond yields mean? The Number One reason is to get a return of capital and to hell with return on capital. Sovereigns are considered bullet-proof, at least the high-rated sovereigns. You will get your capital back. This may not be the case if you have a lot of money to spread around government-insured banks—for big insurance funds and hedge funds, there are not enough banks.

That’s the extreme-fear case. In practice, you can still make a profit on a negative yield bond if you don’t hold it to maturity and if yields go even more negative. Besides, that’s a capital gain for tax purposes.

Steven Saville at the Intelligent Investor, in an article at seekingalpha.com in January, has a wonderful additional possibility: “That is, in addition to the willingness to accept a small loss for a guarantee that almost all of the money will be returned, the “greater fool theory” could be at work in the government bond market. In this regard, a government bond having a negative YTM is not that different from an internet stock with no revenue being assigned a multihundred-million-dollar valuation based on ‘eyeballs.’ It’s just another in a long line of examples of the madness of crowds, a madness that is often rooted in central bank policy.” We say this is funny but probably not the case. More likely is that institutional managers can’t hold cash of more than x%. They have to place their money somewhere, and generally they are required to have y% in bonds and z% in equities.

The more pressing questions pertain to ordinary supply and demand factors. During the Greenspan era, before he became Fed chairman, Bernanke spoke of a saving glut, chiefly from Asia and primarily from China. This was part of the Greenspan conundrum—why was the dollar rising as yields were falling? Indifference to return was a puzzle. Okay, so an oversupply of something reduces the price. But where is demand for capital? We might infer that demand for capital is missing in action, or the price would be higher. But these are sovereign debt instruments, not the kind issued by corporations to build new factories or a research lab. What does government capital represent? It would be nice to say “infrastructure investment,” since that would have the same stimulative effect as private capital formation, but alas, it’s not the case. In practice, government money goes more to social spending (and in the US, defense) than anything else. So it’s a borrowers’ market and we have a shortage of borrowers.

It says something that Coca Cola just sold €8.5 billion in euro-denominated bonds of varying maturities, the biggest US company euro-issue ever. The WSJ says US companies are lining up to get cheap money, already double the issuance so far this year compared to last year—and investors are lining up to get their hands on it. Coke’s 8-year is going at 0.75%. Well, it’s not railroads, but it’s not Facebook, either. So, it’s not dumb or bad perspective to fear negative yields. They imply a giant global slowdown—recession. Recession brings deflation, which feeds a feedback loop to more recession, with accompanying unemployment, lower tax revenues, etc. Not surprisingly, rising uncertainty about recession/deflation is good for gold, of all things. The gold bug inflation obsession is not a thing of the past—just wait for oil to return to $145—but inflation is not the only reason to like gold. Scarcity suffices, as long as one can observe rising demand by other Nervous Nellies or the newly wealthy with few choices, like the Indians and Chinese.

A final point to end the week: Krugman has an op-ed piece in the NYT today celebrating Greece’s victory over the anti-Keynesians in the EC, saying Greece got a major concession in the form of the primary surplus. The old deal was a tripling of the primary surplus, which is stupid in a major recession. We don’t know what the new primary surplus will be, and certainly Greece is on a short leash, but it was not a Greek failure.

An important factor to keep in mind is that the EC lets France get away with budget murder and did it again on Wednesday. The EC is giving France until 2017 to hit the 3% target—without the €4 billion fine. This is the third time the EC is giving France a fresh deadline. Italy and Belgium also avoided a fine, but France is the serial offender. It pretends to promise reforms and Brussels pretends to believe it. The 2013 extension called for a cut of 0.8% of GDP in the structural deficit in 2014 and 2015. Well, it was 0.1% in 2014 and while France wanted 0.3% for this year, it backed down and accepted 0.5%. New reforms are to be proposed next week. Yeah, sure, and I have a bridge to sell.

Separately, the NYT reports “Italy's and Belgium's public debt has been rising every year since 2008. For Rome it is expected to peak at 133 percent of GDP this year and for Brussels at 106.8 percent. EU rules say governments must reduce their debt every year by one twentieth of the difference between 60 percent and the current level.” This is just not happening.

This kind of nonsense is all too visible and relevant in Athens. It’s also what we suggested last week—pretend to accept the budget rules and then violate them at will—like France. The problem is that France is big and a founding member of EMU, while Greece is small and has too long a history of lying about its finances. Still, the principle is sound, and the end-point is that Greece is avoiding imposing more counter-productive austerity. That makes the negotiating game a win for Athens.

Bottom line—we expect the dollar rally to resume, led by the yield differential and good US data, but as always, we are suspicious of dollar rallies. They tend to be short, nasty and brutish. Bad GDP today (under 2%) could derail the whole move.