The Fed should not have raised rates

Outlook:

We were not the only person appalled by the press reports on negative yields. Not only Europe, but now Japan! There is simply no way for negative yields to build anything. It takes a return on capital to get capital working. Negative yields are always and everywhere a Bad Thing. Underling the dollar’s crash yesterday is the sneaking suspicion the Fed has it all wrong and the US will get negative rates, too. The Fed should not have raised rates in December. It was either too late or too early, but whichever, wrong. The economy is not resilient, let alone robust, and the Fed is over-optimistic about everything.

Given this gloomy stance by a large group, NY Fed Pres Dudley was the trigger. The Dudley comments were emailed far and wide and made the front page of the FT today. Remember, Dudley is the guy who was worried about liquidity once rates began to go up, and devised a special repo facility to grease the skids. Yesterday he said in an interview with Market News that global turmoil may be a roadblock that inspires a further surge in the dollar, and if it continues, would have “significant consequences back to the US.”

He also said “One thing I think we can say with more confidence is that financial conditions are considerably tighter than they were at the time of the December meeting. So if those financial conditions were to remain in place by the time we get to the March meeting we would have to take that into consideration in terms of that monetary policy decision.”

Two things: we have a Fed talking about the dollar, and not just any Fed—the head of the New York Fed. As we know from long experience—and Dudley should know, too—any mention of the dollar by a Fed official is always toxic. Secondly, how can anything be much changed in a little over two months? The one big thing that has occurred since the Fed hike is the China equity market meltdown the first week of January. Again, this gives the impression that when China sneezes, the US catches cold.

The FT goes on to say the primary deduction from the Dudley comments is no more rate hikes this year. Fed funds futures “indicate that there is now about a 60 per cent chance that the Fed stays its hand for the rest of 2016, and only a 7 per cent chance that the US central bank tightens policy just twice this year, according to Bloomberg data.”

Oh, please. Talk about an overreaction! The FT itself provides a short rebuttal. The same day as Dudley spoke, “This year would mark the seventh consecutive year of expansion in the US economy, a trend that would continue through at least 2017, according to forecasts from Economic Advisory Committee of the American Bankers Association on Wednesday.

“Nevertheless, the outside risks of a recession are growing, forecasters have warned. There was a one-in-five chance of recession in the next 12 months, according to a survey of 51 economists by the Financial Times conducted in the days after the Fed’s January meeting. In the FT’s December survey, economists had put the odds of a US recession at 15 per cent during the next two years.”

Economists are just like traders—they operate on a herd mentality. If one or two big forecasters (like Goldman) comes up with a scary story, many of the others will jump on board so as not to look out of touch. But let’s be reasonable. The world got over the China events in August. The Fed deferred the Sept rate hike because of China and its aftermath, but felt conditions had calmed down enough to justify a hike in December. If the same pattern were to hold, the March hike is off the table but not the June.

See the daily chart below. If you like the Fibonacci take on things, the euro has surpassed the 50% retracement level and is headed for the 62% level at about 1.1258. Getting all the way back to the last intermediate high, 1.1562 from Aug 24, will take some doing. In fact, it’s unlikely, not if Mr. Draghi is on his game. Not getting press attention it deserves, today Draghi said at the BBK that it’s dangerous to be relaxed about low inflation that makes the economy vulnerable to supply shocks.”

Draghi said "Adopting a wait-and-see attitude and extending the policy horizon brings with it risks: namely a lasting de-anchoring of expectations leading to persistently weaker inflation. And if that were to happen, we would need a much more accommodative monetary policy to reverse it. Seen from that perspective, the risks of acting too late outweigh the risks of acting too early.

“There are forces in the global economy today that are conspiring to hold inflation down. Those forces might cause inflation to return more slowly to our objective. But there is no reason why they should lead to a permanently lower inflation rate. What matters is that central banks act within their mandates to fulfill their mandates. In the euro area, that might create different challenges than it does in other jurisdictions. But those challenges can be mitigated. They do not justify inaction."

Of course, Draghi was speaking to the BBK, which famously dislikes QE. But many see his comments as justification for additional measures in March.

Bloomberg, in its main dollar-crash story, found two analysts to complain about the ever-lower forecast. A Credit Agricole analyst said “Investors are betting that lingering risk-off will stay Fed’s hand when it comes to further tightening… [but] It would take disappointing U.S. data today and Friday to see the dollar coming under sustained selling pressure.”

The RBS Singapore analyst comes the closest to our view: “The dollar’s weakness looks like a correction in its multi-year bull trend given the Fed is still more likely than other major central banks to tighten rather than ease monetary policy this year. We remain, though, cautious about greenback strength against the yen.”

Right on. The yen is a real problem, not least for Japanese government plans and hopes. We see no reason for dollar/yen not to fall to at least the last low just under 116, if not more, as managers repatriate funds, negative yields notwithstanding. It’s the Chicken Little sky-is-falling mentality and we have seen it many times before.

Economically, it’s not helpful. Japan can use a weak yen in the face of other Asian countries vying with China for exports and China itself, Japan’s biggest export market, slowing down. A strong yen is the last thing the BoJ wants. But let’s remember that the yen marches to its own drummer. We often get the dollar up against everything except the yen, or down against everything except the yen. The dollar/yen does NOT lead the overall “dollar.”

Moreover, the yen does not track trade balances, and usually not the capital flows, either. We spend years following the monthly MoF capital report data—how much buying or selling of equities and bonds by foreigners, for example, and hardly ever did it give us any insight on the yen. Then along came the overriding explanation of the carry trade, but that doesn’t always work, either. In today’s world, the carry trade story would have the yen on the ropes, not rising.

Our final word: breakouts must always be respected. But never bet the ranch on them. They fail, a lot.
Buy this time, the fixed income gang is having the equivalent of the taper tantrum. It could take months for them to get over it, not to mention a great deal of good data. And payrolls is tomorrow, not likely the reversal trigger we want but you never know.