Keep the faith

Outlook:

Today we get manufacturing ISM and construction spending, with vehicle sales, the ADP forecast of payrolls, the factory orders, and the Beige Book, ending with payrolls on Friday. For what it’s worth, Market News has a median estimate for payrolls of 200,000 from a range of 170,000 to 230,000. Unemployment should stay at 5% and earnings up 0.2%. We cannot expect another blockbuster month like October (271,000 and earnings up 2.5%). As always, the issue is the divergence between expectations and the actual. It’s possible a tiny number (under 100,000) could derail the Fed, but not likely.

As for Fed thinking, Yellen speaks to Economics Club of Washington tomorrow and to the Joint Economic Committee on Thursday. Alas, we expect nothing new. In fact, we expect more of the same lack of clarity about precisely what the Fed is looking at and precisely what is the Fed’s view of the economy. Is it recovering robustly or are we barely keeping our head above secular stagnation?

The FT has an interesting article about currency wars, although it doesn’t name it that, based in part of a note from Unicredit economist Nielsen. Nielson says current central bank policies are not modern in the least and look more like the policies of 40 years ago. Specifically, central bank divergence means the absence of the coordination we used to have. “The Fed and ECB have abandoned the free-floating policy regimes they ostensibly are practicing in favor of a ‘managed floating’ regime in which they keep their currencies within set levels. But this isn’t an explicit policy goal, and the resulting confusion is creating more problems than it is solving. ‘In terms of exchange-rate policies, we are back at managed floating, but still in limbo because it remains unannounced and uncoordinated.’”

Using the exchange rate as an agent of stimulus “raised the whole specter of currency wars, which has been painful for emerging-market nations like Brazil, where the currency was pushed higher as other currencies went lower. This has retarded, rather than stimulated, growth… “Many of the world’s central banks, with the noticeable exception of the PBoC, have changed their attitude towards FX, sending us back to the pre-free-floating era. Yet, so long as they haven’t defined the new regime, and do not coordinate their policies, we are in limbo with additional volatility, speculation and uncertainty, which is not good. Indeed, an FX regime, which facilitates excessive volatility, is detrimental to growth.”

“The major central banks – the Federal Reserve, the European Central Bank, the Bank of England – all seem to be expressly working to drive down their currencies, he points out. The ECB until October appeared to be targeting 1.10-1.15 on the euro, Mr. Nielsen said, then got nervous and started targeting ‘in all but words’ 1.05-1.10. ‘Check their October statement and following statements, and you can only be left with an impression of attempted micro-management of the euro during the last two months.’” The currency war point of view has been around for a long time. We have all seen Australia and Canada explicitly manage their currencies down. Europe has done it a few times (starting with “brutal” euro move decried by Trichet in Nov 2004). We have tended to take the Fed at its word—the level of the dollar is a consideration, but not the primary or even secondary consideration. The addition of Mr. Fischer to the Fed has raised the consideration, but still not to a top policy point. To say that the rising dollar harms exports is a statement of fact, not a feint in a currency war. We are still quite reluctant to attribute currency war attitudes to the Fed, although far less so to the ECB.

But Nielson makes an important point—the lack of clarity by central banks on this and other matters is making markets feel confused and lacking the usual anchors. One point we disagree with—that central banks in some golden age coordinated with one another. Those of us who lived through the Plaza and Louvre Accords recall that they worked very badly indeed. In what is now an old book (Changing Fortunes, 1992), former Fed chief Volcker described the reasoning, the negotiations and the outcomes blow-by-blow. He says, more than once, the only central bank to “coordinate” was the Bank of Japan. Having said that, we feel confident that Janet and Mario talk on the telephone quite often, with Carney and others no doubt conference-called in. We never learn about these behind-the-scenes efforts at coordination. They must have discussed the divergent-policy problem and in detail, and we would be amazed if a solid plan for intervention is not fully prepared.

The real problem is not that the central banks don’t see that divergent policies are going to wreak havoc. That’s obvious. But they are unwilling to admit they don’t know what kind of havoc, how big it gets, where it spreads to (contagion), and how much it will cost in the end. Central bank reputations are on the line, with the Fed more at risk than the ECB. No central bank has ever emerged from QE and normalized. It’s literally a first. The only Fed to speak of being scared and needing to have emergency measures ready is the NY Fed’s Dudley.

But while we can feel sympathy for the Fed, we can also still wish they would speak a little more plain-ly. Yellen was the best regional Fed president in her day—always plain-speaking and often saying things nobody else had the guts to say. Her very reticence now speaks volumes about how dangerous conditions are now and how much worse they can get. Failures and collapses are not a silly idea. Maybe we won’t get the kinds of failures and collapses we have had in the past—Long-Term Capital, Asian debt crisis, Bear Stearns and Lehman. The Fed has to be ready for a different kind of crisis. Maybe it will be Brazil this time (we would not be surprised).

This is just one reason—belief that the Fed has taken all this time partly in order to get prepared for a tsunami—to think the divergent policy is not fully priced in. A little pullback here and there is only to be expected—the big move will come when the divergent policy becomes real. So far we have the US 2-year hitting a 5-0year high yesterday at 0.95% while the German Schatz is at -0.41%. How wide can this most-sensitive spread become and who will break ranks to dump European paper by the boatload? We can tell FX traders are scared from the size of the high-range range—contracting down to abnormally small. A breakout always follows. It’s silly to think the breakout will be to the upside, unless we think Mr. Draghi will disappoint. But Draghi has yet to do that. Keep the faith.