How will the Fed interpret recent events?

Outlook:

Last week we got an equity market bear-rout on the dovish ECB, rising oil, and si-lence out of China. We still have two of those three factors. The implication is that until oil or China gets noisy, renewed oil prices declines might, possibly, get taken in stride. After all, fall-ing oil prices are a Good Thing for most parties, including consumers. We paid $400 less for heating oil this January and a good $700 less for snow-plowing than last year. Like other consumers, we will not be running out to buy a Mercedes with the windfall, but stress is definitely reduced. It remains to be seen how households use their small amounts of extra money.

More importantly, it remains to be seen how the Fed interprets recent events, including the “tax cut” to consumers, when it meets Tuesday and Wednesday this week. Everyone will pay heed to the messages in the 2 pm Fed statement on Wednesday. The probability is high that the Fed will duck answering the question of whether it still sees four hikes this year. You’d duck it, too.

Another key question is whether the Fed mentions global market turmoil as a factor in its decision-making. Last year the Fed used market turmoil as an excuse to defer the First Rate Hike, which we saw as a huge mistake. We also think the Fed belatedly saw it as a huge mistake, too, reducing the likelihood the Fed will do it again. But it might, and the mere mention of global market turmoil might bring the pundits out in force to say March is off the table and the Fed will defer any additional action to June. This may not be true—perhaps the Fed thinks turmoil will be long-gone by March—but that’s how it will likely be interpreted.

While we don’t get a revision to the data or the dots at the Jan meeting, the Statement surely must men-tion inflation. It’s hard to see how Yellen can say anything too divergent from what Draghi said, since the facts are the facts. Draghi said inflation risks are lower, and they are.

Whether additional deferral of another hike is good or bad depends on how you view the first rate hike, with many saying the Fed overestimated the robustness of the recovery (as usual) and was hiking just when the fragile recovery could absorb it the least well. In other words, the Fed waited too long, or the abnormally tepid recovery may never allow a return to the 3.5% average rate of past dec-ades—it’s a new world.

We are not going to get answers from this week’s data. After the Fed, on Thursday, is when the juicy data comes out—durables, pending home sales after a snow-less December, and the Q4 GDP first esti-mate. We also get a ton of earnings releases this week and a heavy Treasury issuance calendar.

We continue to say that normalization has its own rewards, many of them not yet known. One of the key problems is that we have been so in thrall to central banks as the central player that both traders and in-vestors don’t know how to manage their portfolios in an environment of uncertainty, let alone a rising rate environment. Everyone wants and expects low rates forever. The astute Market News fixed income analysts writes “It is beginning to look like the financial markets are going to be unhappy unless the cen-tral bankers of the world can provide EASE-4-EVER.”

China will not be silent and stable forever. The probability is pretty high that the debt crisis will stick its head up and scare everybody. While we don’t know the extent of bad loans, we do know it’s a huge number.

And this is always and forever the nub of financial crises—expansion of money supply by vast amounts, in part by excess lending to bad borrowers, that comes back to bite the lending institutions on the rear end. Economic historians have written about it for literally decades. The best of the books is George Cooper, The Origin of Financial Crises (Harriman House, 2008). Cooper makes the brilliant and oft-forgotten point that excess money supply growth and unwise lending is the origin of financial crises, to which our central banks respond with more money supply growth and encouragement of lending. It would be funny if it were not so sad. Of course, in the US, the banks didn’t expand lending on QE. They sat on reserves. We may blame the tepid recovery on that, and rejoice instead of complaining.

So, enjoy the rosebuds while we may. Something awful is probably just around the corner. And the di-vergent monetary policy thesis is still a good one, even if the Fed chickens out.

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