By David Schane, USA – 29 Dec 2015.
Now that the Fed has notched short term interest rates higher for the first time in nearly ten years, almost all analysts and commentators are contemplating where interest rates are headed (i.e. the destination of current Federal Reserve policy). To dispel any misconceptions that the Fed has begun a regular and rigid series of gentle but sequential interest rate hikes (as former Fed chief Alan Greenspan initiated and executed under his watch in the early 2000’s), the Fed in its public communications has indicated it is going to remain “data dependent” and “gradualist” in its approach. Fair enough. The question I believe worthy of increased consideration though is what does the back end period of policy accommodation look like this time around – and how might it differ from previous interest rate cycles?
While we are in uncharted territory here (since we have been living under massive Fed and global central banking activism and experimentation since the “Great Recession” of 2008/2009 – where normal market price discovery mechanics have been superseded by central bank “puts”), I believe many market commentators are nonetheless guided by a traditional mentality regarding the path the Fed embarked on with its recent opening salvo – where the Fed’s first interest rate increase is perceived like a “hot stove” (that’s heating up even further and which should be avoided) or like “cock roaches” (which seldom, if ever, appear in singular isolation).
While I recognize exclaiming the statement “it’s different this time” should be made with great care and consideration, I believe investors and commentators are generally too historically reflexive in believing that the activist Fed is now retreating back to a more traditional posture (and assuming a more prudent, modest and “chaste” profile). Specifically, is a renewed “chastity” really likely or even possible after the bold period of Fed policy experimentation and activism we’ve been living through? Is the Fed suddenly a “hot stove” that investors should recoil from? Are interest rate hikes going to be as regular as the theory of cock roaches – where there is one there are many? Or rather, should we look towards other more nuanced frameworks (perhaps drug treatment therapy withdrawal mechanisms which necessitate recurrent interventionism) for guidance when we contemplate the back end of policy accommodation? If so, would it not be more appropriate to believe the Fed rate hiking cycle they’ve just embarked on is likely to be very shallow and gentle – and more of a “velvet glove” (as opposed to the “hot stove” or “cock roach” framework)?
While I’m not a psychologist, I don’t believe the supposed central banking “Maestros” (the name of a successful biography on Alan Greenspan by the acclaimed journalist Bob Woodward) have suddenly rediscovered modesty and chaste and are ready to yield the podium (and the long end of the yield curve) back to the humble musicians (the market participants who heretofore played the melodies and themes of price discovery and fundamental valuation analysis) with less interference and just a bit more “religioso” (i.e. smaller leverage). Apart from central bankers own belief in themselves as masterful conductors who can subjugate markets, I believe that from a variety of standpoints – particularly an ongoing suboptimal recovery in the US real economy, the weariness of renewed dollar appreciation, as well as potential global market stress (despite continued major accommodation by the ECB and other central banks) – Fed hiking flexibility will continue to be constrained.
Basically in my opinion, the Fed will find it very hard to wean markets off the unconventional “medicines” they have administered such that right now I feel the peak of the Fed’s hiking cycle will at most reach 2.00 to 2.50% on the Federal Funds rate. Personally, I would not even be surprised if the Fed barely reached 1.50% before abating its current set of hikes, especially as we’ve seen various central banks from Sweden to Israel and India (which represent a range of economies) recant on the interest rate hikes they initiated and revert to additional policy accommodation. As such, I believe the Fed will ever so gently reload its policy gun and reach a level of interest rates that would still be considered very accommodative – as they are stuck in their own “circularity” of responding to market angst and “tantrums” (as opposed to the “real economy”) that they themselves created.
Moving beyond economic fundamentals (and most specifically the Fed’s dual mandate on employment levels and inflation rates), can industrially mature (and demographically aging) G-7 type nations even afford to service their future IOU’s in an era of significantly higher debt ratios (and unfunded liabilities), post the Great Recession of 2008/09, should the long end of the yield curve (as measured by the US 10 year Treasury) even move back up to what historically would have been considered the extremely low rate of 4.00%? Can “carry trades”, spread trades and higher rates of leverage – as well as the mad dash for yield (that were implicitly blessed due to Fed largesse and zero interest rate policies) be suddenly jettisoned without causing market blowback as well as “real economy” manifestations/weakness?
While many market participants may not be opera fans, I personally am reminded of the story of Gounod’s “Faust” where the leading character “Faust” makes a Mephistophelian compact with the devil. While Faust drinks a potion to regain youth (and the earthly love of a woman), the opera ends in great tragedy.
While I’m not suggesting similar tragedy lies ahead for markets, I do believe the “great wind down” of central banking policy concoctions and “potions” is fraught with risk. While history may be able to inform us better on which of the unprecedented central banking actions during and in the wake of the Great Recession and banking crisis of 2008/09 were wise and effective, I personally believe central bankers are potentially fooling themselves if they believe themselves to be “Maestros” or “Houdinis” (especially as we know what ultimately happened to Houdini when he tried to defy physical nature one last time). So while I applaud central bankers for beginning the “great wind down”, so many policy distortions have been introduced into the market universe for so long (perhaps dating to Greenspan’s early rescue of LTCM in 1998), that it is difficult to see the Fed (or the current nascent Fed hiking cycle) as a “hot stove”.
While history has already seemed to re-evaluate whether Alan Greenspan was indeed a “Maestro” (even during his still ongoing lifetime), I leave it to readers, investors, and history to determine (as it surely will) whether the more “creative” policy actions and “QE” measures occurring well after the nadir of the Great Recession might ultimately be viewed a bit like “Black Magic” which ultimately overwhelmed those confidence artists (like Bernanke and Draghi) who summoned and willed these potions into creations, however benevolent their original intentions may have been.
In any case, I personally doubt the period of policy accommodation and experimentation is over. Indeed, I don’t believe the normal physical universe (of market pricing and discovery) can so quickly resume its prior and complete function – as it has been tampered with for so long and for so deep (and there are many trades still to be unwound). As mentioned, governments will find it difficult to service their much higher level debt levels and commitments (that they took on as a direct result of their policy actions during the Great Recession) if the long end of the interest rate curve reverts to traditional yields (uninfluenced by central bank outright purchases of this category/duration of debt) pre-2008.
This is why I personally believe interest rate sensitive sectors of the markets may well remain stronger than the consensus currently seems to believe (as long as inflation, particularly “wage push inflation” continues to remain constrained, which I believe it will – as I don’t see the US worker having leverage on wages, despite low rates of unemployment, in the foreseeable future).
In sum, I believe the back end period of policy accommodation is likely to be at least to some degree as unrehearsed and surprising as the front end of the central banking policy interventions we just witnessed, especially as the central banks have not been playing classical economic or symphonic music but rather have been improvising (like jazz musicians) in an unprecedented fashion over these last several years. Indeed, the “great wind down” is likely to test the central bank “Maestros” just as much, if not even more, than the past several years.
David Schane, Oberlin, Ohio, December 29th, 2015
From the editor: we thank Mr. David Schane for sharing with us his thoughts on the FED policies. Having traveled the world and lived in Europe as well, we believe Mr. Schane’s thoughts are vey valuable. They convey both a holistic view and a differentiated perspective. The opinions expressed here are his own and Mr. Takushi and the other contributors do not necessarily agree with the views of Mr.Schane. All contributors to our website express their own independent opinion based on their research. Thus, their articles are not edited by us, Geopolitical Economics.