Thomson Reuters
- Jerome Powell is set to replace Janet Yellen as Fed chair in February, pending Senate confirmation.
- He’s expected to follow Yellen’s game plan closely and look to normalize interest rates.
- This could invert the yield curve: quantitative tightening will put upward pressure on short-term rates, while lower inflation will put downward pressure on long-term Treasury yields.
- In short, the Fed is going to drive us into recession.
President Donald J. Trump nominated Jerome Powell to be chairman of the Federal Reserve Board. If confirmed, Governor Powell will replace Janet Yellen in February. Powell is smart, well-liked and respected by Republicans and Democrats alike.
Importantly, Powell’s confirmation as chairman of the Fed Board means there will be no change in monetary policy. He has never dissented against Chair Yellen on any interest rate policy decision. Yellen has raised rates four times since December 2015. Expect to get more of the same.
The same is a desire to get interest rates near 3%, or so-called “normalization.” Federal Reserve policymakers have raised their target for the benchmark federal funds rate by a quarter point, to a current range of 1 percent to 1 1/4 percent. Despite the increase, inflation, as measured by their preferred indicator (year-over-year change in the PCE Price Index), remains well below their targeted 2% inflation rate.
The trouble with inflation
The index is reported monthly with a one-month lag. The Fed’s conundrum is that while the labor market is strong, the other part of their “dual mandate,” inflation, is not responding as their models might suggest. Here is a look at the year-over-year change since December 2015 (data from the St. Louis Fed). Not so good on the inflation goal front.
RiskHedge
Tighten (raise rates) more? Currently, odds show a 90 percent probability of a December rate hike. The next PCE Price Index number comes out on November 30. Keep it on your radar.
Last week I wrote about the Fed. Specifically, “Don’t Fight the Tape or the Fed.” Despite four rate increases, the Fed model is neutral and the trend (or tape) component is bullish. So put that in your mildly bullish bucket.
However, the drum beat pounds on as the Fed looks to normalize rates. Expect more of the same game plan with Powell as chairman.
The Fed is wedded to the Phillips Curve. It believes that low unemployment will drive wages higher and inflation higher. Yellen recently said that low inflation is “a mystery.” We are not yet seeing the inflation they believe we should be seeing. Mystery indeed but stay alert. Yet they are determined to get to 3% and that will likely bring risk back into the global markets. The following is from Ambrose Evans-Prichard:
The message from a string of BIS [Bank of International Settlements] reports is that the US dollar is both the barometer and agent of global risk appetite and credit leverage. Episodes of dollar weakness – such as this year – flush the world with liquidity and nourish asset booms. When the dollar strengthens, it becomes a headwind for stock markets and credit.
More of the same?
Nothing changes under Chairman Powell. I shared the above quote along with this next from Evans-Pritchard in late September. “The long-awaited reversal of quantitative easing will kick off in October. Deutsche Bank calls it the start of the ‘Great Central Bank Unwind,’ candidate ‘Number One’ for the world’s next financial crisis. …The puzzle is why the Yellen Fed – usually so cautious – has chosen to enter these treacherous waters when there is no strict need to do so and before it has raised interest rates to minimum safe levels. This tightening sequence makes no sense.” (Source: Yellen Fed courts fate by reversing QE so soon.)
Makes no sense? The Fed is in a challenging spot. I wrote about inflation a few weeks ago and noted there are signs of inflation appearing and that a new inflation indicator from the New York Fed called the Underlying Inflation Gauge (UIG) suggests that inflation pressures may be on the rise. Specifically, the price-only component called UIG has been edging higher since April 2015 and rose 2.3% year-over-year in September, the most since April 2012. The bigger UIG has been increasing since February 2016. It is up to 2.8% year-over-year through September and marks the fastest pace since 2006.
I personally feel the PCE Price Index and Core CPI understates the inflation you and I are actually experiencing, but they are the Fed’s go-to gauges. Notable is that PCE tends to lag and follow UIG. If that’s the case, the Fed will continue to raise rates. On the one hand, we have the data in the chart above; on the other hand, we have inflation rumblings in UIG. But where do you place your bets? What will happen over what kind of time frame?
Fundamentally, I find myself in Dr. Lacy Hunt’s camp. As he said in his recent quarterly client letter, “These existing circumstances indicate that a Fed policy of QT (quantitative tightening) and an indicated December hike in the federal funds rate will put upward pressure on the short-term interest rates. At the same time, lower inflation (SB here – Lacy argues we will ultimately see lower inflation) and the resultant decline in inflationary expectations will place downward pressure on long Treasury bond yields, thus causing the yield to curve to flatten. Continuation of QT deep into 2018 would probably cause the yield curve to invert.” You can find his quarterly client letter here.
Steve, translation into English please: Once again, the Fed is going to drive us into recession. This is the worst recovery of all recoveries since WWII and it required the greatest injection of unprecedented global central bank liquidity and even asset purchases. And with all of this, our initial starting conditions are not great. Sub-par growth, record high debt, aging demographics and a coming-down-the-tracks-at-us-quickly pension crisis. Because of this, Lacy is saying the Fed is making a mistake. Raising rates will drive us quickly into the next recession. I think they will raise rates another 25 basis points in December.
My friend, John Mauldin, shared the following during a panel discussion a few weeks ago. I love his honest way. He said, “You know, this market has me so confused. Honestly, I think that trying to make predictions about market leadership in a market that just keeps relentlessly wanting to go up. I think where the leadership is actually coming from is the move into passive investments. I mean they’re buying these big across-the-board indexes. And not only that, the Bank of Switzerland now owns something like 4% or more of the S&P 500 and the Bank of Japan is buying the S&P 500. They’re buying products that track the indexes, they’re not stock picking, they’re just saying, ‘We want the whole thing.’ If there’s any leadership out there, it’s coming from the move to passive investing.” Amen, brother John.
Herding like it’s 1999
We humans tend to herd and boy are investors herding. Much like investors did in 1999. Then it was the tech stock craze. More buyers than sellers and prices goes up. More buyers into the same few stocks and prices really go up. Until they don’t. Minus 75% and 15 years to get back to breakeven was the cost of that error. Were value plays the better pick then? Yes. Were utility stocks a better pick then? Yes. Were bonds a better pick? Yes. Was portfolio diversification a better plan? Yes. But everyone wanted that shiny red Ferrari.
So when your moderate growth client calls in wanting to buy a Ferrari, point him or her to the risk questionnaire and investment policy statement you carefully crafted with them. And if goals and risk objectives have changed, then ok… consider the Ferrari. But one can’t expect a minivan to drive like a Ferrari or a Ferrari to provide you with the benefits of a minivan. Two different things.
As Dalio said, “You should be building a diversified portfolio with assets that are balanced according to their risk rather than their dollar amounts.” Tech was the 1999 Ferrari. Passive S&P 500 Index exposure is today’s Ferrari. Well, actually FAANGs are today’s faster Ferrari but you get the point.
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