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VTB Capital: The Federal Open Market Committee Is Boxed-in

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According to VTB Capital:

https://is.gd/ibCddR

The Federal Open Market Committee (FOMC) Is Boxed-in

The Federal Open Market Committee (FOMC) decided to leave monetary policy on hold at the conclusion of its two-day meeting yesterday. Although the fed futures market had only given a 28% probability to a 25bp hike in the target range for the fed funds rate, there was still nervous anticipation over the FOMC’s intentions. In an ‘ideal world’, the FOMC would telegraph its intentions well in advance, make it crystal clear why it was raising interest rates so that when the actual announcement came, markets would react calmly.

That’s the theory. In practice, the FOMC had not communicated its intentions well and, as a result, there was a lot of speculation over whether they would raise rates by 25bp, 12.5bp and economists talking about a ‘hawkish hold’ or ‘dovish hold’ or would the FOMC raise rates just once (‘one and done’) and wrap it all up in a very dovish message that future rate hikes would be very gradual. As a result, investors faced a dizzying set of permutations and combinations with economists almost tying themselves up in knots over a relatively tiny move in the fed funds rate when in the real world, commercial borrowers and households face much higher and quite variable rates of interest.

Our view was that whatever the FOMC decided to do, the ultra-cautious nature of Janet Yellen and most of her colleagues was bound to result in a dovish outcome for financial markets. Markets have become highly dependent on every utterance from Fed officials for the simple reason that the markets have been pumped up by super-accommodative policies which have resulted in excessive risk-taking and high levels of leverage. The markets need the Fed to keep the life-support machine on. US equity market valuations are at historical extremes while corporate earnings and sales growth decline. S&P500 companies are incentivised through the Fed’s cheap money policy to spend its cash mountain on buying back its own stock rather than investing in fixed assets. Markets have become distorted and increasingly dis-connected from economic fundamentals.

Our view that we have articulated in our research through the course of this year is that the Fed has kept interest rates too low for too long. A monetary policy designed for emergency conditions back in 2007-2008 is no longer necessary. It is not as though the US economy is in a depression or that the US banking system is on its knees. “Unconventional” monetary policies are no longer necessary. Indeed, the FOMC’s latest set of economic forecasts upgraded its GDP projections for this year to a central tendency of 2.0-2.3% which actually is the long-term average growth rate of the US economy and lowered its forecast of the US unemployment rate for this year to 5.0% from 5.3%. In the last 50 years, the US unemployment rate has actually been very rarely below the 5.0% level (the 1960s, late 1990s and just prior to the 2007 crisis). The Fed should have started to ‘normalise’ monetary policy a lot earlier in this cycle. Now as the FOMC acknowledged in its statement, “international developments” are a key factor in its thinking.

“International developments” is code for China. The FOMC, by delaying the decision to raise rates and finding every excuse to delay, has now found itself at the mercy of external events. The collapse in the Chinese equity market, the worries about a ‘hard landing’ for the Chinese economy and the ‘mini-devaluation’ of the currency on 11 August are all things the FOMC cannot control. In the past, China did not matter for the Fed’s deliberations. Now China does matter.

A Chinese economic slowdown will affect the global economy and increase the risk of a ‘Made in China’ global recession. In addition, China is exporting deflation as a result of the massive over-investment made in recent years which is now redundant and resulting in the slump in commodity prices. These deflationary pressures affect the global economy and help explain the downward pressure in government bond yields in the major markets.

The twist for the US Treasury market, where China is the largest official holder of US Treasuries, is that the beginnings of a decline in China’s fx reserves is also corresponding to a decline in the holdings of US Treasuries. At the moment this is not necessarily a problem for the US Treasury as the US budget deficit as a percentage of GDP has fallen sharply from a peak of 10% in 2009 to 2.5% currently. If anything it is Chinese deflationary price pressure which is pushing US bond yields lower. So worries of some form of Chinese ‘Quantitative Tightening’ (QT) looks over-stated.

All of this presents a dilemma for the Fed. Having ‘missed the boat’ in normalising monetary policy, the door seems to be closing for future US interest rate increases. In the aftermath of yesterday’s FOMC decision, the fed futures market is giving just an 18% probability to a 25bp rate hike at the 28 October FOMC meeting and a 34% probability to a move at the 16 December meeting. The FOMC itself has lowered by 25bp its projections of the median fed funds rate increase though 2018: the FOMC sees the fed funds rate rising to 3.5%. This seems very over-stated. Global recession risks and a US economic ‘expansion’ that is long in the tooth suggest that the peak in the fed funds rate in this cycle will be a lot lower than 3.5%. In an extreme scenario where a global recession and/or financial crisis rules out interest rate increases completely then we go back to ‘square one’ with the Fed left with no option but to implement ‘QE4-ever’.

Whether more QE is the answer is very debatable as even the research findings of the St Louis Fed questioned the impact of QE on the real economy. At some stage, the channel of a reduction in long-term rates in creating any sort of stimulus must exhaust itself in the same way that at the zero bound in terms of short term official interest rates, the conditions of a liquidity trap exist. In this world, the next suggestion from economic theorists would be ‘helicopter money’ or in the UK, ‘QE for the people’ as advocated by the new Labour leader, Jeremy Corbyn. This is really moving into uncharted and potentially dangerous territory.

In the short term, the FOMC’s decision to do nothing does not remove the endless speculation over their intentions, which, on occasion, spark unnecessary market volatility. Mohamed El-Erian in the FT today warns that the Fed “risks finding itself in a cul de sac that, in itself, would risk transforming it from a volatility suppression machine to being a source of financial and economic instability”. Against a background of still high debt levels in the major economies as well as the massive credit expansion in China, the risk is also that monetary policy becomes ineffective. Central banks would then be in danger of losing credibility as investors wonder what comes next. Global deflation, global recession and a bursting of the credit bubble financed by the Fed’s ultra-easy monetary policy would all be a hard price to pay.