Wednesday, 18 July 2018

On the Fed's "natural" rate of "r*"

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Anthony Peter’s unpacks the latest FOMC minutes.

Please permit me to be slightly doubtful of what I read on the news wires this morning. Bloomberg News, in its “Business Briefing”, came up with the following pearler: “Stocks rallied across Asia after US Federal Reserve meeting minutes reaffirmed policy makers’ faith in the world’s biggest economy and stressed the pace of any rate increases will be slow.” Do people really get paid good money to give us this?

I would like to suggest that Asian stocks rallied on the back of a strong performance of Wall Street which might have found itself turbo-assisted by the minutes but of the 247 points which the Dow gained in yesterday’s session, the first 100 points had already been booked before the minutes were released at 2.00pm EST. I have read them and would love to simply copy and paste them for everyone to have a look at but I think I might meet with quite some resistance despite the fact that this set of minutes really is particularly interesting.

Though couched in all the usual vague and non-committal wording, it is clear where we are heading. Thus we get: “During their discussion of economic conditions and monetary policy, participants focused on a number of issues associated with the timing and pace of policy normalization. Some participants thought that the conditions for beginning the policy normalization process had already been met. Most participants anticipated that, based on their assessment of the current economic situation and their outlook for economic activity, the labor market, and inflation, these conditions could well be met by the time of the next meeting.” Does it get any clearer than that?

They went on to pick up a point I have been making for a while, namely that we should give up focusing on the first tightening move and that we should begin to think about the timing and level of the last one. In the FOMC’s own words: “During their discussion of the likely path for the federal funds rate after the time of the first increase in the target range, participants generally agreed that it would probably be appropriate to remove policy accommodation gradually. Participants also indicated that the expected path of policy, rather than the timing of the initial in-crease, would be the more important influence on financial conditions and thus on the outlook for the economy and inflation, and they noted the importance of under-scoring this view at the time of liftoff.”

Further down the text comes the section which gave markets a reason to rally rather than to sell down in the face of imminent tightening: “The Committee reiterated its expectation that, even after employment and inflation are near mandate consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.” I guess “normal” is 3%?

The full minutes are over 7,000 words long and include the summary of a presentation given to the members by in-house economists on the concept of an equilibrium real interest rate, labelled “neutral” rate, “natural” rate or “r*”. It might also be worth reading this section, cutting it out and keeping it in a safe place for I have little doubt that we will be hearing plenty about “r*” in the future when the trajectory of the funds rate is discussed.

The take away is that rates are as good as certain to go up in four weeks time but that they may be going slowly thereafter. What we must, however, not forget in the aftermath of the failure of the Committee to begin the tightening cycle in September is that the members are just as fickle as the rest of us and just as prone to be influenced by current developments in the immediate economic and market environment. The vision of a slow and gradual increase in key rates could be overhauled at the drop of a hat. What is clear from the minutes is that this time the members are trying to cut through the white noise of too much information but I’m not entirely sure that they really have.

High-yield, high-stakes

Anyhow, markets took the minutes to be dovish and that made traders and investors bullish and, hey presto, we were off to the races again. The up-front excitement does, however, mask some serious problems out there. The pink’un reported yesterday that refinancing the debt portions of some of the leveraged transactions of the more immediate past is becoming progressively more difficult. Pushing financing off bank’s balance sheets and into the high yield bond and leveraged loan markets might have looked dandy during the booms in the debt environment but lending investors have no stake in the life and death of most companies, the debt of whom they hold. One serious shift in the perception of a credit or in strategic asset allocation and it could be game over. Lending banks have relationships; asset managers have investments. One shot, no tears.

The greatest shift in the business of bank lending in the final years of the last century and into the first decade of this one, then accelerated after the GFC, was the decline in relationship banking and the rise of transaction banking. Since then ever more transactions have moved from the banks’ balance sheets to the portfolios of institutional investors. These have not yet been properly stressed but there is a build-up of risks – not primarily of the default variety – which need to be submitted to a test. Regulators are still busily re-fighting the last war while not even scanning the horizon for the possible front lines of the next one. The wording of the FOMC’s minutes affords them more time. Money is that they will waste it.

Sell into strength

Meanwhile, treasury yields dipped immediately after the release of the minutes, only to give back large parts of the gains by the end of the day. Likewise and understandably, the dollar also weakened across the board giving up a full cent against the euro – US$1.0620 to US$1.0720 and ¥123.65 to ¥123.10 – but it has clawed back a goodly share of that overnight an in early Asia trading.

For choice, I’d be a better seller into strength at these levels as I still think markets lack longer term conviction which makes them more prone to go up by the escalator and down by the elevator. Also, at the end of troubled year I’d expect investors to shun putting everything on Red 16 when the performance for the year (and the bonus) is gone anyhow. A cash build-up through year-end could, on the other hand, lead us to lots of fireworks at the beginning of January.

Thanksgiving is a week today; bring on the Christmas lunching season….

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