There are a growing number of regional Fed Presidents who are increasingly nervous about the Fed’s ultra-easy monetary policy. The end of QE is inevitable in the next few months, and regional Fed Governors are openly talking of the need for rate rises early next year. They believe that the economy has healed enough, their key targets on unemployment and inflation are very close to being achieved and they are increasingly worried about the recent pick up in the rate of inflation.
“You are basically going to be near normal on both dimensions later this year...That’s shocking, and I don’t think markets, and I’m not sure policy makers, have really digested that that’s where we are.” James Bullard, St. Louis Fed President speaking in an interview on Fox Business Network this week (emphasis ours). As an aside, Bullard is very much seen as an opinion former having helped blaze the QE2 trail on the back of too low inflation.
Despite a growing number of regional Fed Presidents openly worried about current policy, Janet Yellen and her Reserve Board colleagues in Washington continue to look in the rear view mirror and believe that pumping up asset prices and ignoring rising CPI is a good policy mix. As we asked last week, have these guys not learnt anything from past mistakes?
It strikes us that interest rates and bond markets are increasingly focused solely on what Janet Yellen is saying and they are ignoring the broader message that is coming out of the FOMC and is evident in the economic data. The chart below shows the US Treasury curve from the March FOMC meeting to today, and although the two year note has risen by 4 basis points, yields have declined at every other point along the curve. This is despite FOMC forecasts for the Fed Funds target being higher than they were at the time of the March meeting.
So who is right? Is it the bond market, encouraged by soothing words from Yellen and perhaps worried about the underlying health of the economy? Or is it the regional Fed Presidents?
We have said many times that the underlying pace of real growth in the US economy is likely somewhere around 2% to 2.5%, and despite a disastrous first quarter, we still believe this to be the case. We said last week that we felt that a policy error is increasingly likely and in our opinion, yields have to rise in the event that the FOMC move now to either prevent inflationary pressures or fall behind the curve followed by a period of catch up (i.e. more aggressive rate rises) later in 2015. The only scenario whereby rates stay low or move even lower is if the underlying health of the economy is much weaker than we think. There are some very clever people who believe that the US is only one shock away from a new recession, and the odds of this happening are certainly not zero, and are probably rising.
With markets seemingly grinding to a halt even before we get to the dog days of summer, should we be worried about an imminent shift higher in yields? Possibly not, although there are several signals that should be monitored closely. As well as watching for more signs of hawkish shifts amongst FOMC members, measures of inflation and wage growth should be monitored closely.
Although we know that Yellen simply does not care about rising inflation, there is no denying that inflationary pressures have been building in recent months, alongside discernible improvements in the employment market and wage growth. Although markets have bought into her dovish narrative (hook line and sinker) over the Spring, this could change very quickly and a Fed Chairperson with declining credibility could be a dangerous backdrop for the bond markets later this year. The chart below shows the growth in average hourly earnings for the US private sector versus the Fed Funds Target Rate. It appears to us that earnings growth is on a rising trend and is at a level that would be consistent with higher interest rates – get to work Madam Chairperson!
If we are right in our view that yields across the US curve shift higher during the second half of the year, the investment stance should be quite simple. We need to be long the US Dollar against most currencies, underweight or short bonds and most likely underweight or short equities (there’s that broken record again!). In our view, it is only a matter of time before this scenario plays out. What we cannot predict in these completely manipulated/low volume markets is the timing. What we can say is that buying longer dated optionality is exceptionally cheap at the moment and if/when this scenario starts to become reality, markets will adjust rapidly before investors have a chance to fully react. It makes sense to be positioned for this scenario today, albeit in modest size only, and looking to add to positions as and when momentum builds.