Monday, June 16, 2014

Watching the Fed's body language on growth and inflation

As the markets await the FOMC statement on Wednesday, I want to highlight one risk that I outlined before about rising inflationary pressures. As I highlighted in my post (see Correction, interrupted) and Joe Wiesenthal correctly pointed out, PCE inflation rates are fast closing in on the Fed's 2% target.

I also said that shorter annualized rates of core PCE inflation and trimmed mean PCE were already above the 2% target:

Wiesenthal also added that the unemployment rate is dropping relatively quickly and approach NAIRU, the natural rate of unemployment, which would be a signal for the Fed to start tightening.

Blinder: Greater volatility ahead?
I am therefore carefully watching the FOMC statement about the inflation and employment outlook for hints that that day of tightening is getting closer. Former Fed vice-chair Alan Blinder stated that the current environment may create greater uncertainty about Fed actions going forward as an active debate about the sequencing process of QE withdrawal starts to heat up. Blinder explained it this way in a Marketwatch interview (emphasis added):
There has been very little division on the Fed, because everybody has signed on to gradual tapering of the quantitative easing. That has left undebated, I mean it’s been debated but it has not been debated intensely and not very much publicly, about what happens when this [QE] is over...

The Fed has previously announced, it is on record, but the record goes back a few years, that there would be some draw down of the size of the portfolio before any interest rate increases. A number of Fed spokesman have started, either tacitly or very explicitly, backing away from that and saying that is now under reconsideration and so on. It is clear that that is up to debate inside the Federal Reserve, whether interest rates will start going up first or the balance sheet will start shrinking first, but that is a subtle issue of timing. And as we think of the exit proceeding over months and years, it is clear that both have to happen. The Fed is not going to stay at near-zero interest rates as the economy strengthens and the Fed is not going to stay with a $4.5 trillion balance sheet as the economy strengthens.
How the process works could be a source of uncertainty:
I think the sequencing — what comes first and what comes second — matters a little bit but the speed matters a lot – really, a lot.

Let’s do a thought experiment. If everybody — hawk and dove and everybody, agreed on the endpoint, say, the federal funds rate will be 3.75% and the balance sheet will be $1.5 trillion — the speed with which we get there is hugely consequential for the economy. That’s what the hawks and doves will be arguing about.
Macro Man had an amusing and more dramatic example of why this all matters:
Is there anyone out there who still doesn't understand what artificially depressing volatility does? OK. Last time.

This is your market volumes when you promise low rates forever:
This is your market volumes on talk of a possible rate hike.

Much ado about nothing?
Even though my inner trader is cautiously bullish on stocks, he is holding back from taking too big a directional bet on the markets until after the FOMC announcement. Of course, it could all turn out to be nothing and the market reaction to the Fed statement could be relatively benign, as per Tim Duy`s forecast:
All that said, if such a (hawkish) change were to occur, it will not be in this week's statement. My expectation is that Yellen sticks to the fairly dovish tune she has been singing. If there are clues that the tenor of the tune is changing I think they would be subtle. Watch for any language from Yellen regarding proximity to goals, optimism on the JOLTS numbers, or references to inflation bottoming out and turning higher. These would be hints that the Fed is increasingly concerned of the possibility of falling behind the curve. Such talk would also hint at the possibility that the new Board members seek to edge policy in a different direction.
I would also point out that the IMF is lowering its US growth forecast and believes that rates will stay low for longer than the market expects (emphasis added):
The International Monetary Fund cut its growth forecast for the U.S. economy this year and said the Federal Reserve may have scope to keep interest rates at zero for longer than investors expect.

The Washington-based IMF now sees the world’s largest economy growing 2 percent this year, down from an April estimate of 2.8 percent. The IMF left a 2015 prediction unchanged at 3 percent, and said it doesn’t expect the U.S. to see full employment until the end of 2017, amid low inflation...

For the Fed, the IMF’s employment and inflation forecasts mean “policy rates could afford to stay at zero for longer than the mid-2015 date currently foreseen by markets,” the fund said in its annual assessment of the U.S. economy.
In other words, the FOMC statement on Wednesday could be pivotal to market psychology. That's it might not pay to try to be a hero going into the FOMC meeting.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

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