We all recall Janet Yellen having relied on, or shall we say hidden behind, her data dependency when she steered monetary policy earlier in the year. Then, around summer, something changed and she resorted to what is commonly known as schedule dependency, as in making sure certain rate hike moves were completed on time. Now, all of a sudden, we seem to be getting back to data dependency.
As this space has been arguing for years, the Fed has never gotten its head around the nature of inflation in an economy that is in the grips of structural change instead of a cyclical rebound. The idea was to just keep looking at predominantly labour numbers, which admittedly were nice to watch on a nominal basis, and raise rates along with their improvement. Inflation would catch up at one point.
The problem is it never has, and finally the members are getting cold feet. This week we will hear a slew of speeches including Yellen and Jay Powell, and they won’t be able to duck the glaring question. What will the Fed do if inflation really doesn’t pick up? Well, there is the December hike that is almost a given, and it appears that schedule dependency will have the better of it, and no one will be able to mess with that.
But for Powell and the new members incoming, it will be a material decision how to define the future course of US monetary policy. It would be foolish to believe that consistency is the only option. The warning signs are everywhere. Long Treasury yields are unimpressed by the Fed’s inflation expectations and have remained depressed. And the rate curve has been getting flatter and flatter, to a level not seen in 10 years.
So, what to do? Since the central banks of the world have made that pact with the devil in the wake of the financial crisis and manipulated markets to a considerable extent, they now need to be careful not to be bitten in their rear ends. The recent and current Fed communication has driven the short end up, Libor and the 2-year yield by over 100bp in the past 24 months and the 2 year sharply almost 50bp since only September…
… but the curve didn’t shift in parallel. Lack of inflation kept 10- and 30 years in check causing this massive curve flattening. What on earth is going on, Powell must be thinking to himself. If he drove the short end up even further by hawkish rhetoric, the curve could easily invert at one point, a scenario much like we had in 2000 and 2006/07, ahead of respective recessions and the financial crisis, and the eventual risk market crashes.
Instead of abandoning Yellen’s course entirely and u-turn outright, Powell’s most neutral amendment to policy would be to communicate a new data dependency again, with inflation the key data to be observed. And if inflation did not pick up or only showed in oil-related readings, as crude prices have been moving up recently, then he would have no choice but to abandon all models pointing toward further normalisation and strike a dovish tone again.
The market is sniffing around such a scenario already, not yet by aggressively bidding up the short end but by constantly buying the long end whenever 10 years approach 2.50% and 30 years 3%. Also, the dollar has been weaker against the Euro and other currencies which is commensurate with a recurring dovish sentiment by the Fed, and gold is getting ready for another leg up.
The hedges are being built in. The suspicious types ask themselves what it would mean if Powell had to steer the ship around. They also ask themselves whether the rate rise craze hasn’t already pushed the economy over the cusp and into a coming slowing or even recessionary scenario. Also, they wonder what a u-turn would entail… sitting still on rates, lowering them again, or even launching a new form of QE?
One thing’s for sure. If more balance sheet accommodation were in the offing, in contradiction of the just announced trimming, the dollar would fall much more considerably, the rate curve may halt its flattening trend but sink again in lockstep, and gold would have a field day. Don’t make the mistake of thinking such scenario is impossible. This space has certainly always put its money where its mouth is.
