A black hole is a region of space having a gravitational field so intense that no matter or radiation can escape. Even light is held captive to the overpowering forces of its gravitational field. It is an enigma of science, where the rules of space and time are altered, and our grasp on physics is confounded. As the markets prepare for Janet Yellen’s speech at Jackson Hole, Fed policy is at risk of a radical paradigm shift that could alter its mandates for the foreseeable future. Such a shift is unmerited in my opinion, but there have been external ruminations and Federal Reserve comments indicating that the very tenets of monetary policy are being questioned. If such policy change is adopted, make no mistake, the economy will be approaching the unknown, where our understanding of economics and market dynamics will provide minimal navigational help in a warped monetary world of time and space.
The dual mandate of the Federal Reserve is to adopt monetary policy to maximize economic growth while keeping inflation within an acceptable range – its stated target is 2%, as measured by the core PCE deflator (currently at 1.6%). The fixed income markets have become acclimated to the Federal Reserve moving its goalposts when it is poised to normalize rates. Years ago, it was indicated that an unemployment rate below 6.5% would be an accurate indication of when the Fed would act. Then 6%. And so on and so forth. While endogenous economic data currently fits the timeline of rate normalization (accelerated wage growth, increasing price measures, low unemployment, etc.), there are indications that the Federal Reserve is starting to adopt the point of view that rates are already normalized – at least a couple of members are advocating such. James Bullard, the president of the St. Louis Fed, has stated, “The best that we can do today is to forecast that the current regime will persist and set policy appropriately for this regime.” As a result, any pre-emptive moves out of the Federal Reserve should be taken off of the table and rate hikes will be sporadic at best. Historically, the Federal Reserve has been reactive rather than proactive when it comes to macro-economic data responses. But at least their focus was on leading economic indicators, like accelerated wage growth. Bullard is now advocating a reactionary policy to coincident indicators like inflation. Such policy adoption would mean the Federal Reserve will be further behind the curve and could potentially be forced to act erratically if inflation accelerates. When it comes to the economy and capital markets, historically, the only constant has been change, and a purely reactionary Fed that assumes baseline economic growth and inflation for the foreseeable future, when leading data indicates otherwise, is irresponsible.
John Williams, the San Francisco Fed President, meanwhile, believes that the neutral rate, historically around 3%, is now hovering around zero, leaving the Fed minimal room to pursue expansionary policy. Williams points to secular reasons why the neutral rate has decreased, including demographic shifts, savings gluts and lack of investment. We believe that the disinflationary demographic shift has largely run its course, as we cited in a prior perspective entitled, “The Bond Bubble Burst and the Death of the Disinflation Trade.” Differing opinions aside, at least John Williams still adheres to a proactive approach, albeit with a different model for the neutral rate. Proactive Fed policy, in such an environment, would be one that included expanded QE and negative rates, in conjunction with fiscal stimulus. We are in the camp that such action is unwarranted at this time, and that secular demographic changes in the United States will ultimately bring the San Francisco neutral rate model higher based on our own economic projections.
The good news about a Fed policy paradigm shift is that it is already largely priced into the market. Fed interest rate projections have already been discounted by market participants and term premiums are near all-time lows. So it is entirely possible (perhaps likely) that dovish statements from the Fed on Friday will not jeopardize the recent rally in risk assets. However, they are much more pernicious as they relate to longer-term economic prospects, and the possibility that the Federal Reserve falls behind the inflation curve. Continued acquiescence to market interest rate projections will ultimately drive inflation and steepen the yield curve.
It is important to note that a dovish Fed is not our baseline scenario. We think that economic data continues to support rate normalization and there are still quite a few Fed members who agree, namely Stanley Fischer, Vice Chairman at the Fed, and Esther George, President at the Kansas City Fed. Nevertheless, the recent comments from Williams and Bullard are not only currently dovish, but they speak to the possibility that the Fed will adopt new procedural models that would ensure low short-term rates for years to come – right or wrong. If such a paradigm shift occurs, we believe it would have important implications for capital markets, many of which can’t be quantified. Off the cuff, inflation protection would be a much more important component of client portfolios. Structured notes, TIPS and gold would likely do well in such an environment. Meanwhile, floating rate notes that adjust off short-term benchmarks would likely continue to underperform short maturity bullets.
Hawkish statements on Friday pose a threat to risk assets in the short term, however, ultimately are proper policy. It is interesting to note that due to the recent uptick in Libor rates, short-term money markets have already tightened. If the Fed adheres to its normal playbook, rate hikes are on the horizon. The chart below illustrates that the Fed has historically reacted to accelerated wage growth, which bottomed in 2012.
Current dissidence among Fed members is not abnormal, but it undermines market clarity. Thunderdome is most prevalent prior to policy shifts. I just hope that the policy shift is within the confines of historical Fed procedure. A significant alteration of Fed models will propel the economy (and markets) into an unknown world, where historical relationships and covariance among asset classes become increasingly distorted.