Over the weekend, Deutsche Bank’s chief credit strategist Dominic Konstam released a report in which as we documented, he explained his reasons why “the market is not ready for a June hike.” This was his key point:
The operative question is whether markets are sufficiently calm for the Fed to use the June 2016 meeting to pave the way for a July hike.
We think the answer is no because the issue is not just the timing of a single hike toward some static goal for rate level in 2017. What is at issue is the existence of some Shanghai “accord” whereby global policymakers have agreed explicitly or implicitly that excessive dollar strength is counterproductive and that policymakers should shift their focus to domestic demand and structural reform within an environment of dollar stability, at least through the next G20 in early autumn. If there is no accord then divergent monetary policy could drive the dollar stronger, restarting among other things speculation against CNH versus the dollar rather than CNY versus the entire CNY basket with now very familiar results: reserve loss exacerbating higher Fed expectations for US rates, and downward pressure on risk assets with a non-trivial chance that China might devalue and, worse yet, do so in a lumpy fashion.
He added that “the risk case is then that an overly aggressive Fed would push real yields up and breakevens down, thus undermining risk assets generally.“
So far, following a renewed media barrage explaining just like in December, how the economy and markets are far more stable than they appear, the market has taken the Fed’s renewed allegedly hawkish bias in stride.
However that may change. Recall that just last week we showed a chart from Bank of America which dubbed it the Fed’s “Nightmarish Merry-Go-Round”, which showed clearly and simply how the Fed is trapped in a feedback loop with the market.
This is what BofA said: “By some accounts the Fed is stuck in an adverse feedback loop. They want to raise interest rates so they can “reload” their policy ammunition, but the markets won’t let them. The chart of the day illustrates this nightmarish merry-go-round: the Fed threatens to hike, markets tank, the Fed delays the hike, the market recovers and the cycle repeats. The end result is repeated delays and very little actual policy tightening.”
Today, it is the turn of DB’s Chief Economist Peter Hooper to discover just this diagram, which he takes on in a note titled “Financial conditions feedback loop unlikely to stay Fed’s hand.” In it he says what is effectively the same, namely that the anticipation of future Fed rate hikes is sufficient to tighten financial conditions (read a market drop) to the point where a Fed itself is unable to proceed with an actual monetary tightening.
This is what how Hopper summarizes the BofA chart:
The recent drumbeat of hawkish commentary from the Fed, along with last week’s release of the minutes from the April FOMC meeting, has triggered a sharp re-pricing of expectations for Fed rate hikes by the market. While the market was only pricing about 4% odds of a rate increase in June less than two weeks ago, those odds now stand close to one-third.
It is believed that this shift in rhetoric toward a more hawkish message will ultimately be self-defeating. By signaling rate hikes, interest rates adjust higher, the dollar strengthens, and risk assets may come under pressure. This produces tighter financial conditions, which ultimately prevent, or at least limit, the eventual rate increase. This natural tightening of financial conditions in response to rate hikes is expected.
But there are reasons to believe that this negative feedback loop may be more severe in the current environment: a stronger dollar is likely to increase pressure on China’s currency and weigh on commodity prices, thereby re-introducing the key elements of stress that led to a sharp tightening of financial conditions earlier this year. If this view is correct, the scope for further rate increases by the Fed is reduced.
There is, however, one loophole: if the Fed’s hawkish bias is also accompanied by stronger economic data.
What does this mean for the Fed? If the Fed adopts a hawkish message in the absence of better macro data, a negative feedback loop from market pricing to financial conditions may very well limit the ultimate tightening the Fed can undertake. On the other hand, if the Fed is data dependent, and hikes only when the data warrants, a tightening of financial conditions should not prevent the Fed from hiking in the coming months. Indeed, recent experience suggests that financial conditions can ease even as the market prices more rate hikes from the Fed.
At this point the question emerges: is yesterday’s unexpectedly good housing data sufficient to offset not only ongoing manufacturing sector deterioration, but as today’s Services PMI revealed, a sharp contraction in the service sector as well, one which would likely lead to just a 120,000 NFP print for the month of May.
DB also notes that it is not just domestic data: a question is what happens externally, something we touched upon overnight.
To be sure, this relatively benign view of financial conditions could be upset by shocks from China, for example, as was the case earlier this year, which could again raise uncertainty and tighten financial conditions sufficiently to delay rate increases by the Fed. And other factors could still prevent a hike – the rebound in the data remains tentative and may reverse and geopolitical risks, namely Brexit, also loom large.
DB then provides the example of the October 2015 case study:
Relevant for the current environment is the experience in late October 2015, when the Fed sent a clear signal that they expected to hike at the next FOMC meeting in December 2015. Similar to recent experience, the market was pricing low odds for a rate hike at the next meeting (December at the time), and the Fed felt the need to use a verbal “sledgehammer” to jolt market pricing to be more consistent with the Fed’s own expectations. This experience bares close resemblance to the recent stream of hawkish messages from Fed members and the April 2015 FOMC minutes that again provided a jolt to market pricing.
In the weeks following the October 2015 FOMC meeting, financial conditions continued to ease as the market began to price a significantly higher near-term path for the Fed (Chart 7). Financial conditions then held steady through November and into early December while market pricing for the Fed reached a plateau. However, financial conditions then began to tighten ahead of the December FOMC meeting, and plummeted through mid-February. At the same time, the market revised down its expectations for Fed rate hikes.
It is important to recognize the role of other factors during this period. First, financial conditions began to tighten following the announced liquidation of Third Avenue’s high-yield Focused Credit Fund on December 9, 2015. The event led to a substantial widening of credit spreads and was associated with deteriorating risk sentiment. Second, financial conditions only tightened sharply as China’s devaluation at the start of the New Year set off a renewed round of global risk-off.
Data may have also played a role during this period. US data surprises reached a local peak near zero in mid-November, and then began to deteriorate sharply, as US data missed expectations on balance (Chart 8). This deterioration continued through mid-February, as data for the first quarter once again signaled a slowdown in the US economy.
To be sure, the sharp re-pricing of the market’s Fed expectations led to a stronger dollar which added pressure to China’s currency. In this sense, the China devaluation in early 2016 can be viewed as (at least partially) a lagged result of the adjustment in market expectations. However, the closure of the Third Avenue fund appears to have been driven more by idiosyncratic factors, rather than directly tied to the Fed’s signal of upcoming rate hikes.
The takeaway for the current experience is that the magnitude of the tightening of financial conditions observed earlier this year was at least partially due to other factors – the liquidation of a high-yield fund and weakening US growth momentum likely contributed. However, the prospects for another shock from China as the dollar strengthens on the back of the Fed re-pricing, suggests that financial conditions, and thus the future path for Fed rate hikes, will not be immune to this re-pricing.
In other words, just as we said last week, it’s all up to China…
Looks like its up to China again to derail the Fed’s June rate hike plans
— zerohedge (@zerohedge) May 19, 2016
… the same China which demonstratively devalued the Yuan last night to the lowest level since 2011, however stepped in the market to stabilize the selloff, suggesting it is not fully focused on preventing a Fed rate hike.
Which brings us to DB’s conclusion:
The evolution of financial conditions will be critical for whether the Fed will be able to raise rates in the coming months. Our analysis finds evidence that a negative feedback loop does exist between the market’s expectations for the Fed and financial conditions. However, we believe that, absent a shock from China in the months ahead – which is clearly difficult to predict – it is unlikely that a negative feedback loop that tightens financial conditions will prevent the Fed from hiking.
In other words, just like in early 2016 when the Fed’s relent was driven by Chinese or as the Fed put it “global” conditions, so this time any potential delay in either the June or July rate hike (subsequent rate hikes get too close to the presidential election to make a comfortable extrapolation), will be entirely in the hands of Beijing. Or as some would note, the Federal Reserve of the US is now entirely a puppet of China.
Which brings us back to the rumored “Shanghai Accord” and the all important question: did the Fed co-ordinate the June (or July) rate hike with Beijing back in February?
We will find out over the next few days. If the USD keeps rising and the Yuan keeps probing multi-year lows, all that would take to derail the Fed’s hawkish intentions is one session in the which the PBOC does not step in to stabilize the CNY selloff, in the process sending risk assets plunging and once again making a rate hike impossible for Yellen.
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