The law of unintended consequences once again has made a fool out of the Fed. Not like it’s difficult to do these days. Simply picking a random number between 1 and 2 has proven to be a better GDP forecast system than the thousands of PhD’s working for the Federal Reserve.
If it wasn’t obvious to the Fed already, it will be soon. Inflation has been rising steadily throughout the year. The FOMC made mention of it many times in their minutes, and yet still they held tight, refusing to budge, only talking up the dollar when it was about to fall from its “mystical trading range”.
In the summer months, it was clear momentum chasing and BREXIT fears had pushed government bond yields way too low. At this time inflation had already been rising for many months and was set to go much higher, and yet the Fed stayed put, unwilling to risk any volatility that might put Donald Trump in the White House. Perhaps if they listened to Jeff Gundlach, and perhaps if Jeff Gundlach listened to Jeff Gundlach they’d all be a lot happier right now.
Although I’m sure Jeff’s doing just fine. After all, he’s not the one who is behind the curve, and that’s even before Trump was elected. So now the Fed has to hike. Or as Stanley Fischer tries to explain to the world in his version of the “it’s our currency but it’s your problem“ speech,
“I am reasonably optimistic that the spillovers from ongoing U.S. normalization will be manageable for the foreign economies… I am cautiously optimistic that the drag on the U.S. economy and inflation from past dollar appreciation may have mostly worked itself out, and that foreign economies are on a somewhat more secure footing that poses smaller downside risks to the U.S. economy.”
The Fed has been cornered for years, never able to unwind its policies without inviting disaster. The problem with being behind the curve is that the Fed will have to admit through policy that they made yet another mistake. If the Fed doesn’t react fast enough, inflation could rip higher pushing bond yields to intolerably high levels.
Meanwhile, wages are rising at the fastest rate since the crisis.
Trump has promised to run a highly stimulative government which will push up inflation and increase the available supply of US treasuries. Higher interest rates will also increase the US government’s cost of borrowing which will further increase the supply of US treasuries. Even before rising US interest rates had pushed the dollar higher, foreign central banks, suffering from a serious lack of dollar liquidity, have been forced to sell US treasuries en masse.
Let’s not forget the people who piled into US treasury bonds at the all time highs in the face of this bond doomsday scenario.
The unwinding of the TINA phenomenon will not be pleasant. Bond market liquidity is incredibly low, and with everyone selling, it will likely be non-existent. Trump’s victory has opened a can of worms the world is not prepared for.
Speaking of unintended consequences, imagine you are a yield starved Japanese investor whose interest rates have been pinned to floor. Your own central bank has practically outlawed interest rates. Your currency has already started to fall against the US dollar which now offers a much higher rate of return. Would you hold that worthless government paper if US 10-year interest rate rose to 3%? The BOJ seems to be on the verge of monetizing a lot more bonds than it originally signed up for.
It’s a cocky statement, but given the scenario I’ve just outlined it’s incredibly difficult to argue against. Unlike in Japan, in Europe rates although negative can and have indeed moved higher. The tighter spread between interest rates should pare some of the losses the Euro will have against the dollar. But Europe’s economy is much more fragile than the US, and therefore will be much more sensitive to any move higher in interest rates. Said differently, rising interest rates will increase the spread between the economic health of the two Unions. That widening spread will likely be reflected in further dollar strength versus the Euro.
Of course any rising dollar story would be lost without China, perhaps the largest land mine and dollar bull catalyst of them all. Through the Yuan’s peg to the Dollar, China imports the US’s monetary policy much more directly than the rest of the world. It’s important to remember that TINA also applies to China. Although Chinese investors receive a higher yield than other nations, they arguably took on much greater risk to do so. Over the last few years, to sustain this investor appetite and generate those relatively high rates of return, Wealth Management Products (WMPs) have increasingly invested each other, creating an interconnected web of systemic risk that mirrors the subprime bubble in the United States. The rising dollar and rising interest rates will threaten to reduce the precious liquidity that this ponzi finance scheme so desperately needs to sustain itself.
But aren’t I missing something? Doesn’t the rising dollar crush commodity prices? And shouldn’t falling commodity prices keep inflation in check? Unfortunately, it’s not that simple. In reality, the rising dollar squeezes the commodity complex forcing some commodities artificially lower and others artificially higher. If you hadn’t noticed, the major commodities tied to China have all done incredibly well this year, while oil and gold more recently have been crushed. As Jeffery Snider explains,
Reconciling copper to gold, however, isn’t that difficult. As noted prior, there is much more Chinese influence in the former than the latter. And though conditions in China itself are being driven by the “dollar”, it has responded only recently with what I am sure is a wash of RMB. In that way, perverse as it might seem, surging copper would indirectly agree with a gold slam by the very difference of likely PBOC action – gold suggests an increase in “dollar” pressure, causing a more forceful PBOC internal response, having great positive effect on copper prices.
The rising dollar prompts a liquidity response from the PBOC which increases financial speculation and in turn creates these face-ripping rallies in China related commodities.
As I noted back on November 1st, in a post titled The Mirage: China’s Speculative Fueled Rally,
“Unsurprisingly, these speculative driven commodity rallies have started to impact the real economy. In September, China reported its first YoY PPI gain since 2012.”
The PBOC like the Fed is now faced with its own conundrum. Maintain the peg, and allow the tightening liquidity to crash the economy, OR pump more liquidity, let the currency fall and be eaten alive by rising inflation. The latter is evident in rising short term lending rates despite significant Yuan weakness. And recently, the move higher in short term rates has finally started to push longer term rates higher. Further weakness in the Yuan, instead of easing the economy, may actually push rates higher as inflation in China accelerates.
I understand that this is an incredibly bearish post, especially given the bullish optimism and positive developments in the US economy. The long but shallow profit recession appears to finally be receding, but it is important to remember that inflation always feels “good” in the beginning. The energy sector in particular appears to be stabilizing, but at what cost. These companies piled on trillions of debt to stay alive and maintain their dividends in our TINA environment. TINA is on life support, and the cost of borrowing for these companies is set to rise.
Following up with the bullish price action in the banking sector, given my perspective, it would be a mistake to consider said action as anything more than a head fake. These stocks are simply following a snap judgement response to the steepening of the yield curve, rather than an in-depth analysis of the complex and poorly understood system that is the global debt bubble.
Perhaps the greatest example of this supposed head fake was seen in amazing out-performance of small cap stocks this week.
I truly hate to be so binary, but you have to see the irony. Central banks have been “dying” to generate inflation for years, and now that it’s here, it could destabilize this whole low volatility system they’ve been so desperate to protect. Of course, Trump still has to pass his infrastructure bill through a gridlocked Congress. He does have a republican congress, but it’s not clear how willing they are to work with him. But if the list of foreign leaders lining up to make a deal with Trump is any indication, I’d say the odds of a Trump stimulus package are quite high.
I will also add that the current blow out in US bond yields looks more likely than not to be taking a breather for now. But given the dynamics I discussed here, I think it is a matter of months before the US bond selloff re-accelerates and applies significant pressure to the weakest links in the global economy.