Friday, November 13, 2015

Unconventional Monetary Policies Likely Mean Rate Hikes Nearly Complete...Not Just Starting


  • The Fed's utilization of Quantitative Easing or QE alongside ZIRP since '08 was an extension and amplification of the Fed's interest rate policy.
  • QE was the Fed's means to foster congress and business alike into massive spending absent the penalty of free-market based higher interest rates.
  • When the Fed began it's taper and subsequently ended QE, this was tantamount to starting the "new normal" rate hike cycle from peak "accommodation".
  • I propose the Fed is already 18 months into this hiking cycle and in the later stages likely culminating in early 2016...prior to a new cycle of accommodation.        

Way back in 2013, there was a similar debate to what we face now.  Would the Fed ever end it's quantitative easing (QE) policies?  Ultimately, the Fed made the call to taper and then ended QE entirely in late 2014.  This was taken as a first sign of "normalization".  But strangely, interest rates fell by a third on the Fed's departure from QE to the dismay of nearly all economists.  In fact, on the curtailment and/or outright abandonment of nearly all traditional sources of treasury buying...interest rates collapsed?!?  Said again, on record supplies of existing and new debt vs. collapsing demand - interest rates fell by a third!?!  Those curious to know who did buy...check the link.

QE was simply a means by which the Fed outright artificially created demand for Treasury debt to allow record stimulus via Congressional deficit spending from '08-'14.  So long as Congress could spend more and pay less in interest costs, thanks to the Feds cover, everybody was happy.

But what I didn't contemplate was the fact that the conclusion to the Fed's unconventional manipulation of its federal funds rate was also the start of the effective hiking cycle. The Fed's FFR hike cycle effectively began when the Fed initiated it's taper over 18 months ago. So, now the debate, will the Fed start a hiking cycle seems misguided. I'd say the Fed is actually already in the later stages of this unconventional hiking cycle with a finish line of a .5% or 1% maximum rate the likely peak. And then a new interest rate cycle is entirely likely...a cycle that sees the Fed move rates well into negative interest rate policy or NIRP the new acronym replacing ZIRP.

First - a quick review of the interest rate cycles since 1981 comparing rates, the accumulation of federal debt, and growth of full time jobs during each cycle.

This second chart highlights the duration at the minimum interest rate during each cycle...lengthening as the interest rate cuts lost effectiveness.

Thirdly, the chart below shows the federal funds rate which hit ZIRP in 2008 and was accompanied by the Fed's new tool, quantitative easing. But QE, like interest rate cuts, lost it's effectiveness each time it was used and greater durations were utilized to have the intended impact.

But with the Fed's final announcement of the taper so too the clock began ticking on the Fed's hike cycle from peak accomodation. Given the poor economic performance nationally and internationally juxtaposed against financial markets euphoria...either the Fed quickly wraps up this hike cycle (and make clear the next "accommodation" is imminent) or very negative market forces could see a repeat performance of the '00 and '08 market collapses.

Lastly, as the chart below highlights, the deceleration of the growth in the core population coupled with minimal wage gains has been the primary reason for slowing economic growth. This has been offset by declining interest rates and ramping deficits. However, core population growth will only decelerate further for the next decade (and that assumes continued strong immigration) so greater deficits and negative interest rates seem a good bet...not rising rates or lower deficits.

BTW - The bulk of the dollar gains (about +18%) have come since the end of QE but is the dollar's pause at these levels pricing in a new hiking cycle or pondering the next accommodation just around the corner?

For better or worse, new lows in the 10yr treasury and new highs for equities are the likely imminent outcome of a negative interest rate policy that only furthers the great divide between slowing economic and ramping financial activity (corporations paid to take loans with which to buyback their own shares). I'd anticipate some dollar softening as the Fed finally admits the "new normal" is long on "new" and short on "normal"...but the impact to be muted for commodities as NIRP continues to incentive producers to bring new capacity online in a world of massive overcapacity and decelerating global demand.  Unfortunately, the sustainability of such a system is premised on ever greater central control and diminishing free market price discovery...such is the price of the "new normal".