Tag: monetary policy
Asset Allocation Bi-Weekly – #66 “The Path of Monetary Policy” (Posted 1/10/22)
Asset Allocation Bi-Weekly – The Path of Monetary Policy (January 10, 2022)
by the Asset Allocation Committee | PDF
Our expectation of no policy rate hikes this year is an out-of-consensus call in our 2022 Outlook: The Year of Fat Tails. There are a couple of factors that suggest rate hikes this year. First, financial markets have factored in rate hikes. Fed funds futures suggest a greater than 50% likelihood of a rate hike beginning with the March 2022 meeting and have discounted the same likelihood for four 25 bps rate hikes by December. Second, the Mankiw Rule, a derivation of the Taylor Rule, indicates the FOMC is hopelessly behind the curve in terms of rate hikes.
We have created five variations of the Mankiw rule, which calculates a fair value policy rate from core CPI and various measures of the labor market. The most conservative measure puts the recommended fed funds rate at 4.33%; the most radical is 9.27%.
So, given this strong evidence, what is the argument for steady policy? Part of the reason the Mankiw variations are so high is due to elevated inflation. Base effects alone should lead to lower readings on inflation by mid-year, which should cool the impetus for policy tightening. Although the labor markets show signs of being tight, the labor force remains well below pre-pandemic levels. It may give FOMC members pause, worried that tightening could be premature.
This chart compares the three-month average of the labor force relative to its most recent peak. The drop in the labor force seen during the pandemic was unprecedented in the post-war era. It is uncertain whether the labor market has been permanently impaired by the pandemic. It may never return to pre-pandemic levels. It is also possible that as the pandemic steadily shifts to endemic, workers will return. Thus, tightening could prematurely put this return at risk.
Another characteristic of the FOMC since Greenspan has been the attention paid to financial markets. The concept of the “Greenspan put,” which has been attributed to every Fed chair since Greenspan, suggests a pattern where monetary policy is eased to quell turmoil in financial markets.
One clear measure of financial stress is the VIX, which measures the implied volatility of the S&P 500. In general, the FOMC tends to avoid tightening when the 12-week average of the VIX is above 20. For example, after the Fed raised rates in late 2015, policy remained on hold until the VIX fell decidedly. With the VIX currently holding around 20, we expect the FOMC to delay any moves to raise rates until market volatility eases.
Finally, we suspect financial markets are underappreciating the degree of fiscal tightening that will occur this year.
Fiscal spending during the pandemic was extraordinary. However, as that support winds down, it will act as a drag on economic growth. If the FOMC tightens into this austerity, economic growth could weaken more than expected. The consensus real GDP growth for 2022 is 3.9%. That could be at risk if the Fed tightens into falling fiscal support.
Obviously, we could be wrong on our monetary policy call, and if we are, we will adjust. For now, we think there is a case that the market is overestimating the degree of monetary policy tightening that will occur. If we are correct, it’s likely supportive for equities, short-duration fixed income, commodities, and bearish for the dollar.
Asset Allocation Weekly – #27 (Posted 2/12/21)
Weekly Geopolitical Report – Weaponizing the Dollar: Part II (August 19, 2019)
by Bill O’Grady
Weaponizing the Dollar: Part I
In Part I, we began our analysis with a discussion of Mundell’s Impossible Trinity. We also covered the gold standard model and Bretton Woods model. This week, we will examine the Treasury/dollar standard and introduce what could be called Bretton Woods II. Finally, we will conclude with market ramifications.
Weekly Geopolitical Report – Weaponizing the Dollar: Part I (August 12, 2019)
by Bill O’Grady
Weaponizing the Dollar: Part I
In July 1944, 44 allied nations gathered at the Mount Washington Hotel in Bretton Woods, NH to develop the structure for the economic and financial systems for the postwar world. The Bretton Woods agreement established a system of fixed exchange rates. Exchange rates were pegged to the U.S. dollar and the dollar could be swapped for gold at a fixed price of $35 per ounce. As part of this system, capital controls were widely deployed placing restrictions on the ability of investors to move funds overseas. In the wake of the Great Depression, international bankers were held in low regard so international transactions were mostly to facilitate current account (trade) activity, while capital account transactions were restricted.
A large enough number of nations adopted the plan and the system lasted from 1945 until August 1971, when President Nixon ended the ability of foreign dollar holders to swap for gold. Since 1971, most developed nations have adopted floating exchange rates and, over time, open capital accounts.
There is growing evidence that some policymakers in the U.S. are rethinking Nixon’s break with the Bretton Woods system and are considering a return to fixed exchange rates. In Part I of this report, we will introduce the Mundell Impossible Trinity, which will provide the framework of discussion for the three historical models and the potential change. In addition to the Impossible Trinity, we will discuss the gold standard and the Bretton Woods system. In Part II, we will examine the Treasury/dollar standard and introduce what could be called Bretton Woods II. We will discuss the strengths and weaknesses of each model. As always, we will conclude with market ramifications at the end of Part II.
Asset Allocation Weekly (June 9, 2017)
by Asset Allocation Committee
We have been monitoring the S&P 500 performance relative to new GOP administrations. Based on the historical pattern, the market has reached the average peak level a few weeks early.
This chart shows the performance of the S&P 500 on a weekly close basis, indexed to the first Friday of the first trading week in the year of the election. We have averaged the first four years of a new GOP president. So far, this cycle’s equity market has generally, though not perfectly, followed the average. Based on that pattern, the current level of the market is around the usual peak. Clearly, this election cycle could be different, but the average does suggest we could be poised for a period of weakness.
So, what might cause a pullback? Here are a few candidates:
A debt ceiling crisis: The Treasury indicates that the government may begin to shut down as early as August if the debt ceiling isn’t lifted. With the GOP controlling Congress and the White House, raising the debt limit should be perfunctory. However, there are rumblings that the Freedom Caucus will demand spending cuts to agree to any debt limit increases. The Democrats, after watching President Obama deal with two government shutdowns and the sequester over the debt limit, are in no mood to work with the administration and may force the congressional leadership to deal with the Freedom Caucus. If another debt limit crisis triggers a new government shutdown and raises fears of a potential downgrade of Treasury debt, a pullback in equities would likely result.
Winds of war on the Korean Peninsula: The U.S. will have three carrier groups in the East China Sea in the coming weeks. Although we doubt the Trump administration wants a war with North Korea, the U.S. is putting enough assets in the region to go to war if it so decides. A full-scale attack on North Korea would be a bloody affair; the Hermit Kingdom has been preparing for such an attack for years and even if its nuclear program isn’t ready to deliver a weapon, its conventional forces will wreak havoc on the South. Even a hint of a conflict will likely prompt a pullback in risk assets.
Monetary policy worries: The FOMC appears driven to raise the fed funds target rate. As we have noted before, there is a good deal of uncertainty surrounding the degree of slack that remains in the economy. The FOMC appears to be leaning toward the notion that the economy is getting close to capacity and further declines in unemployment will surely lead to inflation rising over target. Although financial markets didn’t react well to the rate hike in December 2015, the subsequent increases have occurred without incident. Telegraphing the increases has reduced the risk to rate hikes but the odds of overtightening will increase if the Federal Reserve has miscalculated the level of slack in the economy. This potential concern, coupled with plans to begin reducing the size of the balance sheet later this year, could begin to undermine market sentiment.
We want to note that the average decline shown on the above graph is not a numerical forecast; we tend to view the direction as a more important indicator than level. It suggests that a period of equity market weakness is a growing possibility later this summer. What we don’t see, at least so far, is evidence of anything more than a pullback. Recessions tend to be the primary factors that lead to bear markets. The economy is doing just fine; the yield curve hasn’t inverted, the ISM manufacturing index is comfortably above 50 and there hasn’t been any evidence in the labor markets to suggest a drop in economic growth. Thus, we may see a weak summer for stocks but nothing that would lead us to take a defensive position in the equity markets. Instead, a pullback will likely create an opportunity for investors.
Asset Allocation Weekly (June 2, 2017)
by Asset Allocation Committee
In the last FOMC minutes, policymakers signaled another hike at the upcoming June 14th meeting. We continue to closely monitor financial conditions but, so far, financial markets are rather sanguine about the impact of policy tightening.
The blue line on the chart shows the Chicago FRB Financial Conditions Index, which measures the level of stress in the financial system. It is constructed of 105 variables, including the level of interest rates, credit spreads, equity and debt market volatility, delinquencies, borrower and lender surveys, debt and equity issuance, debt levels, equity levels and various commodity prices (including gold). A rising line indicates increasing financial stress. The red line is the effective fed funds rate. Until 1998, the two series were positively and closely correlated. When the Fed raised rates, financial stress rose; when the Fed lowered rates, stress declined.
We believe there are two factors that changed this relationship. The first is policy transparency. Starting in the late 1980s, the Fed became increasingly transparent. For example, before 1988, the FOMC would meet but issue no statement about what it had decided to do. Investors and the financial system had to guess whether policy had been changed. Starting in 1988, the central bank began publishing its target rate. In the 1990s, it began issuing a statement when rates changed. Eventually, a statement followed all meetings. As the FOMC has become more transparent, the correlation between stress and the level of fed funds has changed. Essentially, the markets now know with a high degree of certainty when rate changes are likely. This is especially true of tightening. The FOMC appears to avoid making rate hikes that surprise the market.
The second factor is financial system stability. From the Great Depression into the 1980s, policymakers put a high premium on system stability at the expense of efficiency. Bank failures were rare and there were a large number of rather small institutions. In addition, commercial banks were separated from investment banks. The drive to improve efficiency led to consolidation among commercial banks and a breakdown of the barriers between commercial and investment banks. Although this made the system more efficient, it also undermined stability. Thus, when raising rates, the Fed must pay close attention to system stability to prevent crises, which has tended to lead to gradual and measured policies; this behavior maintains stability…until it doesn’t!
Essentially, policymakers and investors face the Minsky Paradox; the more stable markets become the more risks investors take, leading to conditions that cannot be sustained. Unfortunately, it’s hard to know in advance when rate hikes become problematic. It is likely that as rates rise, factors that may have been manageable at lower rates become dangerous at higher rates. Those conditions can change faster than policymakers can likely react. For now, there isn’t much evidence of trouble but the fact that policy is tightening raises the likelihood, however small, that problems could develop.
Asset Allocation Weekly (May 26, 2017)
by Asset Allocation Committee
The dollar is in its third major bull market since currencies began floating in 1971.
This chart shows the JPM dollar index which adjusts for relative inflation and trade. The previous two bull markets exhibited greater strength than the current one. Because of the dollar’s reserve currency role, there will always be an underlying demand for dollars for foreign reserve purposes. Thus, U.S. policymakers can run fiscal deficits and tax policies that penalize saving (for example, we tax income instead of consumption) and not suffer from foreign exchange crises. At the same time, dollar strength can act as a drag on the economy; it tends to make imports more attractive and can undermine the competitiveness of domestic firms.
The previous two dollar rallies were tied to specific fundamental factors. The 1978-85 bull market was mostly attributable to the Volcker Federal Reserve. Paul Volcker instituted monetary policy based on money supply growth instead of interest rate targets. This allowed interest rates to rise to extraordinary levels (fed funds peaked at 19.1% in June 1981) and made the dollar very attractive. The 1995-2002 bull market was mostly caused by productivity gains, although fiscal surpluses likely contributed as well. Technology investment began to boost the economy in the latter half of the 1990s and made the U.S. an attractive investment venue. The surplus reduced available Treasuries and made it difficult to build reserves without bidding the dollar higher. The current bull market is similar to the Volcker bull market in that it appears to be mostly due to monetary policy. The Federal Reserve began to reverse its unconventional monetary policy measures before the other major G-7 economies, boosting the greenback.
Valuing currencies is difficult as it is generally true that the currency markets focus on different factors over time. There are periods when relative inflation is dominant. During other periods, the external accounts drive the exchange rates, while other times interest rate differentials are key. The valuation model with the longest history is purchasing power parity, which is based on relative inflation rates. The thesis is that the exchange rate should act to balance prices between nations and so a country with higher inflation relative to another should have a weaker exchange rate to unify prices across countries. In practice, we find that not all goods are tradeable, inflation indices are not the same across countries and relative pricing parity models don’t account for capital flows. Although parity models often deviate from fair value, they can be useful when parity reaches an extreme.
This chart shows the German/U.S. parity model, which uses CPI from Germany and the U.S. to establish parity. Currently, the exchange rate is nearly two standard errors below parity, meaning the D-mark (or the euro) is undervalued relative to the dollar. As the chart shows, the exchange rate rarely stays around purchasing power parity. However, when it reaches the two-standard error level in either direction, it usually means the exchange rate will eventually reverse. It isn’t uncommon for the exchange rate to remain over or undervalued for a long period of time. However, we eventually do see a reversal from extreme levels. Usually, there is a catalyst that brings an adjustment to valuation. In 1985, it was the Plaza Accord which was specifically designed to weaken the dollar. The end of the second bull market was likely due to the end of the tech bubble in equities and the Bush tax cuts, which reduced the fiscal surplus.
It appears we are seeing two catalysts that may be signaling the end of this dollar bull market.
The reversal of monetary policy: The dollar initially rallied on the divergence of monetary policy. The Federal Reserve was ending QE and beginning to raise rates, while the Bank of Japan (BOJ) was expanding QE and the European Central Bank (ECB) was implementing QE and experimenting with negative interest rates. This kicked off the current dollar bull market that began in mid-2014. Although the FOMC is planning to raise rates further that action has been well telegraphed. At the same time, it appears the ECB is poised to raise rates and end its QE program. And, European economic growth has been strengthening, which will likely accelerate policy tightening. Even the BOJ is considering easing some of its support. Given the degree of dollar overvaluation, foreign policy tightening will likely weaken the dollar in the coming months.
Political turmoil is favoring foreign currencies: There is no lack of political turmoil in the developed countries. We have had two major elections in Europe thus far, with upcoming German elections in the fall and Italian elections expected in February. Brexit continues to roil Europe. Tensions are rising in the Far East as North Korea continues to test missiles and threaten its neighbors. When President Trump won the election in November, the dollar rose on expectations of trade restrictions, tax reform that would support repatriation and infrastructure spending which would boost growth. As the Trump administration has gotten sidetracked on other issues, these expectations have dwindled. Even though political risk remains high throughout the developed markets, the high dollar valuation and disappointment surrounding the president’s policies appear to be undermining the dollar.
If the dollar’s bull market is coming to a close, what can we expect? First, it gives a tailwind to foreign investment. Emerging markets, which have been strong this year, would likely receive further support if the dollar begins to weaken. Second, commodities would benefit. For example, our oil inventory/EUR model for oil prices indicates that a €1.30 would generate a fair value for oil near $78 per barrel, even with the current elevated level of inventories. Gold prices are traditionally supported by dollar weakness as well. The asset allocation committee will be weighing the likelihood of dollar weakness and take appropriate measures in the coming months.