Lift Off!

“Sorry," [Hamlet] said, rubbing his temples. "I don't know what came over me. All of a sudden I had this overwhelming desire to talk for a very long time without actually doing anything.”

― Jasper Fforde, Something Rotten

The scene: Large conference room in the Eccles Building, Federal Reserve.

Enter: Members of the Federal Open Market Committee.

Enter Chair Yellen: “To lift or not to lift, that is the question. Whether ‘tis nobler in the mind to suffer the slings and arrows of zero interest rate policies or to take arms against a sea of financial troubles and by opposing lift off the Fed funds rate.”

With all systems set on “GO,” the broadly-advertised and widely-anticipated lift off by the Federal Reserve from the zero-bound Fed funds rate is expected to take place this Wednesday, December 16. One would hope that the fate of the tragic Danish prince does not befall what comes afterwards. As a skeptic of unconventional monetary policies, we look at the impending action and potential consequences with trepidation.

We do not subscribe to the view held by some pundits that the likely rate rise does not matter. For one thing, the timing of the move comes on the heels of an ageing business cycle, characterized by tepid growth, wide gaps in capacity usage, and a low participation rate in the labor force. Also, despite significant restructuring of household balance sheets, there is still a lot of deleveraging needed to bring debt levels into better alignment with disposable personal income. This process seems to have started to reverse in the face of rising household indebtedness and weak wage growth. As our office mate, Al Wojnilower, points out, as the economy nears full use of labor, employment will grow more slowly. That might be 75,000 or 125,000 a month, not the 200,000 to which Wall Street has become accustomed.

Junk Bond Blues

Nor is the business side of the economy more reassuring. Business capex has been firing on only a few cylinders, while steep cutbacks are taking place in the energy and commodities sectors in the wake of collapsing prices. Importantly, thanks to massive issuance of long-term debt and equity redemptions through buybacks and mergers and acquisitions, the leverage of nonfinancial corporate balance sheets now stands significantly higher than prior to the 2007-08 financial crisis. Led by rising bankruptcies and defaults among energy and commodity companies, the junk bond market has already come under severe pressure. There is a risk that the tremors might spill over to leveraged loans and higher quality credits as a result of the Fed’s expected action, triggering a wider credit market turmoil. Considering that the economy has already lost considerable momentum this year, financial market instability and prospects for higher interest rates raise the odds of a recession in 2016. In that event, it might be too late for the Fed to come to the rescue by reversing course considering the lags of policy actions. A recession during an election year would not bode well for Fed independence.

Marching to its own drummer

The timing of the expected lift off is at odds with developments abroad, as well. Faced with lackluster growth prospects, the European Central Bank (ECB) has extended its quantitative easing (QE) program into 2017, while driving official rates deeper into negative territory. Similarly, with the Japanese economy back into recession, the Bank of Japan (BoJ) is left with no choice but to continue with massive QE infusions. Also committed to an easy monetary stance is China’s central bank (PBoC) in the face of a pronounced slowdown in growth as the country attempts to shift away from manufacturing and exports and towards more dependence on services.

Dollar Levitation

The Fed appears smug in its reading of the economy and feels that a rate rise is fully justified. This attitude is justified based on the Fed’s domestic-centric bias, but this leaves out currency considerations. The dampening effect of the dollar’s strength on domestic growth aside, the pain it has inflicted on emerging market (EM) currencies is a serious concern. As a result, the dollar’s strength has erased ten years of equity returns for dollar-based investors, and primarily accounts for the EM underperformance.

The turmoil in EM currencies is dangerous for it could easily spill over into credit markets, e.g., dollar-denominated EM corporate debt, which have already come under pressure as shown by widening credit spreads. EM debt has been a popular feeding ground for ETFs and index funds searching for yield. Any further selloff by these funds could bring a broader weakening of paper beyond EMs, including investment-grade corporate bonds and high yield paper. Given the links between credit markets and equities, the biggest question would be whether developments here could undermine equity markets in the US, Europe and Japan, where a lot of froth has been blown off in recent months.

There is the notion that the dollar’s strength would dissipate after the Fed’s lift off. This has been the pattern following the beginning of interest rate cycles. In the five such periods in the last 30 years -- 1986, 1994, 1999, 2004 and the rate spike in 2013 in reaction to “taper tantrum” -- the dollar gained almost 3 percent in the 120 days prior to the rate rise on a trade-weighted basis, only to slide 5.2 percent in the following year, according to Credit Suisse estimates. We consider such historical references largely irrelevant. In the words of L.P. Hartley, “The past is a foreign country; they do things differently there.”

In our view, dollar strength will be sustained in the period ahead propped up by, among other things, a tsunami of carry trade as a result of policy divergence and rising liquidity premiums in the face of spreading anxiety in the credit markets. Today, for example, it was reported that liquidity cracks were growing in the $400bn Danish mortgage-backed covered-bond market, Europe’s largest. And as Brendan Brown, chief economist at Mitsubishi UFJ Securities International in London and a member of our firm’s Board of Advisers, observes, “As always, liquidity risk premiums and credit risks premiums are correlated. Fears about growing illiquidity in debt markets spill over into other markets, where liquidity may be deteriorating for in part totally unrelated reasons.” It is not farfetched to trace recent pullbacks in the US stock market to rising pressures in the debt markets. This is another reason why we view the Fed’s intended lift off with great trepidation.

That Old Time Religion

The Fed’s reliance on a Keynesian model of the US economy, while appropriate in a closed economy, is outdated in today’s global marketplace. It is used to underscore the central bank’s new mantra of data-dependent policy and forward guidance, and it would be referred to, if not directly by name, to justify the lift off on December 16. Focusing on 5 percent unemployment in the midst of the lowest labor force participation rate in 40 years soundly debunks the Phillips curve, while capacity utilization rates, traditional precursors of inflation, carry no analytical weight in the face of global supply lines.

The Fed showed some sensitivity to international events last August following China’s currency devaluation and the global stock market’s spasm, but the Fed’s strong Keynesian DNA was in full display in “Inflation Dynamics and Monetary Policy,” Chair Yellen’s speech at the University of Massachusetts in Amherst last September. She mentioned “inflation,” defined as price increases of a broad group of goods and services, 174 times, but made only one reference to “asset prices,” and there was no mention of “asset price inflation,” or “asset bubbles,” the gifts of unorthodox Fed policies. There was also no mention of the money supply or the monetary base, a significant contributor to bank credit growth and under the direct control of the Fed. Professor Milton Friedman must be turning in his grave.

Normalizing monetary policy through a series of expected modest increases in the Fed funds rate and reassuring statements by the Fed of a gradual rise ahead is unlikely to allay fears of asset price deflation and its potential damage to economic activity worldwide. Looking ahead, project higher volatility, anemic growth and rising risk of policy accidents and shocks. Against this backdrop, we will continue with our investment strategy emphasizing US Treasuries and high-quality developed and EM sovereign bonds, reduced exposure to US equities, but significant positions in other developed market equities and, selectively, EM equities.

The Fed’s upcoming lift off is but the first act. Let us hope that in the following acts investors would be spared the tragic fate of Hamlet.