Strong Job Gains, Prospects For a Fed Rate Hike, BIS Warning, and Other Opinions

By the Curmudgeon

Introduction:

The one decision stock market continues--with very low volume and even lower volatility. We explore the possibility of a Fed rate hike in light of the strong job gains last month. We then contrast Fed Chair Yellen's recent remarks at an IMF conference with a warning from the Bank of International Settlements annual report. Opinions of those who think the Fed may be behind the curve (by not raising rates quick enough to prevent accelerating inflation) are presented along with a closing comment.

Note that Victor is on vacation this weekend, but will be back next week with his incisive, cutting edge comments.

Implications of July 3rd U.S. Employment Report:

With 288,000 new jobs created, Thursday’s employment report was much better than the consensus expected. The three-month moving average of payrolls growth is now 272,000 and the six-month moving average is 231,000 – the highest at any time during the economic "recovery." Payrolls growth has been above 200,000 for five consecutive months – the first time that has happened during the recovery.

The economy may finally have shifted into a higher gear, despite comments by respected economist John Williams of ShadowStats, who writes that the job gains are primarily due to "seasonal factor shenanigans."

After several strong employment reports, inflation above the Fed's 2% target, and after almost six years of ZIRP (Zero Interest-Rate Policy), do you think there's any chance of a Fed rate increase in the near future? Read on.....

Fed Won't Raise Rates to Prevent Irrational Exuberance:

On July 3rd, Fed Chair Yellen told an IMF audience in Washington that the Fed is more interested in having a resilient financial system that can cope when asset bubbles burst than it is in popping them through rate rises. That means there is little chance of a rise in interest rates to head off exuberant stock or bond markets, suggesting that investors will be allowed to inflate and collapse asset classes as long as the underlying financial system is strong enough to withstand shocks.

“I do not presently see a need for monetary policy to deviate from a primary focus on attaining price stability and maximum employment, in order to address financial stability concerns,” said Ms. Yellen. “Because a resilient financial system can withstand unexpected developments, identification of bubbles is less critical,” she added.

Do you really believe Yellen's last quote, especially with margin debt at record highs for months and HFT's not required to make a market in stocks that are sharply declining (like a specialist used to do)?

Monetary policy was too blunt a tool to tackle all but the most extreme financial risks, Yellen said, because there would be a cost in terms of high unemployment and below target inflation. “The potential cost, in terms of diminished macroeconomic performance, is likely to be too great to give financial stability risks a central role in monetary policy decisions, at least most of the time,” she added. That statement implies that there is not enough of a financial asset bubble to warrant a departure from Fed ultra-easy money policies.

In sharp contrast, former Fed governor Jeremy Stein and Kansas City Fed President Esther George argue the Fed should consider raising interest rates more aggressively to curtail the possible buildup of asset bubbles or other dangerous types of risk taking.

Bank for International Settlements Warning:

Yellen’s remarks also run counter to a warning from the Bank for International Settlements (BIS) in its annual report release June 29th. The BIS doesn't set policy but serves as a forum for central bankers to exchange views on relevant topics from the global economy to financial markets.

The BIS suggested short term rates should rise now to control financial speculation. They suggested policy makers should take advantage of the current upturn in the global economy to reduce the emphasis on monetary stimulus. It warned that taking too long to do this could have potentially damaging consequences, by encouraging investors to take on too much risk (as if they haven't done that already?).

"By mid-2014, investors again exhibited strong risk-taking in their search for yield: most emerging market economies stabilized, global equity markets reached new highs and credit spreads continued to narrow. Overall, it is hard to avoid the sense of a puzzling disconnect between the markets' buoyancy and underlying economic developments globally."

"Growth has disappointed even as financial markets have roared: The transmission chain seems to be badly impaired," the BIS continued.

[Over 2 years ago, the CURMUDGEON referred to the disparity between stock prices and the real economy as the "Great Disconnect." Since then that disconnect has gotten so wide it is beyond what I ever thought remotely possible.]

"Over time, policies lose their effectiveness and may end up fostering the very conditions they seek to prevent," BIS said. "The predominant risk is that central banks will find themselves behind the curve, exiting too late or too slowly," it added. BIS also noted that the U.S. has diverged from other countries which have kept monetary policy tighter than they otherwise would to boost financial stability.

The BIS was founded in 1930 and is the world's oldest international financial institution. Its 60 members (as of 29 July 2013) include the Bank of England, the European Central Bank, the U.S. Federal Reserve, the People's Bank of China and the Bank of Japan.

Fed Guidance on Short Term Rates (Fed Funds and Discount Rate):

In its most recent policy statement, the Fed indicated it has no plans to raise short term rates any time in the near future and they will keep rates below normal levels for some time thereafter.

"The Committee anticipates that it likely will be appropriate to maintain the current target range for the federal funds rate, for a considerable time after the asset purchase program ends. It’s the Committee’s current assessment that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrants keeping the target federal funds rate below levels the Committee views as normal in the longer run. This guidance is consistent with the paths for appropriate policy as reported in the participants’ projections, which show the federal funds rate for most participants remaining well below longer-run normal values at the end of 2016."

However, Philadelphia Fed President Charles Plosser (a voting member of the FOMC) said this week that he has "growing concerns that we may have to adjust our communications in the not-too-distant future. Specifically, I believe the forward guidance in the statement may be too passive."

Other Voices: When Should Rates Rise?

Several economists seem to agree with Mr. Plosser that the Fed should start to raise rates sooner than their forward guidance indicates.

“Every business survey we know is screaming that wage gains are set to accelerate rapidly, and companies are already seeking higher prices in anticipation of higher costs,” said Ian Shepherdson of Pantheon Macroeconomics. “The Fed is in real danger of falling behind the inflation story,” he added.

“The evident strength of the labor market in June is one of the key reasons why we think that the Fed will be persuaded to begin raising interest rates earlier than most expect,” said Paul Ashworth at Capital Economics. He expects wage growth to pick up in the second half of this year, with a first rate rise in March 2015. [NOTE: Wages have only grown 2% y-o-y due largely to slack in the labor force].

Roberto Perli of Cornerstone Macro LP wrote in a note to clients, "If the recent trend in the labor market continues, the next FOMC interest-rate projections should be even higher. With inflation approaching the 2 percent target and the unemployment rate continuing to decline, the odds that the Fed will lift rates off of zero sooner than the market expects are increasing.”

“The stellar jobs report hits the Fed right between the eyes on how good labor-market conditions out there truly are,” said Chris Rupkey, chief financial economist for Bank of Tokyo-Mitsubishi UFJ in New York. “It shows how far behind the curve they are,” he said, adding that he now expects the first rate increase in March next year instead of June.

The Fed has other tools to tighten monetary policy besides increasing the Fed Funds and Discount rates. They can also raise margin requirements (margin debt continues at record highs) and/or raise bank reserve requirements (which leaves banks with less money to lend or invest). They could also reduce their bloated balance sheet by ending the re-investment of expiring bonds and mortgage securities. Note that the Fed's tapering of asset purchases can't be seen as tightening, but rather as gradually reducing an extraordinary free money policy (QE).

Fiendbear/Curmudgeon Q &A:

Q: What will Yellen do when the stock/bond bubble bursts? She won't have the monetary tools Bernanke had, who in turn didn't have what Greenspan had. Each succession of Fed Chairs has brought with it more extreme, ultra-easy monetary policy.

A: My guess is that Yellen will stop tapering and restart QE. The Fed might also buy leveraged loans, junk bonds, or make cheap loans available to non-bank corporations. Agree with your statement of progressively easier and more extreme Fed policy from each of the last three Fed Chairs.

Q: What happened to the Bernanke led Fed saying they'd raise rates once unemployment is under 6.5% (it's currently 6.1% and trending lower)?

A: The Fed has backed off of that pledge, due to the weak economy and very low labor force participation rate (at 62.8% for the past three months- a 36 year low). Their most recent policy statement addresses your question:

"The Committee anticipates that it likely will be appropriate to maintain the current target (0 to 0.25%) range for the federal funds rate, for a considerable time after the asset purchase program ends." The Fed has been reducing its bond purchases by $10 billion a month at each monthly FOMC meeting. At that rate, the Fed is likely to end QE by the end of this September. The Fed funds rate won't be raised until "a considerable time" thereafter. To most Fed watchers, that implies a good six months or well into 2015 before the first Fed Funds increase.

Curmudgeon's Closing Comment:

The CURMUDGEON strongly believes that the Bernanke and Yellen led Fed have created huge stock/bond bubbles and removed all fear from the markets. We think those bubbles will eventually burst with very negative consequences for "investors," and real economy. We've argued for months that all the oceans of liquidity will disappear in a "flash." Record high margin debt and very low volume are a deadly combination when everyone wants to sell at the same time. As Victor has stated in several past Curmudgeon posts, the catalyst will be an unexpected event which the Fed can't control.

Yet the Fed seems totally oblivious to those risks, especially Yellen's talk to the IMF audience noted above. In this weekend's Financial Times, Hendy Sender wrote: "The longer (Fed) easy money continues, the trickier the exit and direr the consequences in the eyes of the debt markets. The desperate search for yield is considered an affirmation of Fed policies. The Fed wants to have its cake and eat it too. Might it be that the Fed has everything in reverse?"

In October 1955, Fed Chair William McChesney Martin said that it was the "Fed's job to take away the punchbowl just as the party was warming up."

That sound message has long since been forgotten by the last three Fed Chairs (Greenspan, Bernanke, and now Yellen), who have spiked the punch bowl, created and inflated huge financial market bubbles (like the one we are currently in). Easy money fueled the Dot Com bubble, the real estate/credit bubble, and now the stock/bond bubble. Where it goes, no one knows. C'est la vie.

Till next time........................

The Curmudgeon
ajwdct@sbumail.com

Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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