2 Charts That Might Define The Fed"s Jerome Powell Era

Authored by Daniel Nevins via FFWiley.com,

In September, we proposed a theory of the Fed and suggested that the FOMC will soon worry mostly about financial imbalances without much concern for recession risks. We reached that conclusion by simply weighing the reputational pitfalls faced by the economists on the committee, but now we’ll add more meat to our argument, using financial flows data released last week.

We’ve created two charts, beginning with a look at cumulative, inflation-adjusted asset gains during the last seven business cycles:

According to the way that the Fed defines its policy approach, our first chart stamps a giant “Mission Accomplished” on the unconventional policies of recent years. Recall that policy makers explained their actions with reference to the portfolio balance channel, meaning they were deliberately enticing investors to buy riskier assets than they would otherwise hold. Policy makers hoped to push asset prices higher, and they seem to have succeeded, notwithstanding the usual debates about how much of the price gains should be attributed to central bankers. (See one of our contributions here and a couple of other papers here and here.) But whatever the impetus for assets to rise, it’s obvious that they responded. In fact, judging by the data shown in the chart, policy makers could have checked the higher-asset-prices box long ago, and with a King Size Sharpie.

Consider the measure on the vertical axis, percent of personal income. From the risky asset trough in Q1 2009 through Q3 2017, households accumulated asset gains, in real terms, equivalent to 139% of personal income. (Nominal gains were much greater, but we used the CPI to deduct the amount of purchasing power that households lost on their asset holdings. Also, we defined asset holdings as the four biggest categories that the Fed computes gains for—equities, mutual funds, real estate, and pensions.)

In other words, households are enjoying an investment windfall that amounts to nearly sixteen months of personal income, which is larger than the windfalls accrued in any other business cycle since the Fed began tracking asset gains in 1947. Not only that but the gap continues to widen—as of this writing, we’re likely approaching 145% of personal income and well clear of the previous peak of 128% from the 1991–2001 expansion.

Getting back to policy priorities, the chart seems to tell us that asset prices no longer need boosting. The Fed’s pooh-bahs proved they could boss the investment markets, and they’ve almost certainly moved on to new endeavors.

Bull, bear, or donkey?

But record asset gains are just one of the reasons the Fed’s priorities are likely to be changing. To describe another reason, we’ll first show that policy makers may wield a King Size Sharpie but that it’s not a Permanent Marker:

As you can see, our second chart looks like the first, except that we pinned the tails on the asset price donkeys.

We tacked on the down halves of each cycle, showing that the portfolio balance channel has a reverse mode.

So what should we make of the result that asset price cycles, adjusted for inflation, have ended with busts that reverse a large portion and often the entirety of the prior booms?

According to our beliefs about how investment markets work, the up and down phases of asset cycles are closely connected. Also, monetary stimulus influences both phases at the same time. It helped fuel the giant gains of recent expansions, but it also helped create the imbalances that led to giant losses. And after the accelerated advances of 2016-17, it’s fair to wonder if today’s imbalances are approaching the extremes of 2000 and 2007. Even some FOMC members are gently acknowledging that risk.

But we think the committee members are even more concerned than you would know by just reading their meeting minutes. We expect financial imbalances to become their biggest worry, bigger than the risk of recession, which should matter less and less to the central bankers’ reputations as the business cycle expansion continues to lengthen. In fact, a garden variety recession would barely affect their legacies at all by mid-2019, when the expansion, if still intact, would become the longest ever. By that time, the FOMC’s greatest reputational threat would be another financial market debacle, which would suggest that manipulating asset prices maybe wasn’t such a good idea, after all. In other words, the committee’s reputational calculus will change significantly during Jerome Powell’s first few years as chairperson.

All that said, Powell probably wants a recession-free economy in, say, his first year or two in the position. Moreover, he’ll certainly stress continuity with his predecessors’ policies. But once he becomes comfortable in the job, the Fed’s priorities will look nothing like they did under Janet Yellen and Ben Bernanke. Instead of fueling asset gains, Powell’s biggest challenge will be containing imbalances connected to prior gains. He and his peers will aim to avoid pinning another oversized tail on the donkey—or at least to manage the fallout from said tail—and that’s a challenge that could very well define his regime.

"It's The Economy, Stupid... Not Drugs & Demographics"

Authored by Jeffrey Snyder via Alhambra Investment Partners,

The mainstream media is about to be presented with another (small) gift. In its quest to discredit populism, the condition of inflation has become paramount for largely the right reasons (accidents do happen). In the context of the macro economy of 2017, inflation isn’t really about consumer prices except as a broad gauge of hidden monetary conditions.

Therefore, if inflation behaves as it is supposed to after so many years of “stimulus”, then the political opposition to the status quo really is about racism and xenophobia. If, however, inflation underwhelms for now the sixth year and counting, there just might be something to this economic anxiety element of grand and growing political discord.

In many ways this isn’t a point of contention at all, merely a misreading of what policymakers are actually doing and why. The global economy really has suffered some horrible fate, but what? Inflation underwhelms because the economy does and has, but policymakers in 2017 are trying to figure out why in a way that leaves them blameless.

Any long-term GDP chart for any place shows clearly that it is small wonder political and social devastation took so long to start manifesting. That speaks to the power of Economics and the tremendous benefit of the doubt it began with, and then squandered. People largely believed Ben Bernanke when he said he knew what he was doing with QE2 (without ever accounting why he felt there needed to be a second) or Mario Draghi when he made his promise. The public did so because they wanted to believe such a big awful thing was fixable.

The media is still stuck on the idea of the economy being fixed, however, though policymakers have more than a year ago shifted to figuring out why it won’t ever be. Inflation for them is now the measure of who’s to blame, not what will happen.

Again, if inflation continues to underperform the 2% target here and elsewhere, even textbook Economics makes it a monetary reason. If it gets back to and above 2%, drug addicts and Baby Boomers would have been a legitimate structural drag, meaning QE failed because it stood no chance of ever working. You can see the stakes for central bankers as they have this year practically resorted to outright pleading, as if saying the thing over and over will increase the chances of it happening.

So it must have been some relief when earlier this year oil price base effects raised the CPI to above 2% for three months starting last December (and the HICP for only one month in Europe). It would stay above 2% for a total of five, but those last two were on the way back down again, clearly showing that it was oil not the opioid epidemic the public should turn to for answers.

Given the nature of its annual comparison, WTI was this July on an upswing whereas in July 2016 falling again. Crude oil’s contribution to consumer price inflation last month is once more significantly positive, meaning that in all likelihood on Friday when the BLS reports the CPI for July it will be accelerated from four straight months of “unexpected” weakness. There will certainly be much crowing and rejoicing.

But it won’t matter for more than just a single news cycle, not the least of which because of the bond market that policymakers and especially economists (therefore the media) just can’t (or refuse) seem to understand.

“The market has paid a lot more attention to inflation than in recent years, simply because that has the potential to be what changes the Fed’s mind on further rate hikes,” [said Gennadiy Goldberg, an interest-rate strategist at TD Securities]. This week’s report “has a pretty substantial amount of power to push rates to annual lows or getting us off those lows and pushing rates higher.”

Once again, no, no, and no. The bond market takes no cues from monetary policy except if it views that policy to be effective. Interest rates rise because of opportunity, not because the Fed attempts to command it with the federal funds rate as in 2016, 2004, or even 1994. There is no “hawkishness” or “dovishness” by itself, instead the interpretation of “hawkishness” if things are actually getting better or “dovishness” if they aren’t. This other convention where the Fed is at the center of everything just doesn’t wash.

It presupposes infallibility which has been proven not to exist. Presumably the Fed’s “hawkishness” derives from its proficiency in economic interpretation. Therefore, bond rates would rise not based on monetary policy action per se, but rather agreeing with the Fed’s interpretation of what “hawkishness” means as far as economic opportunity. To claim that the bond market must follow monetary policy is to simultaneously claim that the FOMC is always right; and further that bonds must always defer in that judgment to these economists.

The bond market does not do this, though it does take into consideration central bank judgment as part of its stream of information. Before the summer of 2011, the bond market largely agreed with FOMC assessments. By and large, though, ever since 2011 the bond market which is always free to disagree with them about the economy or even the state of monetary function has exercised that freedom and in convincing fashion. From 2013 forward, nominal rates should have risen and curves steepened as economists and policymakers declared QE3 a resounding success, with particular emphasis on the unemployment rate. The bond market was correct, not economists.

What drives UST yields or eurodollar futures prices is therefore not “hawkishness” or “dovishness”, but rather perceptions about whether “hawkishness”, “dovishness”, Trump, or even Paul Krugman’s fake alien invasion scenario will amount to anything positive and the significance of it. It is the translation of current conditions into considerations about the future, captured in prices and yields – the actual discounting of information, of which monetary policy is only a (variable) part.

And oil prices factor to a much higher degree than Janet Yellen for these reasons. It is oil that moves the CPI (or PCE Deflator) which is a very negative commentary on the economy tomorrow as well as today. Unless oil prices really break higher, then the bond market gives far more weight to what the FOMC members would all rather never consider – the problem really is money and economy rather than drugs and demographics.

"Psycho"

Gold remains inside its 5 year wedge with no clear trend yet revealed.

But there are a number of near-term potential catalysts such as the German Elections, Debt Ceiling Debate & Commitment of Traders positioning  which may help give some clarity.

In the meantime, "People are literally losing their minds.”

So says Santiago Capital"s Brent Johnson in this clip regarding gold, global markets and cognitive dissonance.

 Whether it"s those on the Left that cannot handle Trump in the White House, or those on the Right who can’t understand how CNN is still in business.  Whether it"s the gold bugs who can’t understand why gold is not over $10k/ounce, or the equity bears who think equities are overvalued by at least 50%.   They cannot reconcile the fact that their minds are saying one thing while simultaneously trying to comprehend the information being broadcast on their T.V.s and computer monitors.

Tracing the source of this cognitive dissonance back to the real “Seven Psychopaths” (voting members of the FOMC), Johnson asks you to just listen (and keep an open mind) to see whether you are guilty of psychotic thinking as well.

While referencing characters from real life and the movies,  Johnson wonders whether the bears are overly focused on the equity market (symptom) rather than where the real psychos are focused, which is the bond market (problem). 

And also wonders, based on studies showing that “The feeling of knowing” is based on an involuntary brain mechanism much like lover or anger, is it reason or biology that is determining our opinions on the markets?

Johnson believes the danger that most people don’t see is in interest rates.  And whether due to a currency crisis, sovereign debt crisis, or the simple forgiveness of G20 sovereign debt,  rates may very well rise further and faster than most currently see possible. 

In the end, fundamentals always win.  But in the short term, markets are Psycho.

Ahead Of The Fed: Strongest Demand For 2Y Paper Since 2015; Lowest Dealer Award On Record

With the FOMC members currently huddling deep inside the bowels of the Marriner Eccles building, perhaps scheming how to spook markets by announcing a surprise rate hike tomorrow, one would have assumed demand for 2 Year paper in today"s auction would be less than stellar. One would be wrong, because moments ago the Treasury sold $26bn in 2 year paper to what was clearly an overabundance of demand: the high yield of 1.395% stopped through the When Issued 1.401% by 0.6 bps, and was the highest yield going back to October 2008.

The bid-to-cover rose to 3.06 from 3.03 in June, and was above the six previous auction average of 2.84. It was also the highest Bid to Cover since November 2015.

The internals were also rather impressive, with Indirects taking down 58.5%, above the 56.6% in June, and above the 6MMA of 54.1%. Directs were awarded 16.9%, down slightly from 18.4% last month and above the 6 month average of 13.7%. Combined these two meant record buyside interest, leaving Dealers with just 24.6% of the auction, down from 25.0% and below the 32.1% 6month average. This was the lowest Dealer award on record.

In other words, if anyone was worried about a surprise announcement by the Fed tomorrow, one which would send 2Y yields spiking, it wasn"t to be found among the bidders for today"s auction.

Visualizing "Conundrum 2.0": This Is What The Fed Is Missing

While it may come as a surprise to the current crop of 17-year-old hedge fund managers, the current period of persistently low long-term interest rates and plunging, near reocrd volatility in the face of a  hawkish Fed and rising short-term rates, is hardly new: exactly the same happened from 2004 through 2006, despite the Fed"s continued rate hikes and jawboning. Alan Greenspan, the Fed"s Chair at the time, called this phenomenon a "conundrum" and blamed it on many things, including the global savings glut. 

And, as the latest FOMC minutes demonstrated, the current period of especially loose financial conditions despite a projected 3 rate hikes in 2017 coupled with a balance sheet rolloff is likewise confusing the Fed. Deutsche Bank has called this "Conundrum 2.0."

So, in an attempt to explain what the Fed is missing as it stubbornly hopes to push LT rates higher and risk prices lower, Deutsche"s financial strategists believes the causes of long-term rate decline to be as shown in the chart below: they think that rate declines are largely being caused by four factors:

1. disappointment over policy of the Trump administration (pink),


2. geopolitical/political risk outside the US (orange),


3. increased demand for and decreased supply of bonds (yellow) and


4. concerns about slowing US and Chinese economies (grey).

At the same time, Deutsche believes the causes of rising share prices in a time of declining long-term rates, are shown in the bottom right quadrant on the chart below. The first of these is

1. an “excess liquidity spiral”. In the absence of risk-off factors, declining long-term rates (with the added impact of a weakening USD) give rise to excess liquidity. Pension funds/individuals/insurers strengthen their risk-taking stance to compensate for reduced income from government bonds and the like. Strengthening of the risk-taking stance brings about decreases in long-term rates through aggressive acquisition of term risk.


2. Strengthening of the risk-taking stance acts to reduce the risk premiums required by investors, boosting stock market valuations (P/Es).


3. Naturally, 3) a reduced risk-free rate acts to increase P/E (Note: theoretically, P/E = 1/ (discount rate – growth rate). If the growth rate is zero, P/E is 10x based on a discount rate (risk-free interest rate + risk premium) of 10% and rises to 20x when the discount rate falls to 5%.)


4. USD weakness acts positively on US-listed companies" profits (EPS).

And charted:

DB also believes that these conditions, which lead to "excess liquidity" markets, also explain the dramatic moves in FAANG stocks in 2017.

Looking at the transition from "low-volatility, high-dividend shares to high-volatility, low-dividend shares", the German bank says that in recent months, shares with low volatility and high dividends are seen as alternatives to bond investment. Amid falling interest rates, risk-taking money had not been satisfied with investing only in defensive stocks as an alternative to bonds, but had also been investing in technology stocks.

Interest rates (investment yields) have trended back downward since 2H of last December, prompting greater risk-taking (see chart above), and "amid the slowdown in corporate earnings growth, the market focused on technology stocks like FAANG with robust fundamentals."

As a result, the implied volatility of technology stocks in January-May had dropped to the level of defensive stocks in early 2016. Investors who had bought defensive stocks as an alternative to bonds when yields were in decline at the start of last year could buy technology shares in terms of risk volume.

This is whay tech shares offered the best return in the Jan-May period, something which as Bank of America showed yesterday has led to the best outperformance for the mutual fund industry since 2009. As shown in Figure 32, the volatility of excess returns in US technology stocks was around one-third that of defensive stocks. Technology shares had lower dividend yields than defensive stocks, but the difference was tiny, comparing with the scale of excess returns in line with price movements (Figure 32). We see that technology shares had the lowest risk and highest returns this year through May. The financial sector largely underperformed due to the low interest rate.

Inversely - and obviously - rising long-term rates have an adverse effect on excess liquidity, damaging the P/Es of US technology shares, which were in the front-line of risk-taking (Figure 31).

The first verbal intervention in two years by Fed Chair Janet Yellen and other members of the FOMC, whose de-risking comments in the last week of June sent yields higher and risk lower...

27 June 2017, Yellen, Fed, Chair, “Look high, but there’s no certainty about that.”... “Asset valuations are somewhat rich if you use some traditional metrics like price earnings ratios, but I wouldn’t try to comment on appropriate valuations, and those ratios ought to depend on long-term interest rates.”

26 June 2017, Dudley, New York Fed, President, "Monetary policymakers need to take the evolution of financial conditions into consideration.", "When financial conditions ease, as has been the case recently, this can provide additional impetus for the decision to continue to remove monetary policy accommodation

27 June 2017, Fisher, Fed, Vice Chair, “So far, the evidently high risk appetite has not led to increased leverage across the financial system, but close monitoring is warranted.”

... also had an adverse impact on the sector. In a turnaround from Jan-May, return on risk for technology shares has deteriorated greatly from June (Figures 32 and 33).

As such keep an eye on tech for the market"s interpretation of just how serious, and credible beyond the already loose financial conditions, the Fed"s tightening threat truly is.

"The Paint May Be Drying, But The Wall Is About To Crumble": BofA Explains What The Market Is Missing

One of the recurring laments about the Fed"s hiking cycle, most recently from Goldman, is that despite 2 rate hikes so far this year, financial conditions remain the loosest they have been in over two years.Whether that is due to the market being so drunk on the Fed"s "punch bowl" it is unable to grasp the liquidity is being dragged away, or for some other unknown reason despite repeated warnings by FOMC members that stocks here are overvalued, markets simply refuse to concede that financial conditions should be tighter, in fact, as Goldman observed yesterday "so far, the Fed’s efforts to tighten financial conditions have achieved too little, not too much."

That, in the view of Bank of America"s rates strategist Shyam Rajan is a big mistake because as he explains in his latest note titled "When paint dries, does the wall crumble?" despite the market"s repeated unwillingness to acknowledge what the Fed is doing, "recent market moves mark the beginning of a prolonged tightening of financial conditions."

And, more notably, he underscore that despite the benign financial condition regime, the market is missing one key thing: in light of what the market perceives as a "benign flow effect" the risk currently is in the the Fed"s balance sheet "stock" and adds that "we think the market is complacent on the stock effect of the Fed"s balance sheet decline. Specifically, higher deposit betas, UST supply and/or real rates could all trigger significantly tighter financial conditions."

To underscore his point, Rajan shows the following chart which shows just how vast the upcoming normalization will be, in light of the moves for both inflation expectations and real rates that took place during QE2 and QE3, and how small the unwind has been so far under the Fed"s tightening regime. As Rajan explains further (more below), "ever since the conversation for the Fed shifted from hikes to balance sheet after the March meeting, we have seen a significant increase in real rates and a decline in inflation expectations: the anti-QE trade. Recall that the primary objective of an expanded balance sheet was to push real yields lower (when the nominal funds rate was constrained at 0) and inflation expectations higher. As shown in our Chart of the day, when looked at through that lens, the reversal over the last few months is just the beginning of a long process."

Rajan"s main point, as noted above, is that while the market has remained focused on the central bank flow which it - erroneously - assumes will not be a major risk factor, what the market should be looking at instead is the stocks. He explains:

With rate hikes in the background, market and policymakers’ attention has squarely moved to the Fed’s balance sheet. In this regard, over-communication from Fed officials to prevent a repeat of the taper tantrum has  no doubt helped. Repeated emphasis on the balance sheet being a “passive tool” and the tapering reinvestments being equivalent to “watching paint dry” seem to have convinced markets that the initial steps ($6bn UST, $4bn MBS runoffs) are unlikely to cause disruptions. Yet, while the market appears very comfortable with the flow effect, we think the longer-term stock effect is underappreciated.

Specifically, we identify three areas where the market seems most complacent going into the unwind experiment.

1. Does the balance sheet unwind lead to an increase in deposit betas sooner than expected?


2. Can the resulting increase in Treasury supply have a significant impact on yields?


3. Will the increase in real yields have knock-on implications for other asset classes? All three signal a significant, albeit slow moving, tightening of financial conditions up ahead.

Going back to a point we have pounded the table on since 2011, Rajan notes that the excess reserves created by the Fed have created a liquidity illusion on bank balance sheets, in the form of excess deposits (the same excess deposits which not only are not inert as many erroneously assume, but are in fact what JPM"s London Whale used - as collateral - to corner the IG market with notable consequences).

It is these deposits that wil now contract as the Fed proceeds to normalize.  Here is Rajan:

Ultimately, as the Fed’s balance sheet shrinks, so does the banking systems’. On the asset side, banks lose cash (excess reserves) while on the liability side deposits leave (to absorb the new Treasury supply) triggering a mirror image decrease of the Fed’s sheet. However, critical to this process is the kind of deposits that leave the banking system. Although consensus remains that given the $2.1tn in excess reserves, competition for deposits will be non-existent, this assumption is heavily reliant on the less stable deposits leaving the system first (corporate, non-operational, etc.) before the more stable ones (FDIC insured retail deposits). Were the first run-offs in October to trigger the more LCR friendly retail deposit outflow, significant knock-on implications could result:

• Deposit betas will be projected to rise faster than expected resulting in a repricing of the asset side of bank’s balance sheets (loans, mortgages etc.;


• If deposit rates were to increase (and deposit-IOER spreads decline), demand for short-dated fixed income, especially at current levels (close to IOER) is likely to dramatically reduce.


• Third, cash will increasingly become an attractive asset to rich valuations across asset classes. This would reduce the safe haven premium of USTs to hedge against a risk-off.

Then there is the issue of issue of Treasury supply-demand imbalance, something we first touched upon at the start of the month in "BofA: "If Bonds Are Right, Stocks Will Drop Up To 20%." This point can be summarized simply as follows: there is $1 trillion in excess TSY supply coming down the line, and either yields will have to jump for the net issuance to be absorbed, or equities will have to plunge 30% for the incremental demand to appear. 

Rajan summarizes these concerns below:

An unwind of the Fed’s balance sheet also increases UST supply to the public. Ultimately, the Treasury needs to borrow from the public to pay back principal to the Fed resulting in an increase in marketable issuance. We estimate the Treasury’s borrowing needs increase roughly by $1tn over the next five years due to the Fed rolloffs. However, not all increases in UST supply are made equal. This will be the first time UST supply is projected to increase when EM reserve growth likely remains benign. Note both the 2003-06 and 2009-13 increase in UST supply were met with the largest increase in Chinese buying of USTs. With this unlikely to repeat, we believe price sensitive buyers need to step up. Our analysis suggests this would necessitate a significant rise in yields or a notable correction in equity markets to trigger the two largest remaining sources (pensions or mutual funds) to step up to meet the demand shortfall. Again, this is a slower moving trigger that tightens financial conditions either by necessitating higher yields or lower equities.

Readers can read the full analysis of the Treasury"s dilemma at the following link.

Treasury market dynamics aside, BofA says that the third, and perhaps most important, aspect of renormalization is that the forward path of the balance sheet decline is already having an impact on one market in the form of rising real yields:

Ever since the conversation for the Fed shifted from hikes to balance sheet after the March meeting, we have seen a significant increase in real rates and a decline in inflation expectations: the anti-QE trade (Chart 3). Recall that the primary objective of an expanded balance sheet was to push real yields lower (when the nominal funds rate was constrained at 0) and inflation expectations higher. As shown in our Chart of the day, when looked at through that lens, the reversal over the last few months is just the beginning of a long process.

The message from this combination (higher real rates, lower breakevens) is that even though there is a decline in nominal interest rates, the composition is a “bad” decline.

Besides rates, the "bad" decline shown above is negative for risk assets because ultimately "lower inflation expectations (if right) should lower forward earnings growth estimates (as earnings grow with nominal GDP) while higher real rates should raise discount rates for these earnings: an unfriendly outcome for risky assets."

Which brings us to Ra"jan"s gloomy conclusion: "Ultimately, all three of the above – a repricing of the asset side on bank balance sheets higher, higher term premium because of UST issuance, and higher real yields – signal tighter financial conditions up ahead."

 While slow moving, the knock-on impact on asset classes either through a shift in the underlying supply or demand dynamics is significant. We remain a structural bear on real rates to position for this scenario.

And, if right, the conclusion by the BofA strategist is precisely what Yellen, Fischer, Dudley and others have been desperate to communicate to the market over the past 5 months - unsuccessfully - when pointing out as recently as Tuesday, that “Asset valuations are somewhat rich if you use some traditional metrics like price earnings ratios, but I wouldn’t try to comment on appropriate valuations, and those ratios ought to depend on long-term interest rates."

Judging by stocks" reaction to the latest yield spike, the market may be finally getting it.

Your Last Minute FOMC Preview: "Will It Be A Dovish Hike Or Not"

Courtesy of RanSquawk

• The FOMC is seen raising the Fed Funds Rate target by 25bps to 1.00-1.25% at 1400EDT, but the main focus will be on the hike trajectory


• Updated economic projections will be published, and there will be a post-meeting press conference with Chair Janet Yellen


• Analysts aren’t expecting any dramatic changes in the Fed’s updated forecasts and ‘dot-plots’


• Traders will be looking out for details on how the Fed intends to begin shrinking its balance sheet


• Rate decision announced at 1400EDT (1900BST) along with updated forecasts; press conference with Chair Yellen begins at 1430EDT

RATES: MARKETS AREN’T BUYING INTO THE FED’S TRAJECTORY

• The FOMC is expected to raise its overnight federal funds rate (FFR) target by 25bps to 1.00% to 1.25%, in what would be its second hike of 2017. Fed Funds Futures were pricing in a 95% implied probability that rates will be lifted – at one point last week, that probability was over 99%.


• With the rate rise pretty much a done deal, the focus is likely to be on the Fed’s rate hike trajectory. Currently, Fed Funds futures aren’t buying into the Fed’s forecasts which looks for a total of three hikes per annum in 2017, 2018 and 2019. The December 2017 contract implying a rate of 1.25% (suggesting just two hikes in 2017); 1.51% at the end of 2018 (suggesting just two hikes between now and the end of 2018); and 1.695% by the end of 2019 (suggesting three hikes between now and then).


• Given that the rate hike is so heavily discounted, the market reaction isn’t likely to take its cues from the rate hike; instead it will look to the FOMC’s projections of the rate path, and perhaps its balance sheet reduction pace. Consequently, if the central bank refrained from lifting rates, an aggressive, dovish market reaction may be likely.

LABOUR MARKET: CONTINUES TO STRENGTHEN

• The labour market continues to tighten, and with the exception of the Fed’s dovish Neel Kashkari, voting members of the FOMC seem to be encouraged by the progress.


• While the pace of monthly nonfarm payroll additions has slowed, the rate of joblessness has fallen to a 16-year low at 4.30%, and beneath the Fed’s current estimate of NAIRU (non-accelerating inflation rate of unemployment). Even the U6 measure of underemployment has fallen to the lowest since 2007.


• The most recent JOLTs data, one of the FOMC’s favoured measures of labour market health, rose above six million openings for the first time. Oxford Economics’ analysts say the data shows job openings are now outpacing hiring, and this suggests that companies are having a hard time finding qualified workers amid a tight labour market.

Recent FOMC Labour Market comments:

• FOMC May 2017 Statement: The labor market has continued to strengthen even as growth in economic activity slowed


• FOMC May 2017 Statement: Job gains were solid, on average, in recent months, and the unemployment rate declined


• FOMC May 2017 Statement: Labor market conditions will strengthen somewhat further


• Fed’s Brainard (voter): Labour market strength has outstripped what most researchers see as steady state (23/May)


• Fed’s Kashkari (2017 voter): May be more slack in the labour market (23/May)


• Fed’s Harker (2017 voter): There is very little labour market slack left in the US (2/Jun); Labor market at full health (12/May)


• Fed’s Kaplan (2017 voter): There is not a lot of slack left in the labour market (30/May); US approaching full-employment (20/Apr)


• Fed’s Yellen: Labour market now at normal state (10/Apr); Labour market participation sign of improving conditions (15/Mar)

INFLATION: FED EXPECTED TO LOOK-THROUGH THE WEAKER INFLATION PROFILE

• In contrast to the firming labour market, inflation data, especially after today"s third consecutive CPI miss, has been moving away from target. PCE inflation – the FOMC’s preferred gauge of price pressures – have been easing since Q1 and at 1.70%, currently lies at the bottom-end of the Fed 2017 central tendency estimate. Core PCE, meanwhile has fallen beneath the central bank’s central tendency forecast at 1.50%.


• Market gauges of inflation have also been coming off, as seen by the 2y2y and 5y5y inflation swap forwards, which have both been steadily falling as traders become sceptical about the prospects of Trump’s fiscal agenda materialising in the short-term; the 5y5y measure has nearly wiped-out the ‘Trumpflation’ bounce it saw since November 2016.


• Consumer gauges of inflation have also been falling. The NY Fed’s most recent survey found consumer expectations falling to the lowest levels since early 2016, with the survey noting “inflation uncertainty” among respondents.


• Analysts at Deutsche Bank believe that the Fed will address the weak profile of inflation: “They could note that inflation has eased recently, and if so will likely also say that they view this easing as being largely transitory,” the bank writes, adding “the centre of the Committee likely remains reasonably confident that solid growth momentum and further progress in the labor market should keep inflation on track despite the recent downside inflation surprises.”

Recent FOMC inflation comments:

• FOMC May 2017 Statement: Inflation measured on a 12-month basis recently has been running close to the Committee"s 2 percent longer-run objective.


• FOMC May 2017 Statement: Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed


• FOMC May 2017 Statement: inflation will stabilize around 2 percent over the medium term


• Fed’s Harker (2017 voter): Inflation still on track despite recent softness; sees it hitting Fed’s 2% inflation goal around the end of 2017 (2/Jun)


• Fed’s Powell (voter): Good reasons to predict rebound in inflation, slow inflation progress means Fed should be patient with hikes (1/Jun)


• Fed’s Kaplan (2017 voter): Uneven recent inflation a concern, but price pressures likely building, inflation not ‘running away’ from Fed (1/Jun)


• Fed’s Brainard (voter): Lack of progress on inflation ‘a source of concern’, may want to delay hikes if inflation continues to slow (30/May)


• Fed’s Evans (2017 voter): Sees a serious ‘miss’ on the Fed’s inflation target from 2009 to now; could be ok with one more hike if there are more uncertainties about the inflation outlook (12/May)

DOVISH HIKE

• The divergence in the performance of labour market and inflation data, combined with aggressive market pricing, has presented the Fed with a conundrum. As such, many analysts are expecting a so-called “dovish hike”.


• Analysts at Bank of America Merrill Lynch believe the Fed will attempt to deliver a dovish hike, where a 25bps rate rise will be accompanied by unchanged dot plots, while the statement will continue to reiterate weakness in inflation is transitory.


• “This would go hand-in-hand with a downward revision to core PCE inflation this year, but maintaining the 2% forecast for next year. We also think the unemployment rate will be revised lower, but as will the Fed"s estimate of NAIRU.”


• BAML also believes that the delivering the so-called dovish hike may prove challenging: “Subdued rate expectations suggest it may be challenging for the Fed to communicate a dovish hike, given the recent shift in market pricing,” the bank says, adding “this could raise policy mistake risks shown in the rates market and lower inflation breakevens. USD impact is expected to be muted, but a negative surprise could come from lower dots.”

FOMC UPDATED PROJECTIONS: UNLIKELY TO SEE MAJOR ADJUSTMENTS

• Analysts are more-or-less in-line with the Fed’s view of growth this year, though are slightly more optimistic in 2018 and 2019, leaving scope for upward biases to the Fed’s growth projections.


• Analysts and the FOMC are generally in-line with each other. It will be interesting to see whether the Fed lowers its assessment of NAIRU given the current low unemployment rate is failing to stoke inflationary pressures.


• Inflation is the area where the Fed may make notable changes to its forecast. The consensus view is 0.2ppts softer than the Fed’s forecast for 2017, though is generally in-line for 2018-19.


• Fed funds are not pricing in a hike trajectory as aggressive as the Fed foresees.

BALANCE SHEET PLANS

• The FOMC has signalled its intentions to begin the process of balance sheet normalisation, and in May’s minutes proposed setting a fixed amount that would be allowed to ‘run-off’ from the balance sheet from maturing securities that it holds, with that level being lifted over time – as the levels are raised, reinvestments will decline.


• But save for the pledge that such normalisation would be conducted in a “gradual and predictable manner”, the logistics remain unclear: when will it begin; what will the ‘cap’ be set at; what size does the Fed want to shrink its balance sheet to, and over what timeframe; how will balance sheet normalisation impact the rate hike trajectory, etc.

Trader: "Equities Are In A World Of Their Own"

"You know what made yesterday so much fun? For a brief window of opportunity we were able to envision a lot of green shoots globally and talk in the context of a whole set of crystal champagne flutes half-full. Which central bank might be the next one to surprise with a hawkish spin was actually a topic. Speculation, idle or not, on widespread retractions of liquidity was good news, not of that soul-crushing bad news is good news variety."

Frankly, writes former trader and Bloomberg editor Richard Breslow "it was the first time in a long time, I could say markets were compelling."

As Breslow notes, The dollar was up, as were sovereign yields. Gold was through an important first line of support and equities more than kept their composure. Fed speakers stayed on message, Draghi’s speech today was eagerly awaited. Sterling held near recent highs as traders debated how many dissenters there might be at Thursday’s MPC meeting over keeping rates on hold. And then events tried to conspire to rob me of all of my sanguineness.

As I read the comments from the North Korean ambassador and then the reactions to the news from Washington, I kept crooning, “Mama, don’t take my rosy glasses away.”

It strikes me that the bellicose comments amount to little. Been there done THAAD. The market reaction, modest as it was, was more an end of day squaring after nice moves than any sort of sea change of opinion.

The White House announcement is more problematic even if the comparisons to Watergate are grossly overdone. The seriousness of that episode shouldn’t be marginalized by the necessities of the 24/7 news cycle of today. The investing issue here is no one really knows what it might mean. And won’t do for a long while. What it means for future policies and governance is unclear. What if he picks a really good or bad successor to James Comey?

I know we love to indulge in being serially outraged, whether justified or not. But markets have also shown a bizarre, at times mystifying, willingness to ignore events that seem to justify immediate repercussions. We’ve had to learn to separate our politics from trading. Which isn’t an easy thing to do.

So what are some obvious things to watch as indicators of whether Tuesday’s trading was merely range extension or the start of something new and interesting? Was the news seminal or transitory? Gold above or below the 1220 pivot is a good start. We didn’t manage a close through that level.

The 10-year Treasury can use a pivot of the ~2.40% yield, but needs to close above there. Not a big ask, nevertheless a meaningful one. It’s hard to think the Fed will change its tune, but markets have probably put a bigger weight in their forecasts on tax cuts and other fiscal policy proposals than the members of the FOMC are willing to admit are embedded in theirs.

ECB President Mario Draghi’s comments today stuck to an important script that supports the dollar. Things have definitely gotten better but “the time hasn’t come to think about QE exit.”

Upbeat, but clearly not a surrender to the German faction. No headwind for the Fed, but no rate competition either. The dollar index needs to hold above 99. That gives only one-half percent to play with.

Breslow sums up the trading environment perfectyly... As far as equities are concerned, they’re in a world of their own. The S&P 500 up or down a percent will tell you nothing. Meanwhile, I retain all of my biases intact and wait and see.

How OPEC Lost The War Against Shale, In One Chart

At the start of March we showed a fascinating chart from Rystad Energy, demonstrating how dramatic the impact of technological efficiency on collapsing US shale production costs has been: in just the past 3 years, the wellhead breakeven price for key shale plays has collapsed from an average of $80 to the mid-$30s...

... resulting in drastically lower all-in breakevens for most US shale regions.

Today, in a note released by Goldman titled "OPEC: To cut or not to cut, that is the question", the firm presents a chart which shows just as graphically how exactly OPEC lost the war against US shale: in one word: the cost curve has massively flattened and extended as a result of "shale productivity" driving oil breakeven in the US from $80 to $50-$55, in the process sweeping Saudi Arabia away from the post of global oil price setter to merely inventory manager.

This is how Goldman explains it:

Shale’s short time to market and ongoing productivity improvements have provided an efficient answer to the industry’s decade-long search for incremental hydrocarbon resources in technically challenging, high cost areas and has kicked off a competition amongst oil producing countries to offer attractive enough contracts and tax terms to attract incremental capital. This is instigating a structural deflationary change in the oil cost curve, as shown in Exhibit 2. This shift has driven low cost OPEC producers to respond by focusing on market share, ramping up production where possible, using their own domestic resources or incentivizing higher activity from the international oil companies through more attractive contract structures and tax regimes. In the rest of the world, projects and countries have to compete for capital, trying to drive costs down to become competitive through deflation, FX and potentially lower tax rates.

The implications of this curve shift are major, all of which are very adverse to the Saudis, who have been relegated from the post of long-term price setter to inventory manager, and thus the loss of leverage. Here are some further thoughts from Goldman:

• OPEC role: from price setter to inventory manager In the New Oil Order, we believe OPEC’s role has structurally changed from long-term price setter to inventory manager. In the past, large-scale developments required seven years+ from FID to peak production, giving OPEC long-term control over oil prices. US shale oil currently offers large-scale development opportunities with 6-9 months to peak production. This short-cycle opportunity has structurally changed the cost dynamics, eliminating the need for high cost frontier developments and instigating a competition for capital amongst oil producing countries that is lowering and flattening the cost curve through improved contract terms and taxes.


• OPEC’s November decision had unintended consequences: OPEC’s decision to cut production was rational and fit into the inventory management role. Inventory builds led to an extreme contango in the Brent forward curve, with 2-year fwd Brent trading at a US$5.5/bl (11%) premium to spot. As OPEC countries sell spot, but US E&Ps sell 30%+ of their production forward, this was giving the E&Ps a competitive advantage. Within one month of the OPEC announcement, the contango declined to US$1.1/bl (2%), achieving the cartel’s purpose. However, the unintended consequence was to underwrite shale activity through the credit market.


• Stability and credit fuel overconfidence and strong activity: A period of stability (1% Brent Coefficient of Variation ytd vs. 6% 3-year average) has allowed E&Ps to hedge (35% of 2017 oil production vs. 21% in November) and access the credit market, with high yield reopen after a 10- month closure (largest issuance in 4Q16 since 3Q14). Successful cost repositioning and abundant funding are boosting a short-cycle revival, with c.85% of oil companies under our coverage increasing capex in 2017.

That said, the new equilibrium only works as long as credit is cheap and plentiful. If and when the Fed"s inevitable rate hikes tighten credit access for shale firms, prompting the need for higher margins and profits, the old status quo will revert. As a reminder, this is how over a year ago Citi explained the dynamic of cheap credit leading to deflation and lower prices:

Easy access to capital was the essential “fuel” of the shale revolution. But too much capital led to too much oil production, and prices crashed.  The shale sector is now being financially stress-tested, exposing shale’s dirty secret: many shale producers depend on capital market injections to fund ongoing activity because they have thus far greatly outspent cash flow.

This is the key ingredient of what Goldman calls the shift to a new "structural deflationary change in the oil cost curve" as shown in chart above. As such, there is the danger that tighter conditions will finally remove the structural pressure for lower prices. However, judging by recent rhetoric by FOMC members, this is hardly an imminent issue, which means Saudi Arabia has only bad options: either cut production, prompting higher prices and even greater shale incursion and market share loss for the Kingdom, or restore the old status quo, sending prices far lower, and in the process collapsing Saudi government revenues potentially unleashing another budget crisis.

Did The Fed Just Hint At Monster Inflation?

We won’t bore you with yet another article about the recent rate hike by the Federal Reserve. This move was widely expected, as the Fed members had been hinting this would happen for several months now. Additionally, the new ‘hints’ about an additional two rate hikes later this year also didn’t surprise the market as we believe this was already priced in. The slight hike in the Federal Funds Rate estimate for 2019 to 3% (from 2.9%) didn’t see to worry the markets as the indices were all sent higher on the back of the FOMC meeting.

The ‘dot plot’ also caught our attention. Even though Yellen specifically announced the Fed was aiming for at least three rate hikes, the dot plot chart shows there are three members who are still expecting a maximum of two rate hikes. Surprising, considering the most recent interest rate decision was almost unanimous.

Source: Bloomberg

It made us scratch our heads as there didn’t seem to be any logical explanation at all, but then the Royal Bank of Canada came up with a theory which makes a lot of sense. Fed member Lockhart (Fed Atlanta- resigned at the end of February and could not possibly have submitted a new rate hike expectation. According to RBC, this could mean his (temporary?) replacement just submitted the same position as the previous time the Fed Atlanta was indicating, before Bostic was appointed as the new President and CEO of Fed Atlanta.

A logical explanation, but this wasn’t the only ‘interesting’ thing after the FOMC meeting. In the very first paragraph after officially announcing the rate hike, we could read this:

“ The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal.”

The logical explanation here would be the interpretation the Fed wouldn’t allow the inflation rate to run at a higher percentage than 2% for a prolonged period of time, but the statement could also be read as the Fed explicity warning of a much higher inflation rate than originally anticipated. We know the market has always been prone to overshooting, either on the positive or negative side of the equation. We don’t think we have ever heard the Fed talk about ‘symmetric’ inflation, but as the FOMC members are leaking more intel than the Exson Valdez spilled oil, this position will undoubtedly be clarified in a ‘coincidental’ interview or public speech.

Source: Federal Reserve

Looking at the expectations of the Fed board members, they are practically still confirming ‘money’ is losing its value pretty fast. Whilst the median expected inflation rate is pretty close to 2%, an additional two-step rate hike would still put the ‘real’ interest rate below zero. And that’s what counts; your money is worth less day after day.

>>> Read our Guide to Gold and protect yourself against inflation!

Secular Investor offers a fresh look at investing. We analyze long lasting cycles, coupled with a collection of strategic investments and concrete tips for different types of assets. The methods and strategies are transformed into the Gold & Silver Report and the Commodity Report.

Follow us on Facebook @SecularInvestor [NEW] and Twitter @SecularInvest

RBC: "The Fed Is Now Forced To Walk Back The Market's Incorrect Dovish Interpretation"

First, it was Goldman"s chief economist Jan Hatzius, who in a fascinating note explained why the market has totally misread the Fed"s tightening intentions, claiming the market surge is "not the reaction the Fed wanted", alleging that the market"s dramatic "easing" response was "not the outcome the FOMC aimed for" and concluding that "at the margin, it will likely make them more inclined to tighten policy", a polite way of saying that the Fed may now not be behind the inflationary curve, but that it is certainly behind when it comes to "explaining" to the market that it has run ahead of itself.

Now, in a follow up note, RBC"s head of cross-asset strategy makes the exact same point as Goldman, and warns that "the Fed will now view the market response as an ‘overshoot,’ and will perversely be forced to ‘walk-back’ the ‘incorrect’ dovish market interpretation with more hawkish rhetoric in coming weeks / months that will again whipsaw the rates market and likely-drive cross-asset vol higher."

And since Goldman still has a direct hotline, both literal and symbolic, to former Goldman employee Bill Dudley who is in charge of the NY Fed, it would not be surprising if during the Fed"s next public appearance, an FOMC member makes it very clear that having both of its core original mandates, inflation and emloyment, supposedly under control, it is now taking on the 3rd one - preemptive market stability, by making sure that risk assets are halted in their bubbly tracks.

Below are the key excerpts from today"s note by RBC"s Charlie McElliggott:

FED CREATES MORE ROPE TO HANG THEMSELVES WITH

#HOTTAKES:

• Despite hiking, the Fed missed a major opportunity to play “catch-up” without disrupting the market—as price-action showed that investors were clearly prepared for ‘hawkish’ outcomes.


• Instead, the FOMC / Yellen’s commentary (in light of the above ‘hawkish positioning’ dynamic) actually created EASIER / LOOSER financial conditions, with real rates collapsing lower on the session.  This will make the eventual exit-process that much more difficult—thus, “more rope to hang themselves with.”


• With Yellen noting that the Fed intended to keep its policy accommodative for “some time”—in conjunction with the overly simplistic market take on the lack of movement in the average dot (FAR more nuanced than that) and the ‘hawkish’ buy-side positioning--the Fed also created significant (under)performance frustration across many strategies yesterday, with the exception of a 2 standard deviation ‘+++’ day for many risk-parity portfolios (which essentially run ‘short convexity’ long only cross-asset books, which are now likely to be in-process of ‘levering-up’ off of the ‘vol crush’).


• For the above reasons, I believe the Fed will now view the market response as an ‘overshoot,’ and will perversely be forced to ‘walk-back’ the ‘incorrect’ dovish market interpretation with more hawkish rhetoric in coming weeks / months that will again whipsaw the rates market and likely-drive cross-asset vol higher.

COMMENTARY:

So the Fed hiked….and nominal rates gapped lower, breakevens traded higher, real rates collapsed, and financial conditions LOOSENED.  Why?  To me, the moves were largely positioning-related, being caught wrong-footed inherently with regards to ‘expectations.’  I do not believe the Fed intended this to be a dovish message, and they are going to have to clarify this to the market in coming weeks, in turn risking / creating more volatility.  There is a fixed-income short / ED$ steepener to be laid-back-out soon. 

To sum up the ‘by-and-large’ client reaction to yesterday’s post-Fed response (with a touch of relief from the Dutch election sprinkled-in) on a scale of 1 to 10, I’d say the buy-side gave it a “MEHHH.”  Optically and absolutely, yesterday WAS of course a day of positive performance for many funds long risky assets, considering SPX +20 handles, EEM +2.6% (+2 SD move), IWM +1.6% (+2 SD move), HYG +1.4% (+3 SD move), LQD +0.9% (+2.6 SD move) et cetera. 

Instead though, it felt ‘empty’ or like a missed performance opportunity for many, because despite your longs doing ‘okay,’ many of your shorts were up just as much, if-not-more.  And regarding the longs, the stuff that did ‘really well’ yesterday is generally underweighted OR in many cases, has recently been pared-back (i.e. cyclical beta equities).  Case-in-point, look at this example within the equities space:

• HF VIP Longs + 0.7% against HF VIP Shorts +0.7%


• High HF Concentration +0.9% against Low HF Concentration +1.0%


• MF Overweights +0.6% against MF Underweights +1.0%

Ugh.

This was an interesting rally because it looked like the old “QE”- varietal, where the interpretation of anything ‘dovish’ (in this case ironically it was a dovish HIKE via a simplified read basically that "unch on median / average dot" countered the recently hawkish momentum / rhetoric / data) actually sent UST"s sharply higher (TY largest ‘up’ day since June ’16) / rates sharply lower / USD sharply lower (BBDXY a -3 SD move lower and largest ‘down’ day since July ’16).  Real rates lower = easier financial conditions = Risk-on, Vol smoked = ‘short convexity’ vol trigger strategies likely driving mechanical re-levering.

The real news to me in the Fed message was two-fold:

• First, the dot shift was beautifully spotted by Mark Orlsey and Tom Porcelli going-into the event.  Looking at the simple scale of the absolute move in the average- or median- dot simply doesn’t ‘cut it’ in the case of “what is to come”—it is far more nuanced.  As such, the takeaway I think the market has initially-missed was the fact that the marginal dot ‘shift higher’ came from the bottom of the plot—i.e. IT WAS THE MOST DOVISH FED MEMBERS WHO UPPED THEIR DOTS.  This dynamic is going to have to be ‘trued-up’ in coming months considering the data trajectory (new 5 year highs in Bloomberg US Econ Surprise Index yday) and is likely to be a source of interest rate-driven cross-asset volatility.


• The second notable takeaway from yesterday was Yellen’s very modest backing-away from prior comments made from Fed officials regarding an absolute-level FF rate (1.00%) acting as a ‘trigger’ for cessation of reinvestments to shrink their balance sheet.  This is important bc again, Fed members have made this a point of focus going-forward, and their time-horizon window is shrinking now.  From a markets perspective within the mortgage space, losing the ‘buyer of last resort’ (into the daily Fed buybacks) will cause ripples, because if rates are going higher against you as a MBS trader—which is inherently a negatively convex product—you HAVE TO hedge by hitting TY.  This is a down-the-road discussion (now a 2018 story), but again will be a source of rate volatility in the future that could be ‘disorderly.’

Regardless of the medium- / long- term potentials…as such with the rates collapse lower on the day, duration sensitive equities were a large part of the equities leadership—e.g. defensives, divy yielders, low vol types like reits, utes, telcos (outside of energy sector with crude"s relief rally), while mega-allocations in tech, consumer discretionary and financials were, relatively speaking, "dead weight" and lagged index.  Of course too, the other leadership driver in stocks was the ‘reflation stuff’ that’s been ‘getting pitched’ over the past month like steels, metals & mining, oil services, E&Ps, high beta materials and industrials etc.  That stings for the majority of equity funds with regards to their current sector allocations, long ‘secular growth’ after reducing a fair bit of their "cyclical beta"‎ / value exposure in 1Q17. Much of yesterday’s leadership was curious ‘late cycle’ stuff, which o/p ‘early cycle’ by an astounding~140bps:

Obviously, the above dynamic is especially frustrating for many equity HF"s.   When you see the broad SPX tape + 0.8%, Russell 2k +1.6 and R3k‎ +0.9% but as a long / short you were only able to eek-out 40bps to 50bps simply due to you net long exposure, it stinks.  Even worse, mkt neutrals strats which simply don"t work in "gap higher" tapes. ‎

‎Bigger picture macro, the rates move spanked fixed-income shorts, while the Dollar crush crunched longs (especially against GBP, EUR and select EM).  Another “ouchy.”  And think about the initial "trump reflation" worldview themes from 4Q16 where it was Emerging Markets that was viewed as the "biggest loser"...and now is the "high flyer" (EEM +12.3% YTD) as the protectionist rhetoric is ‘walked-back’ (Navarro comments yday) and some thinking (benevolently) that US growth is soon to be the "higher water which will raise all boats."  Long EM over DM is now one of the most popular strategy calls going, FWIW.

But was yesterday really about US growth—was that really the case‎?  I"d say that in light of the recent ‘trend trades’ and positioning dynamics, a day where you see fixed-income, (long) duration-sensitives, defensives, low vol, late cycle and EM leadership ‘run higher,’ it speaks to folks looking to buy the "stuff that"s been left behind" in a classic “PM exposure grab” style, yelling to his trader "find me some cheap stuff!"  More "lottery ticket" mode than anything else, as evidenced by GDXJ (Jr Gold Miners ETF) finishing +11.5% higher on the day yesterday--a +3.1 SD-move. ALL OF THE LULZ.

As far as the current framework / narrative we’ve been operating under since midyear ’16, it shouldn"t be lost on anybody that this wasn"t a “higher growth = higher nominal rates = equities rally" which has obviously been the story of all global markets since secular lows for rates were put in last summer.  It was instead an ‘easier conditions,’ central bank driven rally of old QE-era.  As described above, this felt a lot more like “...greedy, not growth-y.”  

I think there"s an important message in there.

RBC US ECON TEAM SHOWS 2017 DOT SHIFT WAS ACTUALLY ‘HAWKISH’:

MARK ORSLEY SHOWS 2018 DOT SHIFT WAS ACTUALLY ‘HAWKISH’ / HIGHER AS WELL:

Trump & Yellen's Collision Course

Submitted by Kevin Muir via The Macro Tourist,

Although the stock market is giddy from President Trump’s pro-growth policies, there is another constituent not quite so enamoured with recent developments. Although a few years ago Fed officials were begging for some help from fiscal policy, with employment now running at a “perceived” tight pace, FOMC participants have switched to viewing fiscal stimulus as a potential inflationary concern that needs to be offset with tighter monetary policy.

Case in point - have a look at the comments from the most dovish member of the FOMC - über dove Lael Brainard (all quotes from Bloomberg):

September 16, 2016

“The case to tighten policy preemptively is less compelling” in an environment where declining unemployment has been slow to spur faster inflation, Brainard said Monday, according to the text of her prepared remarks in Chicago. She made no reference to a specific meeting of the policy-setting Federal Open Market Committee.

Brainard’s comments are the last before the Fed enters its quiet period, during which officials abstain from publicly speaking about monetary policy in the run-up to an FOMC meeting. Policy makers will gather in Washington Sept. 20-21 to discuss their monetary policy stance. Recent comments from the committee’s voters have not projected a cohesive signal about whether they will lift interest rates or stay on hold.

“Asymmetry in risk management in today’s new normal counsels prudence in the removal of policy accommodation,” Brainard said, arguing that with interest rates near zero, it’s easier for the Fed to react to faster-than-expected demand than to a negative surprise that upsets the economy. “I believe this approach has served us well in recent months.”

January 17th, 2017

Federal Reserve Governor Lael Brainard said the U.S. central bank may accelerate interest-rate increases and measures to shrink its balance sheet if Congress approves a sustained, material increase in fiscal stimulus that pressures inflation without lifting productivity.

“Based on recent spending indicators, we might expect progress to continue to be gradual and steady,” Brainard said Tuesday in Washington. “However, if fiscal policy changes lead to a more rapid elimination of slack, policy adjustment would, all else being equal, likely be more rapid than otherwise.”

Brainard is the most dovish member of the Federal Open Market Committee, yet she is openly warning about higher rates. Other FOMC members are even going so far as to signal upcoming balance sheet reductions and even higher rates than the market has currently priced in.

Chair Yellen is also making some hawkish chirping noises. Have a look at the first paragraph from her recent Stanford speech:

In my remarks today, I will review the considerable progress the economy has made toward the attainment of the two objectives that the Congress has assigned to the Federal Reserve–maximum employment and price stability. The upshot is that labor utilization is close to its estimated longer-run normal level, and we are closing in on our 2 percent inflation objective. I will then discuss the prospects for adjusting monetary policy in the manner needed to sustain a strong job market while maintaining low and stable inflation

“Labour utilization is close to its estimated longer-run normal level, and we are closing in on our 2 percent inflation objective” is the key line. In this speech, Yellen then goes on to sketch out the basic formula for setting rates. It’s a boring econometrics discussion, but the important point is that she is setting out how the Federal Reserve will go about raising rates.

Make no mistake - rates are going higher. Probably a lot higher than the market realizes. Just look at this comment buried in Yellen’s speech:

That said, I think that allowing the economy to run markedly and persistently “hot” would be risky and unwise. Waiting too long to remove accommodation could cause inflation expectations to begin ratcheting up, driving actual inflation higher and making it harder to control. The combination of persistently low interest rates and strong labor market conditions could lead to undesirable increases in leverage and other financial imbalances, although such risks would likely take time to emerge. Finally waiting too long to tighten policy could require the FOMC to eventually raise interest rates rapidly, which could risk disrupting financial markets and pushing the economy into recession. For these reasons, I consider it prudent to adjust the stance of monetary policy gradually over time–a strategy that should improve the prospects that the economy will achieve sustainable growth with the labor market operating at full employment and inflation running at about 2 percent.

In the coming quarters, the Federal Reserve will march rates higher. But more importantly, the more Trump pushes on the fiscal accelerator, the harder the Fed will lean on the brake.

The stock market has risen on each pro-business executive order Trump signs. In fact, this latest push to new highs is the direct result of Trump’s following through with his promised plans.

Although the stock market is screaming higher, the bond market is not at all happy. Not only does the bond market need to deal with the threat of increased inflation from Trump’s policies, but also a Federal Reserve intent on tightening monetary policy to offset the fiscal stimulus.

I think the Federal Reserve is too eager to raise rates (and also reduce the size of the balance sheet). They continue to fight the last battle and don’t realize that in a balance sheet constrained global financial system, inflation is not the main worry. They run the risk of becoming another Japan with an economy littered with false starts. I don’t know if it is a political bias, or they would have been just as quick on the trigger for a Democratic President, but it really doesn’t matter. Nor does my opinion about the Fed being better off letting the economy run hot for a while mean two shits. All of these thoughts should just be discarded in the dustbin of not worrying about what should be and instead focusing on trading what will be.

It seems obvious the Federal Reserve is intent on withdrawing monetary accommodation until something breaks. There is no sense fighting it.

And it is also clear President Trump will follow through with his fiscal stimulus plans. Many pundits thought Trump’s actions might not follow his rhetoric, but the market is quickly realizing that Trump means what he says.

These two different forces are on a collision course. More fiscal stimulus translates into more monetary tightness. And Trump isn’t going to back down anytime soon, so all that is left is an expanding fiscal environment with a Federal Reserve desperately trying to apply some brakes.

This economic expansion is already running long in the tooth, and there is a pattern of recessions occurring in the first year of office for newly elected Presidents, so an overly aggressive Fed is a worrisome development. Ironically, Trump’s fiscal stimulus might be the trigger that ushers in the next economic slowdown.

Many strategists believed Trump might ask Yellen to step down and appoint someone more hawkish. They mistakenly confused Trump’s campaign complaint about low interest rates killing the economy as future policy.

Well, Trump will do no such thing. In fact, I suspect before Yellen’s term is complete in 2018, Trump will be blaming her for all his problems when the economy rolls over. I am not sure if Trump is this smart, but keeping Yellen around for exactly this task would be the wise move.

In the mean time, Trump will keep pushing forward with more fiscal stimulus, and Yellen & Co. will push back with tighter monetary policy.

This interplay between Trump and Yellen makes for a shitty environment for bonds, and also as real rates head higher, gold and other commodities. Eventually this giant debt disaster will need to be inflated away, but I am afraid this FOMC is not yet scared enough to let that happen.

As this plays out, be careful with your precious metals and other commodity long positions.

Higher real rates are not conducive for precious metal bull markets. As long as the Fed keeps pressing on the brake, it will be tough for these commodities to get up off the mat. It won’t be until something breaks in the financial system that you want to own them. But at that point, you should be buying with both fists.