In our research publications we aim to provide you with insights from a variety of different viewpoints while maintaining an official Cambridge view on asset allocation and portfolio construction in our quarterly VantagePoint publication, written by our Chief Investment Strategist. In this edition of C|A Answers, two members of our Capital Markets Research team provide different viewpoints on the Fed’s recent decision.
Wade O’Brien: The Fed left interest rates at zero because a rate hike was not supported by domestic economic data and may have generated unwelcome side effects in emerging economies where data have recently deteriorated. This decision should not be viewed as a referendum on the health of the US economy—though expectations for future growth have modestly declined—but rather an acknowledgement that growth in some key global economies is fragile and recent capital market volatility is pressuring some imbalances.
US economic data are better than commonly perceived. Over the past 12 months nearly three million new jobs have been created and the unemployment rate has fallen to just 5.1%, the lowest since April 2008. Economic growth, after a soft first quarter, rebounded to 3.7% on an annualized basis in the second quarter, and for 2015 is on track to remain just below the 2.5% average of the last 20 years. While the stronger US dollar is having a slightly negative impact on the manufacturing sector, which represents around 12% of US GDP, the much larger services sector is roaring along, as evidenced by the 59.0 August reading for the service Institute of Supply Management.
The soft spots that do exist in the US economy will not have gone unnoticed by the Fed. Employment is rising but wage pressures are not, in part because adding less-skilled positions does not generate large productivity gains. Despite labor market tightness, recent US Census data revealed that median family income was $53,657 last year, down slightly from 2013 and a substantial decline from pre–global financial crisis levels. This in turn impacts another part of the Fed’s dual mandate—keeping inflation at bay—as does the combination of increased supply and the stronger US dollar pushing down commodity prices. The Fed’s preferred measure of inflation, personal consumption expenditure (PCE), was barely in positive territory (0.3%) in July, though core PCE (and for that matter CPI) show slightly more resilient price pressures.
The Fed was likely influenced by the recent spike in market volatility, and the fears over a slowdown in emerging markets that are leading to self-fulfilling capital outflows. In late August the S&P 500 sold off more than 10% in just four sessions, one of its steepest short-term dives, and even more pronounced losses were seen in other global equity markets. One trigger was the decision by the Chinese authorities to allow the renminbi to trade in a wider band against the US dollar. Coming on the back of weaker Chinese economic data and a recent equity market meltdown, this step was interpreted by some as a last-ditch ploy to avoid a long-feared hard landing. The truth is likely more nuanced; this slight liberalization was very much in line with the long-stated desire of Chinese authorities to open their capital account and help rebalance the economy away from an investment-led model. The government had been selling increasing amounts of foreign currency reserves to defend a peg neither it nor its trading partners wanted, further supporting the slight devaluation.
The market’s focus has now shifted to when the Fed might hike and the potential impact when it does. The rationale laid out for this month’s decision complicates the task for traditional Fed prognosticators. Should the Fed continue to look at economic data outside the United States, the dovish trends unfolding across emerging markets are likely to remain in place for some time. In a similar vein, some of the recent increase in market volatility may be structural in nature (more algorithmic trading, smaller market-making capacity at sell-side firms, etc.), and unlikely to fade in the near future. All of this said, an October or December hike could still be justified based on the improving employment numbers and relatively sticky core inflation, and an unexpected development in the oil market (e.g., supply disruptions) could threaten the Fed’s recently dovish tone.
Eric Winig: The Fed did not hike rates because recent market turmoil, spurred mainly by worries about . . . the Fed hiking rates, caused it to blink.
After a tumultuous summer that saw China’s stock market implode, many emerging markets currencies crater, and a sizable back-up in US Treasury yields—all blamed, to one degree or another, on the Fed’s purported plan to begin raising its policy rate—the Fed kept rates at zero last Thursday, bringing the length of so-called ZIRP (zero interest rate policy) to six years, nine months, five days . . . and counting.
In other words, fear of the Fed hiking rates led to market turmoil, which convinced the Fed not to hike rates. This reminds me of the old saw about how a leaky roof never gets fixed, except in this version, every time the Fed mentions it is even considering “fixing” rates, the skies open up.
As I wrote around this time last year:
This remains true, for the simple reason that market participants have come to depend on Fed support, and the prospect of it being withdrawn leads to panic, which convinces the Fed to hold off. The amount of ink spilled on whether the Fed would raise its policy rate by one-quarter of one percent—including a number of apocalyptic forecasts if it did so—was remarkable, and belies the official narrative that the economy is “healing,” the “shadow of crisis has passed,” etc.
Further, as I pointed out last year, ZIRP remains very important to what vestiges of “growth” do exist—e.g., US housing and autos, both of which depend heavily on the extraordinarily low interest rates. Unfortunately, although not surprisingly, it has also led, particularly regarding autos, to excesses similar to the run-up to the 2008 crisis. Subprime auto lending has exploded, with asset-backed security (ABS) issuance on track to be up 30% from last year’s level, even as the average loan term for both new and used cars is now near 70 months and credit quality continues to deteriorate.
Consider the following quote from a January New York Times story, which could be lifted directly from narratives of housing ABS circa 2007: “In the case of the Santander Consumer bond offering in September, which is backed by loans on more than 84,000 vehicles, some of the highest-rated notes yield more than twice as much as certain Treasury securities, but are just as safe, according to ratings firms.”
Most worrying, from my perspective, has been market reaction to the Fed’s statement. While prediction markets showed only about a 30% chance the Fed would raise rates, the idea that non-action was “priced in” to markets was belied by the strong rise in gold and bond prices, as well as the quickly erased spike in equities after the announcement. Such action, if sustained, could well indicate the Fed is losing control of markets. As the perception that the Fed “has investors’ backs” has arguably been the most powerful narrative driving risk assets in recent years, such a prospect is troubling indeed.
The worst-case scenario is that the world is sinking into a deflationary downturn led by China and the long-deferred consequences of a multi-decade credit binge. The problem for the Fed and other central banks, of course, is that they have left themselves precious few options to deal with such an eventuality by their steadfast refusal to move rates off the zero bound.
Thus, while investors will no doubt now shift their attention to whether or not the Fed will hike rates in December, I continue to believe their next move will be not to hike rates, but rather to implement QE4, 5, etc., ultimately culminating in a repeat of Ben Bernanke’s famous “helicopter drop” of money—i.e., central bank–financed tax cuts.
Wade O’Brien and Eric Winig are Managing Directors on the Cambridge Associates Global Investment Research team.