The world as it is, not as we'd like it

It happened a day early, but we got our anniversary fixed income melt-up after all.  Although a weak retail sales figure (and Wal Mart earnings warning) was the ostensible catalyst, in reality Macro Man suspects that the market had been stewing on the flurry of dovish developments to have emerged from the Federal Reserve this week.  The poor number was merely the last straw that encouraged the market to go full-throttle on challenging the notion of lift-off by year end.   The result?  Dec 2016 eurodollars rallied more and closed higher than they did on payroll day.  Astonishingly, the contract has risen 40 ticks since the end of August.


The analytical and journalistic reaction to the dovish offensive from Brainerd and Tarullo this week has been revealing.  "The Fed cannot go with a body of dovish dissenters" seems to be the conclusion, even though the institution has managed to conduct policy just fine over the past few years with the occasional hawkish dissent- both verbal and voting.  In fairness, none of those dissents came from the Board of Governors, and while all voters are theoretically equal, it pays to remember George Orwell in Animal Farm: all animals are equal, but some animals are more equal than others.

Macro Man has found himself treading a fine line between seeing the world as it is, and seeing it as he would like it to be.   Being "right" intellectually is useless if the relevant policy-makers do not see things the same way, and at the end of the day it is their decisions that drive market pricing and P/L, which is the ultimate arbiter for market practioners.

Academic economists at universities and, yes, the Fed can wave away failed predictions with the sweep of a hand; failed trades, on the other hand, are not so forgiving.   Macro Man was struck by the contrast in reading the latest paper from the San Francisco Fed, which can only be described as a piece of dovish propaganda.

The paper deals with the so-called "natural rate of interest", a theoretical notion brought to the mainstream by the father of forward guidance, Michael Woodford.  The natural rate of interest is, to quote the paper, a construct that represents the real interest rate that is "consistent with an economy at full employment and with stable inflation."  OK, that seems simple enough.  The model output currently suggests a natural real rate of -2.1%.   Wow, that seems low, particularly with the unemployment rate at 5.1%.  The model does not project the real rate turning positive until late next year or 2017.

                                 Source:  SF Fed

The author helpfully provides historical real-time estimates of the natural rate, which is where things get weird.  As you can see, each snapshot starts with the natural rate estimate at very low levels, and the projects it to rise to turn positive within a year or two, much like the current forecast.   What makes this so bizarre is that this time frame coincides with the unemployment rate falling much more quickly than expected.....and yet the natural rate has risen much, much more slowly than expected?   By any reasonable definition, we have approached full employment more quickly than macro models have anticipated over the past few years (even if we are still a ways away, as many believe), and yet the model has continued to suggest a lower natural rate than it itself projected.  Macro Man has not delved into the nuts and bolts of the model's construction, but can only presume that there is an implicit Phillips curve in there that is much, much steeper than reality.

Now, in the hard sciences, any model that was so consistently wrong or contradictory would likely get chucked in the bin.  While economists and econometricians  certainly use a lot of mathematics in their work, what they do is clearly not a hard science, and as such is subject to the (substantial) biases of the analyst.  Of course, if the analyst has the ear of influential policymakers, his work is worth following, regardless of any biases that might be in play.

In this case, the contrast with the Taylor Rule is really quite striking.  Macro Man ran a standard Taylor Rule projection, using a NAIRU estimate of 5.0, an inflation target of 2.0, coefficients of 0.5 for inflation and employment, an Okun factor (representing the relationship between growth and employment) of 2.0, and a real rate of 2.0.   Unsurprisingly, the model thinks rates should be closer to 3% than zero.


The model clearly captures the "QE era," though in this iteration thinks rates should have gone positive by the end of 2011.   Of course, such a simple model can often jump around more quickly than it is practical for monetary policy to adjust, as you can clearly see from the chart.  For this and other reasons, so-called "inertial" policy rules have come into vogue, in which any prescription from the standard rule is essentially diluted by the current policy setting.  For example, if rates are zero, the standard rule prescribes a 3% policy rate, and the rho (i.e., how much the current policy setting is weighted relative to the policy rule) is 0.5, the inertial model would prescribe a policy rate of 1.5% (0% * 0.5 + 3% *0.5).

Unsurprisingly, an inertial model seems to do a much better job of capturing how the Fed actually behaves.   Many models, such as this one from 2008, use a relatively high rho, thus heavily weighting the current policy setting in the prescription.  For example, using a rho of 0.7 makes the fit look great....except it still prescribes the FF rate at 0.94%.   From the perspective of "absolute emergency setting are no longer needed", that doesn't sound like such a bad prescription.


OK, but since the crisis the argument can be made that the equilibrium real rate has gone down...what if we take that to 1% beginning in 2009 (which would render the current standard Taylor prescription as 1.85%)?  It starts to become interesting...the model suggests negative or zero rates until just before the announcement of the taper, and now prescribes a policy rate of 0.64%.  Either literally or figuratively, this is no doubt how a number of FOMC members are viewing the situation.


For fun, Macro Man set the unemployment and inflation policy goals at their extremes of the past 20 years- namely 3.8% and 2.5%, respectively.  Amusingly, the standard model still prescribes higher rates, albeit only at the 0.40% level.   The inertial model suggests a policy rate of 20 bps.


What does it all mean?   Macro Man will admit that he has probably underestimated the inertial considerations that are influencing the Fed's policy calculus.  Much as he would like them to take a step back and say "given where we are, zero rates are ridiculous", he has to concede that they are a model driven lot and simply don't operate that way.  Similarly, while he thinks that their inflation target is largely unattainable and therefore nonsense, it is there and the FOMC is taking it seriously.

The chances of seeing meaningful progress on the inflation front over the next couple of months seems fairly slim, and the FOMC therefore seems unlikely to move rates by the end of the year.   This is not exactly news to anyone with a set of eyes and as pulse, and Macro Man concedes that this feels an awful lot like stopping out at the lows.  Intellectually, it kind of is, though market-wise, not necessarily.

He closed the balance of his USD long on Tuesday night after yesterday's post was written, fortunately at levels well better than those prevailing at the current time of writing.  The breakout in gold is certainly suggestive that the FX market has not fully priced a Fed potentially on hold for many more months, as is the breakdown in USD/JPY.  Flat positioning seems the best idea for now until things clarify a bit.

As Macro Man has noted previously, he does not think that a continuation of ZIRP and an extension of lift-off uncertainty is necessarily a positive for equities, presuming that the Fed continues to direct markets that the next move is lift-off.   (If the Fed were to hint at QE4 or - God forbid!- negative rates, then all bets would be off.)

As for fixed income, he does think that the next policy move is a lift-off and does like a lot of ED curve trades to play for steepening.  The bull flattening has been remarkable, and there are some very nice technical set-ups that offer excellent risk-reward.  It's a relatively simple matter to adjust positioning a bit further out the curve to reflect the (likely) inflection point that the analytical community will shift their forecasts towards in the coming days/weeks.

As regular readers no doubt know, Macro Man thinks that the Fed should look through the current spell and end this nonsensical wait for the lift-off.   Who knows....maybe, come December, they still will.  But with markets deferring their rate hike pricing into next year and the Fed seemingly unwilling to strong-arm market expectations to what they, the Fed, would like to do, it seems as if the FOMC will play the prevent defense for a while longer.   At the end of the day,  we have to analyze and trade the world as it is, not how we'd like it to be...and through that prism, it looks like policy inertia will continue to win the day for a bit longer than Macro Man previously thought.....or would like.

Tomorrow:  some thoughts on financial conditions and calculating a downside to ZIRP.



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Anonymous
admin
October 15, 2015 at 11:08 AM ×

Dear MM, most interesting post, as usual, thank you.... Would you mind elaborating further to the ' (likely) inflection point that the analytical community will shift their forecasts towards in the coming days/weeks ' ? Will it possible to infer with some precision max curvature and curve inflexion point from the fed comments? Many thx....

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Nico G
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October 15, 2015 at 12:52 PM ×

i guess the Nobel foundation is wrong to reward economists. Hell, which ecoomist has really saved (helped?) the world

from 36,000 ft altitude economy resembles religion with different school competing and none ahead of the pack solving metaphysical issues for good

my proudest idea is that there ought to be a Nobel prize in politics (instead)

on a lifelong achievement... perhaps it could motivate some top leaders to think beyond their electoral cycle.... just dreaming here

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Polemic
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October 15, 2015 at 12:56 PM ×

Nobel in Psychology Please. Had psychologists winning Nobel for Medicine and for Economics. And I believe that Economics i just a sub branch of psychology anyway, together with markets.

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Polemic
admin
October 15, 2015 at 12:57 PM ×

BTW. I've been tripped long on my trailing stop entries on equities. mostly Ftse. here's hoping

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washedup
admin
October 15, 2015 at 1:56 PM ×

The Kurdia piece may be intellectually interesting, but it just underscores the limits of monetary policy in a stagnant aggregate demand situation coming out of a financial crisis - the solution here is patently not to take rates to -3% and hope that everything is A OK, but to scare congress into doing something in the fiscal arena. Oh who TF am I kidding - on with the chemotherapy.

The rates debate is a bit like the gun debate - the vast majority knows the rational solution, and yet everyone believes we are more likely to see elementary school teachers armed with assault rifles before we see a mature discussion on the 2nd amendment.

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Anonymous
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October 15, 2015 at 2:01 PM ×

extremely helpful and thoughtful post. is it possible you can post the actual models you were using (the formulas). Many thanks!!

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Anonymous
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October 15, 2015 at 2:07 PM ×

fully sympathise with your rates views....i have for the second time been stopped out within the last few months...still think this move is exhaustive but thought that 25 bps below as well....had a similar double top before so who knows
re impact on equities i just dont think this his plays out like the past few years, valuations already stretched a lot of balance sheet arb done ,faith in CBs shaken. as long as 200d in spoos not taken convincingly i think we make new lows in US equities

long dollars i stick with for now esp aud


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Adrem
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October 15, 2015 at 2:47 PM ×

Lovely post. But can one really taking any model seriously that takes the current unemloyment rate of 5.1% as being in any sense meaningful in Phillips curve terms when the U6 cohort is at 10%, the labour participation rate is a 40-year low of 62.4%, and a large mass of the new jobs in this recovery have been education, health and hospitality. As Volcker once said, we cannot run on an economy flipping burgers for each other, or for that matter sticking needles in each other. So what use is this unemloyment ratio as a measure of anything? Anything to do with setting monetary policy?

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Macro Man
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October 15, 2015 at 2:51 PM ×

Good questions, Adrem, and that uncertainty is a big reason why the inertial model is favoured. That having been said, regardless of how much of the LF partic. rate is cyclical rather than structural, it is difficult to escape the conclusion that 'substantial progress' has been made.

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Anonymous
admin
October 15, 2015 at 2:58 PM ×

Time for fiscal policy, for a change. Clearly, monetary policy is dysfunctional now, as I've pointed out at this forum before. The Central Bankers know this, but one can't blame them for wanting to persist with their policies any more than one can blame a witch doctor for wanting to cure everything with herbs and a prayer... That's all they know. And they'll keep trying it until capitalism itself *fails* (some might argue that this has already happened :)). i^i

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Macro Man
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October 15, 2015 at 3:09 PM ×

Anon, the analogy I like is that of sore knees (speaking from personal experience.) With tendonitis, a bit of painkiller/ice and some time taking it easy, and your knee is good as new. If you tear your ACL, you can give it all the painkillers /time in the world...it still won't repair the damage. Prescribing more Oxyctonin just gets the patient hooked on opiates. At some point, if you want to properly fix the problem, you need to get in and perform surgery. The problem is, the surgeons are currently all in the break room having a punch-up over their fantasy football league...

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Nico G
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October 15, 2015 at 3:27 PM ×

..and surgery is incredibly more costly than a pack of advil

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Anonymous
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October 15, 2015 at 4:01 PM ×

"had a similar double top before ".Your only mistake then was not getting LB to run his skillset over it ;)

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DownWithTheBeanCounter
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October 15, 2015 at 4:02 PM ×

MM-

What are the advantages of looking through the current troubles and raising interest rates?

Prices are heading the wrong direction and wages are not growing much, while spreads are tight-ish and equities are expensive-ish. Under these circumstances, if rates were 3% (as an example) no one would be arguing to raise them to 3.25%.

If a stock is trading at $100 is it expensive? Well $100 is a lot of money, but the stock is pretty cheap if it earns $20/share a year. The unease with zero rates seems analogous. Zero is just a number. It's too low under certain circumstances and too high in others.

I wish inflation were running hot and wages were rising. It would be better for everyone and the Fed's course would be clear. Sadly that's not what's happening. Some action on the fiscal side is sorely needed, but we all know that isn't in the offing. Why then would it be better to raise interest rates? Wouldn't that result in fewer new jobs, declining prices and an increased risk of recession?

You hinted that your response if coming in a post tomorrow. Looking forward to reading it.

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Macro Man
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October 15, 2015 at 4:51 PM ×

@ Down, don't get your hopes up too high...there isn't an exhaustive modelling of the macro impact of ZIRP in the offing. What I would suggest however is that the impact of a rate rise should be dulled relative to history because in may cases, the price of money has little to do with the allocation of credit, because of (seemingly) structural shifts in particularly the supply curve for credit. Where credit is freely dispensed on the basis of price, on the other hand, a very good argument could be made that it has been oversupplied, and thus could do with a higher price to curb demand.

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Nico G
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October 15, 2015 at 6:25 PM ×

Goldman bonus pool down 30%

this is deflationary

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Anonymous
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October 15, 2015 at 6:31 PM ×

The Nobel committe does NOT give a prize in economics.

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Nico G
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October 15, 2015 at 6:39 PM ×

shit who's gonna tell Scholes it was a prank

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Anonymous
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October 15, 2015 at 6:53 PM ×

the irony here is amazing. It is your (Nico) beloved ZIRP to NIRP Riksbank that gives the prize in economics. They just call it "in memory of Nobel".

Some critics argue that the prestige of the Prize in Economics derives in part from its association with the Nobel Prizes, an association that has often been a source of controversy. Among them is the Swedish human rights lawyer Peter Nobel, a great-grandson of Ludvig Nobel.[28] Nobel criticizes the awarding institution of misusing his family's name, and states that no member of the Nobel family has ever had the intention of establishing a prize in economics.[29]

According to Samuel Brittan of the Financial Times, both of the former Swedish ministers of finance, Kjell-Olof Feldt and Gunnar Myrdal, wanted the prize abolished, saying, "Myrdal rather less graciously wanted the prize abolished because it had been given to such reactionaries as Hayek (and afterwards Milton Friedman)."[26]

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Anonymous
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October 15, 2015 at 7:09 PM ×

@NICO,

Do you think that BOJ is going to sit there while USDJPY drops to 100? They have an outright deflation in front of them if they do not do anything soon.

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Nico G
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October 15, 2015 at 7:21 PM ×

EVERYONE is dealing with an outright deflation as we speak. it is worldwide

regarding USDJPY it is as much an undervalued yen as it is an overvalued dollar

a long term position though

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Anonymous
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October 15, 2015 at 8:34 PM ×

MASSIVE equity buy programs in progress...

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CV
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October 15, 2015 at 8:53 PM ×

Strong ramp by equities here; if Draghi brings the goodie bag next week, I fear for the health of Mr. Shorty, I really do. Short-term punters will understandably be starting to sniff for a counter move, but I wouldn't be too cute here. I think it has legs.

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Anonymous
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October 15, 2015 at 9:14 PM ×

Let's face it shorts are not very intelligent. Short equities = betting against central banks (a poor bet). We will be back to all time highs in US equities before year end.

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Anonymous
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October 15, 2015 at 9:38 PM ×

Meh. Op ex tomorrow.

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October 15, 2015 at 10:14 PM ×

Nico G @ 7:21 - Except we are not. US Median CPI is now @ 2.5% and likely will keep rising. "Stagflation" isn't a new term but many folks (including our precious Fed) have forgotten.

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Nico G
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October 15, 2015 at 10:48 PM ×

Anon 9:14

spare us the triumph you are still 5% from the high

competent shorts operate very fast (brief or larger) counter trend - you'd be surprised how much you can scalp off shorting a bull market, and the truckload of money you make swinging sideways/high volatility as of late

yeah sure, you can frontrun both CBs and buy backs trail profits and switch off your machine. Where is the fun in all that? Unless you have another job of course
.
After 6 years or so of bull market it will only boils down to WHEN you took your longs out. We cannot say bulls are monster smart until they have cashed on their profit

i was long on and off between sub-700 and 1540 on spoos. Of course i got out too soon. I do not know anyone retail who is riding this bull since march 2009. NO way.

I am absolutely convinced we'll go back to 1540-1600. Not because i have been missing out since lol - just because that legendary break out will have to be tested, so bare it in mind when you are long should it occur within your timeframe.

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Anonymous
admin
October 16, 2015 at 12:06 AM ×

Damnit. Zerohedge has covered my opex short. There goes that one...

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Anonymous
admin
October 16, 2015 at 7:20 AM ×

Nico - Anon 9:14 here.

I agree with half of what you say: it is possible to make some money shorting (Aug this year for example). I also agree that I know no-one who rode this entire equity bull market all the way up (I remember many thinking it would crash big time in 2011).

My point is that I think that most major governments and central banks (who are all politicized) have totally lost their way. We face massive structural problems but governments are incompetent & just want central banks to print their way out of this mess. As a result I think we face ZIRP and QE forever (like Japan). Going short is basically trading against that and seems to be financial suicide. If we get a major down-turn, I expect: more QE, negative rates, and a ban on all shorting. How can you win against that?

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