Trump's Fed

Quick exposé on the Trump Fed.

What we already know:

Trump is tapping the following for the Board of Governors:

- PhD from Brown in economics back in '78. Currently is an economics professor at Tepper (Carnegie Mellon's Business School)

- The guy doesn't teach the IS-LM model (Video Here). From my understanding, the model describes the relationship between real interest rates and asset prices (specifically real GDP) curve in relation to the liquidity preference and money supply curve.

The idea here is that in the short term, prices are sticky. If the central bank expands the supply of real money, the price of real money increases while prices remain unchanged, thus lowering the equilibrium interest rates and expands real GDP.

It's kind of interesting as this guy doesn't seem to believe this model.

- Has been an advocate of negative rates in the past having its merits if the zero bound is completely unencumbered (thinking going negative 3%).

- Really likes Tom Keene? (shameless plug for Surveillance Midday on which he frequently guest speaks)

Moving on:

- Law degree from Yale in '84. Philosophy and Economic undergrad background from Columbia.

- Senior official to W's Treasury Secretary. Also worked in the Treasury Department for H. W.

- A guy with private sector experience as an MD at Carlyle. Currently, runs his own investment bank in Salt Lake City.

- Will be vice chair of supervision, helping with financial sector regulatory efforts.

- Described as a "mainstream" Republican.

- Has been an advocate for better coordination with Europe in regards to regulation.

What I think:

The overall changes to the Fed will skew to a more hawkish one.

Goodfriend seems pretty hawkish. (Video Here) He's a Taylor Rule type of guy - that means equilibrium Fed Funds should be much higher - about 3.10% to be specific.

Sizable gap to be closed

In addition, Goodfriend has been recorded a number of times speaking regarding the Fed falling behind inflation. For example:

GOODFRIEND: There is no way that this recovery can proceed with any degree of confidence unless the Fed makes sure that inflation does not move up. So I think the risks are exactly reversed from the way the Fed chairman discusses this. He has to make the public understand that any whiff of doubt about the Fed’s ability and willingness to stabilize inflation is going to put a crimp into the public’s willingness to take positions and commitments over the next two or three years that would produce genuine growth.

Additionally, Goodfriend's staunch advocation of abolishing the zero lower bound should not be confused as a conveyance of any desire for easy monetary policy.

His thought is that only when the zero lower bound is abolished before low-interest rate policy (whether zero or slightly negative) can have meaning impact - in layman terms, Goodfriend is saying that only the threat and the potential action of the Fed going extremely negative in rates (hypothetical extreme of, say, negative 5%) would translate to the regular banks providing negative rate loans to the greater public which would actually stimulate the economy. In turn, that would eliminate the current squeeze on bank profitability vis-à-vis a squeeze in net interest margins.

Goodfriend is also a big advocate in regards to the ineffectiveness of quantitative easing. He believes QE is "credit policy", closer related to the fiscal realm rather than the monetary realm. It is reasonable to believe that he will want the Fed to quickly shed its mammoth balance sheet.

Moving onto Quarles.

Private sector guy. Banker. Seems like somebody Steve Munchin and Gary Cohn would like a lot. Hard to imagine a banker agreeing with policy that hampers banks. What's been hampering banks? Squeeze on net interest margin. We just talked about it a couple of paragraphs ago.

So let's put our thinking caps on. What type of policy were we just talking about that can alleviate low bank profitability?

Either higher rates or a lower rate policy that completely disregards the zero lower bound. At these economic levels, should we go super negative or should we have higher rates?

The Fed has a dual mandate of full employment and low and stable inflation. Put yourself in the mindset of this banker - inflation is somewhat low. Okay. Check. 

Let's keep full employment going by stimulating banks and thus economic growth - let's have higher rates across the curve/a steeper yield curve. Should we keep fed fund rates low or raise them?

These factors have me leaning heavily towards a more hawkish Fed.

What can be projected with some imagination:

Letting our imagination run, we can project the following:

Trump is not exactly one for moderation. When he likes something, he likes it yuge - think famous rapper Wiz Khalifa - everything he does, he does it big.

The bigger implication here is that if these are the two he's nominating for the Federal Reserve Board now, we can project what other types of candidates he could nominate when Janet Yellen's (dove) and Stanley Fisher's (contradictorily (vs Janet Yellen) moderate) terms are up.

Hint 1: conservative monetarists.

Hint 2: More Taylor Rule and higher equilibrium Fed Fund rates.

The upcoming Fed meeting is a consensus raise. However, looking at things like the dollar and long end rates, it seems to me that the consensus of a dovish Fed multiple meetings forward is pervasive.

Dollar at 2016 levels shows the market disbelieves potential Fed action vs other central banks

It seems to me that the market is still operating under the same assumptions of the current Fed when there are the beginnings of tectonic shifts happening beneath our feet this very second. 

2018 hike odds seem too low and presents good risk/reward

All this occurring in a market that already consistently underprices the Fed's explicit intent.

Imagine a couple of those lower dots moving higher. With poor Neel Kashkari alone, championing for rates under 1%. *chuckles*

In terms of actionable trading:

With everything regarding the markets, timing is paramount (forget all those academics saying it's impossible to time the markets). 

Everything I've talked about can take a little while to materialize. There are of course things that can derail the thesis. If oil keeps sliding, which I think it can, and lead to lower breakeven inflation and turmoil in the high yield market, we can keep pushing back the eventual rates take-off thesis a bit longer. 

Tomorrow's hike is pretty much 100% priced in. Fellow contributor Shawn cited an article arguing that the Fed should stay put tomorrow. I can only imagine the price action in treausries if that happened. I would look to eventually fade that move if the Fed indeed shocks the world. 

Also, there are a few key assets and spreads that can be keen to offer clues. The breakeven curve has been steepening slightly - if it continues, it can be the harbinger for a general lift off in breakeven inflation.  

Additionally, I'm looking for the curve to stop flattening. I would like to see signs of the curve flattening to establish a bottoming.

Name of the speculation game: anticipate the anticipation of other market participants. 

Ultimately, it's just too damn hard for me to not expect some rhetoric or action from the Fed till January 2019 that doesn't raise the probability of one more hike to be over 30%.

Should we be flatter than before the election? Seems like the market is too skewed in regards to how flat the curve should be. 

Thanks guys. Fed meeting tomorrow. Good luck out there.
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Click here for comments
June 14, 2017 at 2:05 AM ×

Very good piece--I like the "let your imagination run wild" speculation about the next chair. Taylor himself, maybe!

Given the data and our previously discussed anticipation of a China slowdown, I'm not convinced the market has it wrong. But it is worth noting the market has been conditioned to be complacent about inflation and a real fed hiking cycle. A couple of trade ideas come to mind: 1) Dec 2018 eurodollar puts, 2) edm8/z9 steepener, 3) 6mo fwd -2x10 conditional steepeners, 4) Long USD vs. pretty much anything. take with a grain of salt, just threw those out there without looking at any prices...

Cam Hui
June 14, 2017 at 2:21 AM ×

Yellen's term as Fed chair is up in Feb, but she could in theory stay on as a Governor. Same story with Fischer, he could in theory stay on as Governor.

If Trump wants to replace Yellen, it has to come from one of the three new nominees (note that Robert Jones is rumored to fill the community bank governor position). Therefore the most likely replacement is Marvin Goodfriend.

June 14, 2017 at 4:58 PM ×

Theory, shmeory….

The Fed doesn't control the bond market, whatever they may think. All they can do is try to pin the short end, and if the economy slows enough, they will lose control of that. Look at the markets today, US 10y are heading for the 2% level. We will be back at the weekend to chart all this after the FOMC show. For now, the latest Doubleline presentation is a good start.

Another excruciating morning for Mr Bond Shorty, after the CPI and retail sales data. Summer soft patch is coming for the US economy, at the very least, the economy is probably already at stall speed, around 1% growth.

Crude is going to probably flirt with $40 in the latest price range, if not actually break below it. Until oil finds a bottom, inflation expectations will remain anchored, as in attached to the bottom of the ocean. At some point we are going to see another round of credit stress in energy, and then watch that get transmitted to the small caps.

Btw, even if the Fed statement is dovish, it is by no means a given that equity markets will rally on FOMC adjustments to the SEP, once the concept of a slower economy sinks in there is still a really large reflation trade that will have to unwind.

The next modest correction in equities, when it arrives, may become amplified into something much more serious by market forces created by the recent trend in volatility tourism.

Bring on the clowns, I mean the Chair...

June 15, 2017 at 2:47 AM ×

So in the aftermath, looking at the SEP, we know that the lone dissenter and the one dot predicting no more hikes into 2019 is Neel Kashkari. Whatever you think of him and his role in TARP, he is manifestly not a stupid guy, and probably much more intelligent than the average Fed apparatchik, and he was very close to Bernanke. The other Fed member who has a brain is Brainard. Most of the rest are cerebral midgets, and Yellen knows this, so these two dots "weigh" more than the others.

What is interesting is that three other voting members of the FOMC have now joined Kashkari - at least in opining that the Fed is now done for 2017 - and that's a significant change that we should all pay attention to. WONDER WHO THEY ARE?

The Balance Sheet reduction program… LOL. At this rate it will likely take 20-30 years to bring back to pre-crisis lows. Big Ben told us it would be allowed to run off naturally by holding bonds to maturity, in other words there will be no hurry….

I am quite surprised that so many posters/commenters here have drunk the reflationary normalizing Kool-Aid to the extent that they have, especially when all here are well aware of the Fed's record with respect to GDP and inflation predictions.

Students of the Japanese experience are prepared to play the long game here, in the expectation that the US economy will remain stagnant for longer than most American brains can comprehend. It's the demographics, guv'nor, innit?

The Fed is irrelevant now - they are simply playing a few card tricks inside the tent while the carneys are out front on the TV trying to reel in a few more punters. The real circus is going to return though once the lions (and bears) get loose again.

I have seen the next low for US10s called anywhere between 1.50 and 2.00%, with a few at 1.0% from the deflationary fringe. Anyone got a number of their own? Here, we like the number immediately prior to the election of Trump, or about 1.85%. It's almost as though TRUMPFLATION NEVER ACTUALLY HAPPENED. Those of you out there who called US 10y at 3.00% and above in '17, you are already disqualified and lost your punters a load of wonga, so you can just shut up and sit this one out. Those plonkas who have been wrong about rates every year for the last decade can STFU.

June 15, 2017 at 7:30 AM ×

Fed speak translated... We do not give a hoot about the price of oil any more.

June 15, 2017 at 12:46 PM ×

Volatility tourists may be a little nervous this morning, just a little. VIX is up 11% at 7am. One of these days it simply isn't going to decline again into the close, and another generation of punters will learn a lesson in reflexivity. One day we will be reading their sob stories.

If we ever see another 1987-type event (c-word), it will be because of ETFs, algorithmic trading machines and a profusion of strange volatility derivatives. Recently it was reported that 95% of shares of VXX were "borrowed", raising the spectre of a painful squeeze and the mother of all volatility spikes. There is also a popular product called SVXY that is marketed as "an inverse volatility vehicle". It is made up of the first and second month VIX futures, June and July. We think this represents an interesting opportunity for contrarian traders. Imagine if the managers of that had to roll to the August contracts, and that happened during a massive (or even modest) volatility spike…. interesting scenario, eh? One day this is going to happen.

June 15, 2017 at 2:05 PM ×

@LB what are your thoughts on Oil long term? Do you think electric cars are a real deal? What will happen to ME and Canada if oil remains in the ground forever?

abee crombie
June 15, 2017 at 3:57 PM ×

US tech carnage not over...meanwhile Philly and Empire surprised to upside..

Dollar rallying (which should put a bid in the Stoxx sell off). But get short CAD eventually... we going back to 1.30 sometime soon.

June 16, 2017 at 2:42 AM ×

China credit crunch is real, which means Canada housing bubble has already popped, but we haven't seen all the mess yet. China yield curve inversion means the same as it does anywhere else. Yeah, that's right, growth is slower than "the official 8% GDP"…. Chinese defaults will cascade to other lenders in other countries, keep an eye on the yen as the safety valve in Asia.

Oil isn't going away. Not for the rest of the century, but it will. I imagine the whale oil investors had a few difficult years, eh?

June 16, 2017 at 6:13 PM ×

Returning to the Fed, the following commentary from Neel Kashkari is an eloquent statement of the unease felt by many in the markets about the contemporary Phillips curve, inflation targeting approach currently espoused by Dame Janet & co.

I can summarize this beautifully written piece here in my own way: The Phillips curve is bollocks, and half of the FOMC are out to lunch, can't think their way out of a paper bag etc....

Here are a few highlights:

"if inflation expectations drop, as we’ve seen in some other countries (and there are signs it might be happening here in the United States), it can be very challenging to bring them back up" Indeed.

"The growth rate of hourly earnings has fallen since the March meeting — from 2.8 percent to 2.5 percent — and remains low relative to the precrisis period. In short, the cost of labor isn’t showing signs of building inflationary pressures that are ready to take off and push inflation above the Fed’s target." Quite.

"In short, while some asset prices appear elevated, I don’t see a correction as being likely to trigger financial instability. Investors would face losses from a stock market correction, but it’s not the Fed’s job to protect investors from losses." Hmm..

"The views I express here are my own and not necessarily those of the Federal Open Market Committee." Apparently!!

It's well written and an absorbing read. NK skewers the Taylor Rule and its adherents several times, while largely side-stepping Washington other than to note that he is not expecting any fiscal magic.....

June 17, 2017 at 4:58 AM ×

Nice post..!Thank you for posting this blog.
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