The faltering US economy, currency wars and the Fed

According to Jon Hilsenrath at the Wall Street Journal, ECB and PBOC easing aren’t obstacles to a Fed rate hike before year-end. Yet, the Wall Street Journal is running a headline as its top story showing that, “U.S. Companies Warn of Slowing Economy”. Given monetary policy acts with a lag, we are now in a dangerous period for the US economy.

When I last commented on the US economy a couple of weeks ago, I wrote that, “I believe the data support the thesis that tapering was tightening, not just in terms of cross-border flows and currency moves, but also in terms of trend growth in the US economy. The same is true for hawkish forward guidance.” This has translated not just into changing private portfolio preferences and a withdrawal of hot money from emerging markets but also in a material slowing in the pace of US domestic growth. As I wrote then, because monetary policy acts with a lag, it is not clear how much of the previous Fed tightening is baked into the data.” And that means more slowing could be on the way. We just don’t know yet.

Yet the Fed wants to raise rates in 2015 – or at least some Fed officials do; the noise-making from doves has increased substantially to counteract the move to rate hikes – and it will continue to increase. Let’s look at companies though. Here’s the Wall Street Journal today:

Quarterly profits and revenue at big American companies are poised to decline for the first time since the recession, as some industrial firms warn of a pullback in spending.

From railroads to manufacturers to energy producers, businesses say they are facing a protracted slowdown in production, sales and employment that will spill into next year. Some of them say they are already experiencing a downturn.

“The industrial environment’s in a recession. I don’t care what anybody says,” Daniel Florness, chief financial officer of Fastenal Co., told investors and analysts earlier this month. A third of the top 100 customers for Fastenal’s nuts, bolts and other factory and construction supplies have cut their spending by more than 10% and nearly a fifth by more than 25%, Mr. Florness said.

Caterpillar Inc. last week reduced its profit forecast, citing weak demand for its heavy equipment, and 3M Co., whose products range from kitchen sponges to adhesives used in automobiles, said it would lay off 1,500 employees, or 1.7% of its total, as sales growth sagged for a wide range of wares.

The weakness is overshadowing pockets of growth in sectors such as aerospace and technology.

Unless you believe this slowing is done, the next macro change we should expect would be not only to see job growth decline but also to see job losses pick up via increased US jobless claims. I think the claims series is the last unrelentingly bullish piece of US data out there. Yet the talk from Fed watcher Jon Hilsenrathis of more tightening.

Taken altogether, financial conditions in the U.S. have become more supportive of economic growth since the Fed last met in September. That included a net easing in financial conditions last week after the actions in China and the ECB meeting, according to Goldman Sachs.

Goldman’s financial conditions index has eased by the equivalent of a 0.3 percentage point interest rate cut by the Fed since its Sept. 17 policy meeting, said Jan Hatzius, Goldman’s chief U.S. economist, in an email exchange. Nearly a third of the move happened after last week’s ECB meeting. The Dow Jones Industrial Average is up 5.4% since the last Fed meeting. Yields on 10-year U.S. Treasury notes have dropped to 2.08% from 2.30%.

“The rally in the equity and credit markets outweighed the (foreign exchange) moves,” Mr. Hatzius said.

Fed officials said in their last policy statement that developments abroad and in financial markets could restrain the U.S. economy. Taken altogether, they ought to be a little less worried about financial conditions at their policy meeting this week, and because policy makers outside the U.S. are taking action, they might be getting more comfortable about the global outlook. That won’t convince them to raise interest rates at their meeting this week. But on the margin global and financial developments appear to have become less of an impediment to action down the road.

I have a different take here. The rally in shares is a relief rally from deeply oversold levels. It has no importance for assessing true financial conditions. Meanwhile the fundamentals are deteriorating as the simultaneous decline in top line and bottom line numbers at major US companies attests. Moreover, the very reason we saw market turmoil was because of stress on emerging markets and the reaction by China to devalue. And given China’s simultaneous reduction in interest rates and reserve ratios late last week, it is clear that the same pressures are still very much at play here.

What I see then is a “currency war”, with the US losing that war as it maintains a hawkish stance even as the ECB loosens further. This will put more pressure on emerging markets, particularly China and the need for China to devalue will soon re-assert itself as a driving macro issue given the Renminbi’s peg to the US dollar and the decline in Chinese growth rates.

In my mind, these are now dangerous times, with the Fed potentially misreading the macro tea leaves. If the Fed thinks that economic and financial conditions have eased, they are reading the situation wrong. And this incorrect read could lead to more tightening even as the effects of past tightening work their way through the economic system.

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