More on whether Powell’s comments about the economy were hawkish or dovish

I think the general consensus in the markets is that Fed Chairman Powell’s testimony before Congress was dovish. But from the last post, you can tell I take a different view. And I think this is important for the US economy and global markets.

The regime shift at the Fed

Powell does a good job building consensus among colleagues. But right from the outset, I saw his chairmanship as a regime shift from his predecessor Janet Yellen.

The tell was Powell’s last commentary before Congress six months ago. And I remember University of Oregon professor Tim Duy noticing similar things about the likelihood of higher rates at an accelerated pace. It was when Fed governor Lael Brainard, a former dove, weighed in that you knew that Powell had secured wide acceptance at the Fed for his regime shift.

Here we are almost six months later and the projection for 2018 is for four rate hikes instead of three. If the economy holds, we should also expect a move up in timetable for 2019 as well, comments about curve flattening angst notwithstanding.

The question is how much of this shift is premised on a different approach, like the Taylor Rule. The Fed keeps on talking about getting back to neutral i.e. a longer-term neutral rate of interest. What is that neutral rate and how does one move toward it? The sense I get is that Powell is a closet Taylor Rule devotee. I could be wrong here. But if I’m right, then the neutral rate is quite a bit higher than where we are now.

The Fed’s reaction function during a period with a tightening bias

And that gets into whether Powell’s comments before Congress were dovish. The way I would frame the issue is that the Fed believes risks to economy are finely balanced with deflationary risks on the one side and inflationary risks and overheating on the other. Given this balance, the Fed believes moving toward neutral gradually is the best approach.

But the Fed has a tightening bias – meaning it wants to hike to get to neutral. And so, as the data come in, positive data will accelerate the timetable and most negative data will keep the Fed on course. That’s what a tightening bias means, The data would have to be very soft to force the Fed off its timetable. And here we’re talking about 2019 and 2020. The third hike for 2018 in September is almost a lock, with the fourth in December likely as well.

What are the implications of Fed policy

The biggest implication is a contrarian one, namely that the Fed’s actions today will increase interest income and pull forward credit demand, accelerating growth. Over the near term, rate hikes will be an accelerant through these two channels. And the economy will feel almost none of the tightening via credit revulsion. In fact, it’s only when credit distress becomes palpable that the tightening will occur.

The fact that raising rates doesn’t decrease loan demand or have an immediate adverse impact on most borrowers, particularly since the US mortgage market is predominately fixed rate, makes the Fed more likely to overtighten. The Fed will see its tightening as insufficient due to acceleration and add more rate hikes for good measure, unaware of the credit stress already building.

This is why every recent business cycle has ended with the Fed pushing the yield curve to inversion, with recession taking hold soon thereafter.

In the meantime expect:

  • dollar buoyancy and EM currency weakness
  • curve flattening with most of the rate hikes felt only on the front end of the curve
  • further upbeat macroeconomic numbers out of the US
  • signs of financial sector excess: IPOs, mergers, multiple expansion

The denouement comes later

The signpost we are looking for is an inverted curve, followed, of course, by credit distress. We are already seeing this in the emerging markets due to the currency effect. But this is having no impact on the US credit markets.

Eventually rate hikes will cause credit stress as speculative borrowers are forced into Ponzi situations due to the changing rate environment. At that point, workouts, credit restructuring and outright defaults will rise – what I call “the Bonton Effect”. because like Pennsylvania-based retailer Bonton, you are going to see liquidations and deadweight loss.

We’re not there yet. This is still the Goldilocks period. And I expect that Goldilocks period to last through the year. Watch for inversion late this year or early 2019 and for the Bonton Effect, sometime in 2019.

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