Readers of NOTES FROM UNDERGROUND are aware that one of my major themes during the past six years has been Ben Bernanke’s pledge to Milton Friedman at MILT‘s 90th birthday. I’m paraphrasing, but Bernanke vowed the Fed would not make the mistakes of 1937 and raise rates in a period when fiscal policy was tight and monetary policy needed to be loose to sustain its velocity. In 1937 the combined policies of the FED and the Henry Morgenthau Treasury tightened together, which led to a renewed recession of the U.S. economy and a severe bout of renewed DEFLATION. It is the FED‘s and other central banks main thrust: To prevent a deflationary cycle taking hold. Bernanke is the ultimate 37er. For the FED, “whatever it takes” means inflation running hot so as to prevent any possibility of the LIQUIDATIONISTS and DEFLATION gaining a foothold in the economy.
YELLEN has changed the dual mandate into a trident, although we at NOTES FROM UNDERGROUND anticipated this many years ago when reading her speeches on labor market condition and wages. To make her case for keeping rates unchanged Chair Yellen added the importance of INTERNATIONAL DEVELOPMENTS to the Fed’s list of headwinds. More important is that Yellen’s press conference and emphasis on monitoring the deflationary impact of “global economic and financial developments” seems to be in contravention of Stanley Fischer’s recent speech at Jackson Hole. Fischer noted that a strong dollar operates on U.S. inflation with a lag effect but it is difficult to know the timeline. Also, Fischer did note at Jackson Hole, “At this moment we are following developments in the Chinese economy and their actual and potential effects on other economies even more closely than usual.”
So while noting the Fed is closely monitoring international developments, Fischer concluded his speech: “Finally, while I have been talking today about some international influences on economic conditions in the United States, I am well aware that, when the Federal reserve tightens policy, this affects other economies. The FED’S STATUTORY objectives are defined in terms of economic goals for the economy of the U.S., but I believe that by meeting those objectives, and so maintaining a stable and strong macroeconomic environment at home, we will be best serving the global economy as well.”
So while the dual mandate is noted the world is the FED‘s oyster. Interest rates never need to be raised as long as some global phenomenon exists that could possibly stress the U.S. economy. So like Neptune ruling over the world’s SEAS, the FED symbol OUGHT to be the TRIDENT.
In making the case for the international developments plaguing the U.S. economy, Chair Yellen cited (several times, in fact) “the drop in equity prices, the further appreciation of the dollar, and a widening in risk spreads…” She mentioned some variation of this four other times in answers to questions from the press. Yellen discussed the rise of the dollar in the intervening period since the July 29 FOMC Statement. THE PROBLEM WITH THIS IS THAT IT IS WRONG. Since the last FOMC statement, the DOLLAR had actually DECLINED by 3% versus the euro; 3% versus the YEN; and 1.5% versus the British pound.
Yes, while the DOLLAR was weaker against the Chinese yuan and most emerging market currencies, Yellen did not make it clear that the FED was only targeting emerging markets and noted the DOLLAR in general. THE DOLLAR SOLD OFF FOLLOWING THE FOMC STATEMENT AND PRESS CONFERENCE. To the rest of the world seems to believe that there’s an undeclared currency war, merely from the Fed’s mentioning of the dollar.
The EURO had actually gained almost 2% by Friday morning but all the currencies sold off by late afternoon following remarks from the ECB‘s Benoit Couere and Peter Praet. Coeure made mention that if inflation fails to reach the ECB mandate then further QE in Europe would be needed. Praet, the ECB‘s chief economist noted that the ECB is ready to “… modify or expand the QE programme.”
These comments were laid on top of a speech given by Bank of England Chief Economist Andrew Haldane, who said the BOE may need to push interest rates into negative territory to combat following inflation. Also, Haldane noted that to end the desire by savers to remove their money from banks so as not to be penalized by negative rates, the BOE could make all money electronic and thus stem the hoarding of cash. Madness makes the desire to create inflation by any means a global phenomenon. The ’49ers expanded the gold supply, which of course had an immediate inflationary impact but the ’37ers have a multiple ways to create FIAT currency in an effort to raise inflation.
There are three immediate areas to watch if the Yellen’s demons gain credence in the global macro world:
1. Global equities are at first spooked by the fears of uncertainty raised by the Fed’s inaction. The BUY SIDE of the investment world initially pushed the SPOOS higher as NO INCREASE in the funds rate was deemed a positive, but as the next 24 hours showed, the fear factor overwhelmed the immediate greed analysis.
2. GOLD proved to be a repository of stability as investors became nervous over a renewed currency war and the fears of central banks losing their credibility in an effort to slay the forces of deflation. The technicals are still weak but it will be more important to monitor GOLD against all currencies, especially given the swiftness of the ECB and BOE response to the FOMC policy;
3. Most important for me will be the behavior of the yield curves in the U.S. If FED credibility is questioned the curves all the way out to 30 years should steepen versus the shorter end. In a period of great uncertainty why would anybody wish to stretch the term duration of securities sold by an entity of little reliability. The timing of this trade is as difficult as Stanley Fischer’s lag effect of the DOLLAR‘s impact but it is something to watch. The 2/10 part of the curve is hovering around the 200-day moving average but the trade must be on with the correct ratio, which I believe is how 9:5 2-years to 10s but I advise to check with your sources.
We will discuss this more on Monday, in terms of the growing global debt and why central banks are more nervous than the let on. AS AN ASIDE, MOODY’S DOWNGRADED FRENCH DEBT FRIDAY AFTERNOON. While I give the rating agencies little respect I do bring this to traders of European sovereign debt so as to monitor the impact.