Regular readers are familiar with Deutsche Bank’s Aleksandar Kocic.
Back in September, 2015, Kocic penned a hilariously metaphysical assessment of the Fed’s reaction function in the wake of the market turmoil catalyzed by the PBoC’s move to devalue the yuan the previous month. Kocic described the Fed’s dovish tilt in the theatre context as a removal of the “fourth wall,” a reference to the fact that the committee had explicitly acknowledged its own reflexivity vis-a-vis the market.
Last week, Kocic (correctly) predicted a dovish March hike, noting the following:
To do nothing slowly, Fed must do something quickly. By doing only one hike and making a deliberate pause after that could be rationalized by the fact that at that level the Fed is comfortable being (slightly) behind the curve. This would correspond to a dovish hike, i.e. the Fed would remain accommodative allowing for the political obstacles to clear and fiscal stimulus to develop traction without further strengthening USD and tightening financial conditions. There is no revision of the terminal rate and 2018 dots.
Again, that was last Sunday. JPMorgan’s Marko Kolanovic echoed this sentiment on Thursday, as follows:
Early this month, the Fed surprised the market by telegraphing a March hike. At the time, investors started speculating whether this was a sudden hawkish turn, or even a politically motivated decision. We think it might have been the move of a prudent monetary Dove. Hiking in March, gives the Fed the option to skip June should there be market turmoil (e.g. related to French elections).
Well on Monday, we get the latest from Kocic, who reiterates some of the points made above and manages to stay true to Deutsche’s “real bubble” thesis while still acknowledging the possibility that the long end could stage a rally that would be amplified by any covering of the (still) massive Treasury short.
Via Deutsche Bank
Last week, the Fed delivered what appears as a dovish hike, in all likelihood to be followed with two hikes more in 2017 and three in 2018. Such a choice of the Fed action was a compromise driven by the developments in the labor market and the key events in Europe, on one side, combined with the risk associated with the approval of the fiscal stimulus, on the other. The subtext of this compromise can be interpreted as being motivated by the Fed’s desire to extend the comfort zone and to hedge their position against possible fiscal irresponsibility, while, at the same time, not stand in the way to any possible fiscal stimulus by hiking too aggressively.
Despite all the efforts not to create more uncertainty, this is likely to create at least mild ambiguity regarding the long-run. A Fed which is not in a standby position waiting for the fiscal package to arrive and kick in is going to be supportive for USD and higher real rates. The March FOMC “package” (in terms of rate hike, dots, rhetoric and Q&E) implies effectively a real rate rise and is most likely bearish for breakevens, which could diminish the effect of the border tax on the trade deficit and, as such, reduce the impact on growth potential. In addition, having higher real rates increases the costs of borrowing and possibly creates political resistance against deficit expansions and structural steepening of the curve. On top of that, given what we saw in the last weeks, this suggests that the political process around the budget plan and the Legislative package already expected by the market is going to be anything but smooth, which is adding further doubts about its success and timing.
Depending on the interplay of politics and policy — degree of political resolve and the Fed actions — we could see two distinct paths of resolution of the existing tensions in the mid- or long-run. On one hand, it appears that the Fed is removing uncertainty around the terminal rate, while on the other, politics is creating a binary outcomes which could have a dramatically different effect on long rates. In that context, we are facing a future with bifurcating back end of the curve. Either political bottlenecks clear and the stimulus gets approved and goes full force leading to higher growth potential with subsequent rise in price levels and structural steepening of the curve, or political tensions effectively sabotage either its arrival or content (or both), and the curve initially bear flattens or even twists with rate shorts capitulation accelerating the rally of the back end.