Markets care about two things these days:
- how long will the low vol. regime last? (or, put differently, how long will the carry party go on?);
- did the Fed make a policy mistake by hiking into a deflationary backdrop?
On Wednesday, Goldman set out to answer both questions.
You can find the bank’s assessment on whether you should become a vol. seller here.
As to the policy mistake argument, some have suggested that the explanation for the Fed’s “stubborn” hawkishness (to quote BofAML) is that the committee is moving to prick asset bubbles by turning the screws on financial conditions which have so far refused to respond to rate hikes.
In short, they’ve been hiking and hiking, but conditions have gotten easier and easier since liftoff (a relatively brief period before the election notwithstanding):
The rate hikes and hawkish Fed speak are set against a backdrop characterized not only by lackluster inflation prints, but by receding expectations with regard to the viability of the Trump administration’s growth-friendly policies.
That combination has been a perfect storm for curve flattening:
Clearly, bonds aren’t buying the equity euphoria.
So again, the question is whether the Fed has essentially abandoned the economy in order to ensure that the risk asset bubble doesn’t get further out of control.
Was that a “policy mistake?”
Here’s Goldman’s answer…
The argument that the Fed is making a hawkish policy error has been a popular market theme since the June FOMC meeting. Many investors point in particular to the downward drift in the 10-year Treasury rate as evidence that the Fed is tightening monetary policy more than the economy can handle.
The thesis that the Fed has made a policy error would seem to imply two claims: that the Fed’s hawkish stance has led to excessive tightening in financial conditions, and that this in turn has caused the economy to slow more than intended. Neither of these has happened.
Both activity growth and job creation remain solidly above trend, as shown in Exhibit 2, with our current activity indicator still well above our 1.75% estimate of potential GDP growth and monthly payroll growth solidly above our 85k estimate of the “breakeven” rate. Of course, financial conditions play two roles: they influence the economy’s growth trajectory and also offer signals about it. Some might worry that the 10-year rate is pointing to a slowdown that has yet to emerge in the data–the second role. But with few signs of recession risk, it is not surprising that Fed officials have instead seen the first role as more relevant, with NY Fed President Dudley concluding on Monday that “when financial conditions ease–as has been the case recently–this can provide additional impetus for the decision to continue to remove monetary policy accommodation.”
Another popular recent claim in markets is that the Fed has simply given up on its 2% inflation target. How else to explain the FOMC’s bewilderingly business-as-usual attitude in the wake of three consecutive soft inflation reports? In reality, there is nothing strange about the FOMC’s reaction. The Fed has a dual mandate and has generally interpreted it through a Taylor rule-like framework in which the reaction function sets the policy rate as a weighted average of the inflation and unemployment gaps, centered on the neutral rate. In this context, “giving up” on the 2% target would mean placing zero weight on the inflation gap, which the Fed is clearly not doing. Some market participants seem to implicitly expect the reaction function to be a minimum function, responding to whichever side of the mandate looks worst at the moment, but that–not the Fed’s actual path–would be an unusual departure.
As you can see, the real question isn’t answered.
That is: has the Fed simply adopted a third mandate by taking on the roll of “bubble poppers in chief”?