Recent “problems” emanating from Italy, the potential for Spain to pop up as a political flashpoint (again) and perhaps most importantly in the near-term from the Fed’s perspective, the prospect that further dollar strength and Fed hikes could trigger a dramatic unwind across EM, have together reignited the debate about whether the Fed would be inclined to pause for international developments.
Obviously, the Fed would step in to stabilize global markets if the bottom fell out completely – like, for instance, if something were to go completely off the rails and the euro were to dissolve. But barring that, the bar (get it?) is pretty high for international developments to dictate Fed policy. Or at least that’s the standard line.
One could easily argue that the Fed’s relent in September 2015 represented something of a sea change in the committee’s willingness to make explicit what was previously implicit – namely that the market is a co-author of the policy script (to adopt the “fourth wall” analogy employed during that episode by Deutsche Bank’s Aleksandar Kocic, a framework that’s influenced my own writing ever since). Recall how Kocic characterized things after the September 2015 Fed meeting:
September FOMC meeting felt like a blind date that was never meant to be. As the market developments were unfolding, Fed members simply didn’t like what they saw. Despite seemingly robust US data, the global economy appears too fragile and the strong USD is in the center of the crisis. The developments in EM have been negative for risk and, if conditions deteriorate further, the net result could be in a nontrivial adverse impact on DM economies. Rate hikes and further USD strength could have made things considerably worse. So, while the market waited, Fed decided not to engage.
Going into the FOMC meeting, we had to face multiple nested contingencies, from Fed reaction function, to ambiguous signals given by the economic models which largely underwent structural breaks post-2008 and eroded market’s already low confidence regarding economic forecasts. The Fed decision showed that when everything fails, common sense remains the best guide. And common sense prevailed.
This changes everything. Power relations have been revealed; nothing will ever be the same. In that sense, despite seeming status quo, the FOMC was a true Event in the sense of being an encounter which retroactively creates its own causes.
What we now have is another data point which outlines the contours of the Fed reaction function. Fed’s communication strategy, it is becoming clear, is an equivalent of what in theater context is referred to as Removing the fourth wall whereby the actors address the audience to disrupt the stage illusion — they can no longer have the illusion of being unseen. An unalterable spectator becomes an alterable observer who is able to alter. The eyes are no longer on the finish, but on the course — what audience is watching is not necessarily an inevitable self-contained narrative. The market is now observing itself from another angle as an observer of the observer of the observers.
One of the reasons why installing Kevin Warsh as Fed chair would have been a dangerous proposition is that if you go by things he’s said, he would have effectively tried to rebuild the fourth wall, thus revoking the market’s license to co-author the policy script.
There’s an argument to be made that Jerome Powell is attempting to do something similar although in a fashion that’s not nearly as dramatic as what a Warsh Fed would likely have tried to pull off.
To the extent Powell sticks to the script from comments he made at an IMF/SNB event earlier this month, it would appear to represent a deliberate effort to move back towards a situation where policy is, to quote Kocic, a “self-contained narrative” and not subject to being altered by the spectators (markets). Here, for anyone who missed it, is what Powell said about the likely resilience of emerging markets as the Fed normalizes policy:
Monetary stimulus by the Fed and other advanced economies played a relatively limited role in the surge of capital flows to (emerging market economies) in recent years.
There is good reason to think that the normalization of monetary policy in advanced economies should continue to prove manageable for EMEs. Markets should not be surprised by our actions if the economy evolves in line with expectations.
Needless to say, that’s all debatable (especially the bit about DM monetary accommodation playing “a relatively limited role in the surge of capital flows to EM”).
The events that have transpired in Turkey, Argentina, Brazil and Indonesia over the past two months underscore the idea that while idiosyncratic stories will always be part of the equation when it comes to explaining EM vulnerability, when the entire complex starts to crack, one good place to look when it comes to seeking out the proximate cause is Fed policy (more on this in “Shaking The Tree: The Fed, ‘Overripe Fruit’ And A Half-Full Snifter“).
And so, with that as the backdrop, the natural question for markets in light of recent international developments is this (as posed in a new note from Goldman): “will foreign vulnerabilities stop the Fed’s hiking cycle?”
This is especially relevant this week considering the rally in Treasurys on Tuesday (10Y yields fell by 17bps, the most since Brexit) and the repricing of the Fed.
“In particular, political developments in Italy and signs of vulnerability in select EMs appear to have raised doubts about the longevity of the hiking cycle,” Goldman writes.
They go on to explain why folks believe the Fed might be forced to adopt a less aggressive stance, and one argument is obviously that if Italy deteriorates further (or if Spain starts to cause problems), the ECB will be forced to lean dovish, thus increasing policy divergence between the U.S. and Europe and underpinning the dollar. The other argument is the EM issue. Here’s Goldman:
The first is that market conditions in Europe will lead the ECB to delay tightening, and as a result Fed hikes will result in excessive dollar appreciation. The second is that the world economy, especially EMs with sizeable current account deficits and dollar-denominated debt, simply cannot bear the higher interest rates and stronger dollar that could result from too many US rate hikes. In both cases, the argument goes, either foreign concerns themselves or the spillovers to the US economy will force the Fed to stop hiking before long.
Long story short, Goldman thinks the risk that exogenous shocks force a Fed pause is overstated and one simplistic explanation they give is that while the stronger dollar and U.S. equity weakness could tighten financial conditions, the safe haven bid for bonds would mitigate the effect.
“As is often the case in such situations, the recent dollar appreciation and equity market sell-off have been largely offset by falling interest rates, resulting in only a negligible net tightening in the FCI,” the bank writes, before showing you the visual:
Ok, so again, that’s kind of simplistic. But don’t worry, they know that and they’re not stopping there. Goldman goes on to explain why Powell might be right to suggest that EM is less vulnerable to Fed hikes now than in the past, although they cite Powell himself, so there’s a little bit of self-referential argumentation/confirmation bias going on there.
Of course everybody has their own opinion on that issue and everyone from Carmen Reinhart to Mohamed El-Erian to Paul Krugman (go ahead, get the laughs out of your system), has weighed in over the past month.
So instead of going back over that, what’s perhaps more interesting if what you want is snapshot/quick read, is the following effort from Goldman to simply look at what’s happened in the past:
The Fed has historically had a high bar for changing course in response to foreign concerns. In an earlier analysis, we examined the Fed’s response to the Latin American debt crisis starting in 1982, the Japanese equity market crash in 1990, the Mexican peso crisis in 1994, the Asian financial crisis in 1997, the Russian financial crisis in 1998, and the European sovereign debt crisis in 2011. We found that the effects on the US economy were usually minor and the effects on the US FCI turned roughly neutral in the medium term in most cases, with dollar appreciation offset by lower rates. The Fed only changed course in the last two cases–shown in Exhibit 2 as dovish deviations between the actual policy rate and that implied by a policy rule–because both presented risks of contagion to the US financial system.
More recently, the Fed also paused for most of 2016 due to risks from “global economic and financial developments.” In this case, the driver was first fear that a slowdown in China and a selloff in the US equity market might be foreshadowing a US recession, and then later uncertainty about the fallout from Brexit for both financial markets and the stability of the Euro area. History thus suggests that the bar for changing course is fear that spillovers could cause a financial crisis or a recession in the US. Responding strictly to concern about foreign economies would be unusual, in part because Fed officials doubt their impact is as large as often claimed.
They also remind you that with the U.S. economy running at (or at least near) full employment and with fiscal stimulus expected to provide a near-term sugar high (and that implies an eventual crash), the bar might be higher still for international developments to force a pause.
While that’s all fine and good, do remember that September 2015 changed everything with respect to this debate.
The only question is how determined Jerome Powell is to reverse that change.