Has the Fed run itself into a corner?
I used to play soccer in high school. I was a backfielder, or sweeper. Whenever the opposing team’s striker had a breakaway, our coach would shout “Box him! Box him” from the sidelines. He wanted me to cut off the other player’s angle to our goal—to “box him” into the corner—to reduce his options.
I wonder if the markets have boxed the Fed. Several months ago, Janet Yellen noted that the Fed would be “data-dependent” as it evaluated its policy options. She said this in order to guide market expectations—to encourage market participants to follow the data. Since that time, our economy has steadily improved: unemployment has fallen, inflation has remained steady, bank lending has grown.
As a result, the dollar has strengthened, crimping exports and—to a lesser extent—US manufacturing. This, in turn, has hurt export-dependent emerging economies whose currencies are linked to the dollar. Finally, the Chinese government devalued the Yuan, leading their stock market to give up the dramatic gains it enjoyed earlier this year. These factors came together last month to give us heightened market volatility.
Market Volatility Index (VIX). Source: Bloomberg
Now the Fed is facing an irony of its own creation: having committed itself to open communication and managing market expectations, they now have to take their cues on a rate move from the market. They’re in a catch-22: stocks are volatile because the Fed is likely to move, but that volatility makes the Fed less likely to move. Fundamentally, our economy has strengthened enough to justify higher rates. Global jumpiness, though, may cause the Fed to delay a rate “liftoff” once again.
But a delay may cause more problems down the road. Our current regime of negative real interest rates has been in place for a long time. Many investors have taken on more risk just to maintain a low-risk income objective. Rather than spurring inflation, our zero-rate policy may ultimately create deflation. Because there’s nothing more deflationary than generating an asset bubble and then having it explode.
Douglas R. Tengdin, CFA
Chief Investment Officer