At midday on December 16, the Fed will begin a tightening cycle, raising the overnight cost of money — the Fed funds rate — for the first time since 2004. Finance professionals in their thirties have had no firsthand experience with the event.
This will be the ninth such cycle since 1955. The most important thing: how long (oh Lord), how long. Every previous cycle ended in recession, all but one (the 1990s) a straight-line death march. Also in each one, the Fed throughout insisted that it was merely following markets, tightening for our own good to prevent “overheating,” and intended a “soft landing” — a nifty slowdown without recession.
Given the response yesterday to another central bank’s action, we and the Fed and everyone are in for surprises. Mr. Draghi of the European Central Bank (ECB) has gotten a lot of mileage out of another Fed tool: the jawbone. One elaborate promise of certainty after another that the ECB would not allow the euro to fail and would act as necessary to revive the European economy. Draghi had elevated expectations for ECB action at its meeting yesterday, but the timid reality blew up markets worldwide.
U.S. long-term rates — Fed or no Fed — have followed German ones for years. In the last few weeks, it looked as though U.S. mortgages would break down into the threes again, following the U.S. 10-year which was following the German 10. And if euro-zone rates were going to fall more, the euro fell, also, and the dollar rose.
All of that blew to smithereens Thursday morning when we learned that the German block at the ECB had strangled Draghi’s intentions. Europe is still an awful mess, inflation running 0.1 percent, and all non-German economies still borrowing faster than their GDPs are growing, political stresses rising.
This ECB misadventure was sandwiched between Chair Janet Yellen’s latest testimony to Congress on Wednesday and today’s employment report. I don’t know if the ECB hoo-hah has suppressed reaction to the Fed’s intentions, or the Fed’s year and more of wolf-wolf-wolf-wolf did so, but Yellen on Wednesday for the first time flashed the teeth of the matter and very few people got the full import. “Less than 100,000 new jobs monthly are sufficient to employ new entrants to the workforce, and we cannot expect participation to grow.”
There it is. Sooner or later, Fed Chairs come out from the cover of zillions of words and if-then-maybe. San Francisco Fed President Williams said the same thing over and over, but now we’ve got it from the Chair: The Fed will tighten gradually until it sees job growth decline to 100,000 monthly or less. The GDP speed limit will be closer to 1 percent than 2 percent. The more resilience in the economy and job market, the faster the Fed will tighten.
The Fed’s rationale for tightening rests entirely on belief that the job market will overheat, and better to begin now than to wait. No other element of the economy shows the slightest overheating except for auto lending (citizens used to look forward to buying a home, now it’s a new car) and the student loan racket.
The Fed is taking a huge risk, but in favor of prudence. That’s why they have the job and not Congress or the President. Nearly every data thread in the U.S. economy is slowing, and the world outside the U.S. is sinking. The risk is not in the 0.25 percent hike itself, or the one after that, or the ones following. The risk is in the shock to businesses and households, where memories are short and it’s been a long, long time since the last time interest rates rose at all.
“Prime” will rise in 12 days for the first time in 10 years. The payments on home equity lines of credit will rise. LIBOR is already moving up in anticipation of the cycle to come, and adjustable-rate mortgage payments are rising for the first time in ten years. Not a lot. A shock, or a non-event?
People who work in and near finance are bored silly by the Fed’s wolf-wolf, but those at kitchen tables will be surprised.
For most of my working life, I’ve taped the coming year’s schedule of Fed meetings to my desk each December. I quit a few years ago because they didn’t matter. Taped it up again today.
The 10-year T-note has held well, and held down mortgage rates. Partly buying from overseas, and partly bets going down that Fed tightening will stop and reverse sooner than later. This chart is two years back, and shows no technical “tilt.”
The Fed-predictive 2-year note was stable during the wolf-wolf period of 2015, towel thrown in this fall. It has now begun mechanical reaction to tightening, and its next move after Dec. 16 will be the best forecast available.
LIBOR (London interbank offer rates) moves with the Fed and the 2-year note. It is not a guaranteed rate like Treasury’s, and its spread to Treasury’s and the Fed is variable, but it controls the payments on U.S. ARMs and is already up a quarter-point from summer.
All eight prior Fed cycles, each ending in recession (shaded bars). Only the 1990s had an abrupt tightening in 1994 (a near-hit recession) followed by five years of stability and then the coup-de-grace in 1999.
German 10s, only two weeks back. They traded at 1.00 percent last summer. ECB expectations crushed yesterday. With reasonable consistency, U.S. 10s trade 1.60 percent above German ones, the two moving in near-lockstep. Changes in that spread — someday — will tell us a lot about relative changes in the economies of the U.S., Europe and the world.
The interest rate movement caused the currency movement, just as explosive. Keep that relationship in mind. In this case the ECB timidity was completely counter-productive. It had hoped that a minor cut in its cost of money (from negative 0.2 percent to negative 0.3 percent) would pull down the euro. Nope.
The Fed may be wise to worry about labor market overheating in the future, and the lags in the effect of its rate hikes. But it’s impossible to justify sustained hikes based on today’s inflation data (Personal Consumption Expenditure deflator).
Here is the Chicago Fed’s month 85-component measure of the U.S. economy. There is no acceleration, dangerous or otherwise.
Ignore the manufacturing PMI going negative at your peril, Fed. The last time it did, the Fed rolled out QE3.
The GDP has held above 2 percent summer-fall because of inventory accumulation. The Atlanta Fed’s forecasting engine has had a bad November.
The London Telegraph’s amusement at Draghi controlled by Germans while the euro-zone burns. We have our Germans, too; and others merely locked in historical relationships long gone.
Lou Barnes is a mortgage broker based in Boulder, Colorado. He can be reached at lbarnes@pmglending.com.
