“The dollar rally is far from over,” Goldman’s Robin Brooks said, just hours before this week’s FOMC announcement.
“We expect the Fed to signal that it wants to continue normalizing policy, which means three hikes this year and four in 2017,” Brooks continued. “Overall, our sense is that the outcome will be more hawkish than market pricing.”
Yes, “a hawkish outcome” was on the way, which should have led directly to a DM monetary policy divergence the size and scope of which would be unprecedented in the post-crisis era.
Our warning to the market: “Given the fact that i) Brooks’ calls are generally about as accurate as Gartman’s, and ii) Goldman is one for six so far on its Top Trades for 2016, you might want to go with the market’s view on this one to avoid getting the muppet treatment.”
A few hours later, citing growing risks to global financial markets, the FOMC delivered an exceptionally dovish decision, as the median forecast for 2016 rate hikes dropped to just 2 from 4 previously. Here’s what happened next:
Apparently, the Fed’s dovish lean was part of a coordinated effort on the part of global central banks. Have a look at our annotated chart:
We also found a video:
Anyway, Goldman is apparently convinced that it’s not so much the bank’s forecast that was wrong, but rather the FOMC is simply mistaken in its projections about what it will itself eventually do.
As the bank’s chief economist Jan Hatzius explains, Goldman is “more confident than the FOMC that both wage and core price inflation have started to move higher,” and “therefore, [Goldman] continues to expect three Fed hikes this year,” not two.
Generally speaking, Goldman isn’t buying the whole global coordinated easing argument. Well, that’s not entirely accurate. Hatzius agrees that’s what’s been going on this month, but doesn’t think the Fed will be willing to play along for that much longer. Here’s Goldman on central banks’ collective effort to keep the spigots open and avoid the type of USD strength that suppresses commodities and adds to the deflationary impulse:
One interpretation of the recent moves by the major central banks is that they represent a coordinated attempt to ease global financial conditions while avoiding upward pressure on the US dollar, especially against the Chinese renminbi. The FCI easing that has resulted from these moves is highly welcome in much of the world, and to some degree also in the US.
But the supposed relative strength of the US economy versus peers doesn’t support the Fed’s playing along in perpetuity:
But the US economy’s stronger cyclical position compared with its peers is likely to keep this episode short-lived. We are more confident than the FOMC that both wage and core price inflation have started to move higher. And once the economy reaches full employment—we think late this year—further above-trend growth will become less welcome.
Here’s a look at the effect recent easing has had on Goldman’s DM FCI index:
Yellen, Goldman imagines, was more than happy to contribute – this time:
At a time when interest rates are still near their effective lower bound and both inflation and employment have been below target for several years, the risk of tightening monetary policy too early is greater than the risk of tightening too late. Thus, if the policy moves of recent weeks really were coordinated, the FOMC was probably quite happy to participate, not only as a matter of good global citizenship but also out of self-interest.
Hatzius goes on to note Yellen’s dovish presser comments before outlining why the bank thinks her projections are either wrong or simply reflect a kind of willingness to look the other way when it comes to relative US economic strength so as to give the FOMC an excuse to join one last hurrah as it relates to global coordinated easing.
But, Goldman warns, “as we get closer to full employment and inflation moves toward the 2% target, we expect the FOMC to become less tolerant of above-trend growth.” Why? Because as we explained in November, if unemployment undershoots, the snap back would almost invariably trigger a recession:
To be sure, Fed officials have recently argued that limited amount of labor market overheating may be helpful, in part because this may reintegrate more workers into the labor market and thereby reverse some of the structural damage from the Great Recession. But a large amount of overheating is dangerous because it implies that the FOMC would ultimately need to aim for a “soft landing from below”—that is, a gradual increase in the unemployment rate back to its full-employment level that does not tip the economy into recession. This has never been done.
Colloquially speaking then, to avoid causing an inevitable recession, the Fed will need to cut it out with the dovishness before there’s too much employment. And that means Yellen simply can’t participate in these coordinated efforts for too much longer:
To guard against significant overheating, we think that the FOMC would want output and employment growth to slow as we enter 2017. But this seems inconsistent with the current setting of financial conditions.
Or, summed up in one picture:
The caveat is this: global markets are too interconnected for the Fed to pursue its own, independent agenda (i.e. guarding against undershooting on unemployment). If this is true, or, in Goldman’s words, “if the turmoil early this year contains a message that even a small US rate hike can have a much bigger impact on financial conditions, perhaps because of the greater importance of China in the world economy and the unusual vulnerability of its currency peg,” then the Fed may be forced to either: 1) say to hell with the rest of the world and hike anyway while realizing that the soaring dollar, slumping commodity prices, and tightening financial conditions will wreak havoc on markets, or 2) undershoot on unemployment and then risk tipping the US economy into recession as unemployment rises back to full-employment. If the Fed chooses option two, and the economy does tip back into recession, then the Fed will have to go back to easing, and around we go.
Anyway, that’s probably overthinking it. Goldman’s conclusion is simply this:
But we would not want to take this argument too far. Our analysis of the spillovers from China to global growth simply does not support the kind of hyper-sensitivity that underlies much of the current market narrative. And if we are right, the Fed’s willingness to keep policy easier for longer in the name of global policy coordination is likely to be short-lived and the funds rate will rise significantly further than currently discounted in the bond market.
Of course Goldman’s calls are the best contrarian indicator there is (although it’s a close race with Gartman), so in that regard, expect more coordinated easing with the Fed fully on board. Then again, Goldman controls the Fed, so perhaps this week’s seemingly wrong-footed (or “wrong-tentacled”, as it were) hawk/USD call simply means the FOMC is operating on a delay.
via Zero Hedge http://ift.tt/1VnmBUA Tyler Durden