The Fed is trapped.
As everyone knows by now, and as Deutsche Bank reminds us this morning, rising long-term interest rates in the US since August 27 have triggered a case of “risk off” globally, one which juxtaposed higher interest rates and a low VIX, which DB’s team repeatedly noted “cannot coexist.”
And sure enough it did not, resulting in a VIX that jumped in early October, and remained elevated ever since, at around 20. Meanwhile, higher interest rates triggered a rise in the dollar index, depressing commodities and emerging market currencies as – finally – credit spreads widened rapidly.
None of that is new and a similar rise in interest rates and the US dollar took place just a few years ago, back in 2015 following the Chinese yuan devaluation which triggered, via lower commodity prices and emerging market currencies, turmoil in credit markets between December 2015 and February 2016.
According to Deutsche Bank, “recent trends are reminiscent of that period.”
Of course, the 2016 turmoil episode was resolved with the Shanghai Accord: after the G20 summit of 26-27 February 2016, the Fed took back its hawkish stance, and together with the ECB and BoJ deferring on additional easing, the dollar’s appreciation corrected, and market liquidity recovered.
Fast forward to last week when – pressured by president Trump who called for the Fed to halt rate hikes while hinting he may “replace” Powell – a mini “Shanghai Accord” moment took place when on 28 November, Chairman Powell said the Federal Funds rate is just below the neutral (a dramatic reversal to his October 3 statement that “we are a long way from neutral at this point”). This sparked the view that the pace of rate hikes would slow in 2019, pushing yields down and stocks up.
Which in turn brings us to why the Fed is trapped: As Deutsche Bank says, over the short term, lower long-term rates will surely bring about a recovery in global market liquidity. However, with the US is at full employment, inflation still rising, and corporate debt and consumer loans as a ratio of GDP continues to hit new record highs, the Fed is unable to begin a full-blown easing process and even pausing the rate hikes could be seen as betraying its mandates.
So, as the economy and credit have grown “to their limits” and do not permit any additional easing without the risk of several economic dislocations in the future, Deutsche Bank’s ominous view is that “a major turning point could come within the next 1-2 years”, which incidentally is precisely what Morgan Stanley said over the weekend when it previewed 2019 and said it will be the “turning point“ year.
Confused? Don’t be: the following “simple” chart from Deutsche Bank, which recaps the “spread of risk-off sentiment” in 2016, just before the Shanghai Accord, also “explains” the dilemma facing the Fed right now, and why – as a result of fiscal policy which is overheating the economy unlike back in 2016 – Powell is well and truly trapped.