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November 27, 2014

December FOMC Meeting to Provide Clarity on 2015 Rate Hikes

By EconMatters

4 Trading Days - Important Fed Meeting

The FOMC Meeting Announcement, Forecasts & Chair Press Conference on December 17th should provide more clarity on the rate hike schedule for 2015 as this is the first quarterly FOMC meeting since QE Bond Buying has formally ended. Given that third quarter GDP was revised up to 3.9%, and the Employment numbers this year have been record setting by historical standards (More jobs created on an annual basis in 20 plus years) and there is far too much liquidity in the financial markets as witnessed by both bond and stock prices at essentially record highs at the same time, it is time to start raising interest rates, and fast.


Oil Prices Only Inflation Component Down – Watch Transfer from Energy Component to Core Inflation Getting Hotter Inflation Readings as witnessed by last month`s PPI & CPI Reports.

We are already seeing all inflation metrics rise except one in energy (due to an oversupply issue because of US based Shale Production) Core Inflation is definitely rising, and we are starting to see the Energy readings move down because of the drop in energy prices, but move into the core reading inflation metrics, which is what we would expect to see given an above trend growth environment. Lower gasoline prices are actually inflationary and pro-growth stimulative for the overall economy. As consumers have more money in their pockets due to lower gasoline prices they spend more on other discretionary spending items like Movies, Retail Shopping, and Dining Out.

Lower Oil & Gasoline Prices are Inflationary Stimulus in the Overall Economy

This increases demand pressures in the system and merchants raise prices now that they have more pricing power, and then need to hire more workers because business has picked up due to more money coming in as consumers have a massive tax cut from lower fuel costs and spend more in Restaurants, Shopping Malls, and Entertainment categories. The latest PPI and CPI readings were actually quite robust once you take out the energy component, and as you notice the Airlines are raising prices not lowering them even though they are all getting a huge benefit from lower fuel input costs. So areas where consumers might expect inflation to drop because of lower fuel costs just isn`t going to happen in an above trend growth environment. This is why lower fuel costs and a huge tax break in the form of more discretionary income for consumers is actually inflationary in an above trend growth environment because increasing demand pressures with 200k per month job additions with incomes and more available discretionary income for all consumers means more money chasing the same core components in the core bucket, thereby raising prices and causing inflation to rise in the core readings.

GDP Reporting Above Trend Growth

With the second quarter GDP number of 4.6% followed by what I think when all is said and done is another 4% plus GDP quarter for the third quarter, and another 3% plus 4th quarter after all revisions are in, the core inflation numbers are going to start spiking - it is simple economic theory or pricing and demand pressures playing out in the economy. Throw in the 200k plus monthly employment pressures with a tightening labor market and wages are already rising ahead of the official inflation readings for 2014, and I expect both the Core Inflation Readings and Wages to rise more than most economists expect in 2015 as the above trend growth continues in the first half of 2015.

March 2015 Rate Hikes

I think it will become apparent to Wall Street and the Federal Reserve that they are going to have to move up the June time frame for rate hikes, an event that is currently not being priced into the financial markets at all. There is just way too much liquidity in the financial system, most financial markets are completely broken due to the overflow of liquidity in the system, and the entire market is setting up for a massive liquidity trap if stimulus is not slowly withdrawn, i.e., “starting the unwind process” ASAP, in the form of Janet Yellen setting out a much more Hawkish tone regarding Rates in this upcoming quarterly Press Conference to signal to financial markets to start getting out of highly-levered liquidity driven positions like Yield Chasing at any Price level.  

Central Bankers Enablers for Bubble Creation in Bond Markets – European Bonds Absolutely Worthless at these Prices

Central Bankers really are being taken advantage of by market players, this is being played out in Europe where Mario Draghi is being pressured to take on all these QE initiatives that really only serve one purpose to give free liquidity to financial markets so that players can have more cheap money to borrow to push asset prices up to more unsustainable levels. The game works this way complain, whine, put pressure on the Central Bankers, get lower borrowing costs, borrow and invest in electronic markets. It is not the fact that European rates are too high which is holding Europe back from growing. The irony is that Draghi is part of the problem by reducing European borrowing costs this just further incentivizes more inappropriate uses of capital allocation by European Banks instead of loaning to small businesses which would have add on effects of increased employment in Europe - they just take the cheap liquidity push a couple of buttons and buy more European Bonds pushing prices up further, and none of this stimulus ever goes outside the financial system. This is one of the more growth stifling nasty effects of ‘abnormally low rates’ it incentivizes inefficient and unproductive uses of capital allocation by financial institutions.

Debt to GDP Ratios, Historical Bond Prices, Risk Reward Models & Responsible Investing?

Instead of vetting and seeking out business project investments in Europe, European banks just borrow at 10 basis points and buy bonds (in some cases at negative real rates) with little regard for risk and valuations because the ECB will come to the rescue and buy all these bonds in the QE Program that they pressured Draghi to entertain, and this not only doesn`t spur economic growth in Europe, it actually means the ECB will need to be bailed out.

There is no way if you look at the spiraling Debt-to GDP Ratios across Europe that any of these European Bonds at current prices will not be underwater by 50-60% in 5-10 years’ time. The worst mistake for Europe was lowering the borrowing costs, they should have been raising borrowing costs to more normalized conditions, and they further aggravated this mistake by promising a QE program to buy all these ‘over-valued bonds’ from the European banks – this means much of the capital normally allocated to small business and startups went to ‘Electronic- Paper Based’ trades that never find their way out of the financial markets, all the while hurting the European`s purchasing power by debasing their currency.

Given the history of European Debt-to GDP Spending patterns, and a solvency crisis just 2 years ago, this is going to prove the most massive mispricing of any mainstream asset class in the history of financial markets. The price that investors are buying these European Bonds, and the solvency risks ahead in just 5 years’ time, makes any European Bonds of 10-Year Duration the stupid investment in the history of modern mainstream financial markets. One couldn`t try to be this incompetent if they set out to do so ahead of time, this is just beyond creating market bubbles, this is causing an entire European banking system to become insolvent in as little as a two year period on any normal mean reversion process in bond prices. And given escalating Debt-to GDP Ratios, and Bond Prices in Europe just two years ago, the percentages and risk-taking for such a catastrophic event literally means that the European Bond Market is completely broken, Bonds were not designed for 10 basis points borrowing. And moreover, the ECB is directly responsible for encouraging what I will call the stupidest investment of all time, buying European Bonds, which at these prices have limited upside and infinite downside risk in terms of the solvency risk of the entire European Union (not just the 85% plus haircut on the bonds themselves)!  

Mario Draghi Better Get Hawkish Real Fast as the ECB is too small to Buy ALL European Bonds – There is no model in the world that makes any of these European Bonds have anywhere near this level of ‘Price Sustainability’ over a 10 Year Period

Furthermore, Draghi is causing all these banks to buy all these worthless European Bonds ahead of what they think is a QE program where the ECB will buy ALL THESE BONDS from their books, there are not enough Central Banks in the world to buy up all these bonds, and these same banks are going to be stuck holding these deteriorating and worthless assets in five years, needing a bailout number that is just too big this time around, expect major haircuts on all these assets in the future (maybe as low as 15 cents on the dollar for some of these European Bonds).

ECB is Encouraging Stupid Investment Decisions with Absurdly Low 10 Basis Points Borrowing Costs – This Policy just reinforces Poor Capital Allocation Strategies by European Banks

The sheer stupidity is that these banks all complained for more cheap money to buy bonds to unsustainable levels, and then ask to be bailed out by the same ECB that gave them the cheap money in the first place, shame on the ECB for being played like this by the banking community. The best thing Mario Draghi could do for Europe is to start raising the base borrowing rate to 1%, and then he might start to see productive capital allocation investments in Europe. It will never happen, and is why Central Banks have actually stalled the recovery process, even in the US I bet the Recovery would have happened four years ago under normalized monetary conditions. As Japan has shown abnormally low rates are deflationary in the sense that they incentivize unproductive capital allocation strategies.

Too Much Liquidity in the Financial System – Financial Markets Building a Huge Liquidity Trap Vacuum Scenario

One thing is for sure there is just far too much liquidity in the system, bubbles are everywhere in financial markets and Janet Yellen better get her Hawkish act together real quick or she is going to preside over the biggest financial market collapse as the Federal Reserve`s overabundance of cheap liquidity has been ‘a large enabler’ in juicing asset prices above historically sustainable levels. Everybody wants to stay until the last possible minute before rate hikes, but that is part of the problem, everybody cannot possibly get out at the same time without causing a massive liquidity trap on the exit, and Janet Yellen needs to start managing this event by setting a much more hawkish tone at the Federal Reserve. Instead of meeting with Bond Holders and discussing how they would handle the lack of liquidity in their positions in the Bond Market in times of increased volatility, the Fed needs to start encouraging them to lighten their positions ahead of the actual rate hikes.

3.9% GDP, 5.8% Unemployment Rate, 2.2% Yield on 10-Year Bond – The Federal Reserve Better get Real Hawkish Real Fast as Something`s Gotta Give in this Equation

If everybody waits until the actual Rate Hikes to ‘normalize’ their positions, the Bond Market Crash on the other side is going to make the October Crash look like a minor tremor compared to the real Earthquake that a massive exiting all at once in the Bond Market will cause – the Federal Reserve needs to seriously think about what the October Crash implications mean for a gradual exit versus a ‘wait until the last possible minute’ exit from the bond market. This is where the Fed Chairperson provides ‘market guidance’ in the form of Hawkish tone, and the December 17th FOMC Press Conference, Forecasts and Meeting Statement is the time to start this process.

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Item Reviewed: December FOMC Meeting to Provide Clarity on 2015 Rate Hikes Rating: 5 Reviewed By: Econ Matters