In the first installment of In the Trenches on October 29th (A False Sense of Stability), I wrote: �
In the Trenches: As Good As It Gets
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This commentary is being provided to you as general information only and should not be taken as investment advice. The opinions expressed in these materials represent the personal views of the author(s). It is not investment research or a research recommendation, as it does not constitute substantive research or analysis. Any action that you take as a result of information contained in this document is ultimately your responsibility. Epsilon Theory will not accept liability for any loss or damage, including without limitation to any loss of profit, which may arise directly or indirectly from use of or reliance on such information. Consult your investment advisor before making any investment decisions. It must be noted, that no one can accurately predict the future of the market with certainty or guarantee future investment performance. Past performance is not a guarantee of future results. Statements in this communication are forward-looking statements. The forward-looking statements and other views expressed herein are as of the date of this publication. Actual future results or occurrences may differ significantly from those anticipated in any forward-looking statements, and there is no guarantee that any predictions will come to pass. The views expressed herein are subject to change at any time, due to numerous market and other factors. Epsilon Theory disclaims any obligation to update publicly or revise any forward-looking statements or views expressed herein. This information is neither an offer to sell nor a solicitation of any offer to buy any securities. This commentary has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. Epsilon Theory recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial advisor. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.
Among the major central banks in the world, the Fed stands out as the only one that is pursuing a policy of increases in its nominal interest rate target. This policy, referred to as “normalization,” was initiated in December 2015. Normalization, however, is projected to take place slowly and is not motivated explicitly by Neo-Fisherian ideas, though James Bullard, president of the Federal Reserve Bank of St. Louis, has shown interest.
What is the risk associated with Neo-Fisherian denial—a failure to take account of the Fisher relation in formulating monetary policy? Neo-Fisherian denial will tend to produce inflation lower than central banks’ inflation targets and nominal interest rates that are at central banks’ effective lower bounds—the low-inflation policy trap. But what of it? There are no good reasons to think that, for example, 0 percent inflation is worse than 2 percent inflation, as long as inflation remains predictable. But “permazero” damages the hard-won credibility of central banks if they claim to be able to produce 2 percent inflation consistently, yet fail to do so. As well, a central bank stuck in a low-inflation policy trap with a zero nominal interest rate has no tools to use, other than unconventional ones, if a recession unfolds. In such circumstances, a central bank that is concerned with stabilization—in the case of the Fed, concerned with fulfilling its “maximum employment” mandate—cannot cut interest rates. And we know that a central bank stuck in a low-inflation trap and wedded to conventional wisdom resorts to unconventional monetary policies, which are potentially ineffective and still poorly understood.
https://www.stlouisfed.org/publications/regional-economist/july-2016/neo-fisherism-a-radical-idea-or-the-most-obvious-solution-to-the-low-inflation-problem
The Fed on its current path will reach the expected NGDP numbers thru QE unwind ivo end of 2022 if it stays the course??? …is the Fed trying to cut away from interest rate manipulation without collapsing the market….what is normalization? is it getting back to market-based outcomes to exist again? What happens when the unwind stops?
A couple of questions.
If nominal GDP is the sum of trailing growth rates in working age population, productivity & inflation; how can declining growth rates in these three series lead to structurally higher NGDP growth & higher interest rates? 2018 was debt fuelled growth advanced from the future. Using trailing 10 yr growth rates for the 3 series, NGDP potential is around 3.2%; real sub 2. Track potential NGDP using trailing 10 yr growth rates for the 3 series and the realized R squared is > than 90%. Then smooth USGG10YR index (constant maturity 10 Yr) and you have a crazy graph. The belly of the curve has an amazing correlation to potential nominal GDP. Is this why rates in countries with declining working age populations have structurally low rates?
Question 2; if QE and central bank distortions of interest rates are the only reason for low bond yields, why have yields remained low and in recent months declined as the FED’s reserves have declined? Could there be primary investment flows that actually affect rates more than the FED? Since 2007 flows into combined fixed-income mutual fund and ETF portfolios are double the flows into equity funds. Did record flows into fixed income over the past three years have any affect on rates? On the aggregate quality of fixed income indices and ETFs?
As an aside, capitalization weighted indices might make sense in equity markets: winners have the biggest impact. They make no sense in debt markets: biggest borrowers have the most impact. Biggest borrowers are at most risk of ratings downgrades, there is no way you want to to be market weight.
The Fed seems to try really hard to not let their rate deviate too far below LIBOR. LIBOR’s continued rise is why I thought they would hike in December despite the perception of a slowing economy, and they did exactly that. If LIBOR continues to rise do you think they’ll continue to try to stay within shouting distance, or will they accept the risks associated with the deviation and try to avoid being blamed for any downturn by holding off on rate hikes?