While it was generally a quiet day in the market, an unexpected tension emerged today: first central banker incubator Goldman Sachs, and then RBC both made the case that Janet Yellen has not only failed to communicate what yesterday’s rate hike means, but that the Fed has effectively lose control of the market, by unleashing just the opposite reaction of what the Fed had intended: in fact, as Goldman explained, the response to the market was the equivalent of “almost one full cut in the federal funds rate.” In other words, instead of hiking, the market interpreted the Fed’s action as a rate cut, which according to Goldman will force the Fed to explain that the market was wrong, prompting even more volatility when the market’s inevitable cognitive dissonance hits.
But is it the market’s fault it no longer believes the Fed? Of course not, and as SocGen’s Albert Edwards notes, it is the “Fed’s lack of verbal assertiveness means the market still cannot bring itself to believe the Fed’s own projections for interest rate hikes.”
There are several factors at play here, not only the confusing dots (which as RBC pointed out moved in a hawkish fashion for 2017). As Edwards’ co-worker Kit Juckes summed up. “the Fed’s reluctance to send an aggressive tightening signal, instead preferring to again shuffle upwards its dots just slightly, has disappointed markets. But to be fair, the problem isn’t really with the famous dots. It’s with the market, which just doesn’t believe the Fed will tighten as fast as they say they plan to (see left-hand chart below). If the market took the FOMC at their word and discounted a 3% Fed Funds rate at the end of 2019 and beyond, then we’d probably have a 3% nominal 10-year Treasury yield by now.”
Kit also points out ?after spending the 1980s defeating inflation, the Fed has allowed rates to spend progressively longer and longer below the nominal growth rate of the economy (see right-hand chart above). Trend nominal growth is only a first estimate of where the natural rate of interest might be – and it?s definitely been dragged lower than that in recent year – but depressed market volatility, and the strength of asset prices is a result of low rates. And nominal GDP growth is at 3½% while the FOMC?s range for the dots in 2019 was 3% wide, from 0.9% to 3.9% with a median at 2.9%.?
So how did the Fed become what is essentially a joke to traders, and why does the market no longer believe it any time the message may be a negative one?
One reason why the market doesn’t believe the Fed dots is that investors cannot conceive of Fed tightening to the point that it causes the stockmarket any serious damage. Time and time again over both this and previous cycles the Fed has backed off rate hikes as soon as the going got tough. Maybe that is why the S&P trades at such a huge PE premium to the rest of the world?s equity markets (see chart below), for only a small part of this divergence can be attributed to sector composition.
Edwards also notes something that is quite significant from the PE chart above: namely how Japanese forward PEs are roughly the same as where they have been for the last six years whereas the US and the eurozone have seen considerable PE expansion. Yet Japan has seen much more rapid profits growth since the 2008 crisis. Some will put this solely down to the Abe-inspired weak yen, but the domestic-dominated whole economy profits measure shows exactly the same record-breaking profile as the overseas-dominated stockmarket indices.
Just as troubling is that the whole economy profits in the US are not recovering anywhere near as quickly as the stockmarket measures. Indeed it is at this late point in the cycle that US stockmarket non-GAAP, “pro forma” profit measures become increasingly manipulated and detached from the whole economy profit measures.
So what is an alternative metric to look at? According to Edwards, the US whole economy profits measure gives a more ?truthful? representation of companies underlying profit conditions ? the data comes from the IRS and companies don?t tend to lie to the IRS. The whole economy profits data is not so timely as the stockmarket data as the IRS and the Bureau of Economic Analysis have to give the data a good scrub. Hence the Q4 whole economy profits data will only be released with the 3rd estimate of Q4 GDP on 30 March. But a sneak preview is buried deep in the recently released Fed Z1 Flow of Funds release.
What it shows is that very much against expectations, whole economy measures slipped again in Q4 in line with unit labour cost data that show corporate margins are being squeezed. This is in contrast to the heavily massaged stockmarket measures which have been recovering briskly.
As Edwards concludes “we’?ve seen this divergence before at the end of the cycle and I know which I believe. This adds to my concerns that US PE valuations are totally unjustified ? in stark contrast to Japanese PEs.”
Ironically, if Edwards is correct about the collapse in profits, then the market is spot on not believing the Fed: after all, the trend confirms a recession is imminent. As such, after 1-2 more rate hikes, the Fed will not only swiftly cut back to zero, or maybe go ECB/SNB/BOJ, but be forced to launch that $1 trillion in fresh QE4 which Deutsche Bank has been quietly expecting for some time.