Last September, Janet Yellen adopted the now famous “dovish relent.”
A little over three weeks earlier, China “shocked” the market with a “surprise” devaluation of the yuan. To be sure, no one should have been taken off guard. China is an export driven economy with a currency tethered to the dollar. As the dollar moved higher against the currencies of China’s other trade partners, the country’s economy suffered. There was only so much pain Beijing could take - especially considering the necessity of preserving the 7% growth narrative.
It’s not entirely clear whether the People’s Bank of China carefully considered what the implications of the devaluation might be before they implemented the new FX regime on August 11. The move came at a delicate time. Europe, Japan, Sweden, Switzerland, and a whole host of other countries were (and still are) in the midst of an undeclared currency war. China’s entry into the melee carried significant risks for global stability.
Further, it seems as though it didn’t occur to Beijing how costly the new system would ultimately be. Perhaps more importantly, the PBoC seems not to have considered what the implications would be for risk assets in the event the central bank was indeed willing to pay the bill.
Whatever the case, chaos ensued in the form of Black Monday on August 24 and as China began to liquidate their US Treasury holdings in an attempt to manage the yuan, some analysts began to ask if China’s sale of Treasuries would ultimately end up offsetting asset purchases by other central banks.
That was the reality that confronted Janet Yellen at the FOMC’s September meeting. Ultimately, the Fed was forced to tacitly admit that the events unfolding in international financial markets were, at that particular moment anyway, more important than the data emanating from the US. The reaction function had changed. The list of relevant variables had expanded to include anything that had the potential to boomerang and trigger a downturn in developed markets. The potential for exogenous shocks overrode generally strong US economic data.
But in today’s interconnected global economy and interdependent global financial system, it’s easy to put the cart before the horse, so to speak. That is, was it really global turmoil that forced the Fed to stand pat in September? Or was it the case that the Fed missed its window to hike earlier in the year (or perhaps sometime in 2014) and therefore created the conditions that prevailed in August of 2015?
Day in and day out, we hear a veritable cacophony of Fed speculation. We parse every word regional Fed presidents say in their near daily speaking engagements for the slightest clue about hawkish or dovish leans. We believe, apparently, that the fate of every asset class on the planet depends largely upon when the Fed moves next.
But the Fed itself seems to be beholden to the very same markets that are convinced their own fate is beholden to the Fed! As Deutsche Bank famously put it last year, “the fourth wall has been removed”:
“What we now have is another data point which outlines the contours of the Fed reaction function. Fed’s communication strategy, it is becoming clear, is an equivalent of what in theater context is referred to as Removing the fourth wall whereby the actors address the audience to disrupt the stage illusion -- they can no longer have the illusion of being unseen. An unalterable spectator becomes an alterable observer who is able to alter. The eyes are no longer on the finish, but on the course -- what audience is watching is not necessarily an inevitable self-contained narrative. The market is now observing itself from another angle as an observer of the observer of the observers.”
Or, more simply: this has become something of a chicken-egg scenario.
With this in mind, I found BofAML’s latest to be particularly interesting. The bank first addresses the “adverse feedback loop” that seems to keep Janet Yellen in suspended animation:
“By some accounts the Fed is stuck in an adverse feedback loop. They want to raise interest rates so they can ‘reload’ their policy ammunition, but the markets won’t let them. Chart 1 illustrates this nightmarish merry-go-round: the Fed threatens to hike, markets tank, the Fed delays the hike, the market recovers and the cycle repeats. The end result is repeated delays and very little actual policy tightening.”
But is it really the Fed that causes markets to “tank”? The answer, BofAML says, is no:
“For the two more recent episodes we have adopted an ‘event study’ approach that we have used in the past. In particular, we look at the Reuters stock market wrap-up each day that the S&P 500 moved up or down at least a percentage point. We focused on days with relatively large moves on the assumption the cause of bigger moves would be easier to identify. On each day, we “allocated” the market move to eight kinds of stories: (1) US macro data; (2) news from Europe, (3) Japan and (4) China; (5) oil news, (6) corporate news, (7) Fed policy and (8) ‘other.’ The results are not very surprising, confirming that the big story of the last year is not fear of the Fed, but China and oil.”
You’re reminded of what I said here on Friday, namely that this market is driven by oil.
Once again though, one could make the argument that Fed policy feeds headline risk in China and adversely affects crude. A hawkish Fed equals a strong USD, a strong USD equals weak crude, and weak crude is negative for risk, negative for the broad commodities complex, and thus negative for China.
This is a puzzle that won’t easily be solved. But should Janet Yellen decide to shock the world with a hike next month, we’ll at least get some clues.