Quantitative & Strategy

Cam Hui, CFA June 13, 2017 cam@[email protected] SHOPIFY INC.

THE CHANGES TO THE 2018 FED THAT NO ONE IS TALKING ABOUT

Highlights As the market looks ahead to the upcoming FOMC meeting, it's time to consider not just what the Fed might do at its June meeting, but for the remainder of the year. The bigger question is how the Fed reaction function might change in 2018 as the new Trump nominees to the Board of Governors assume their posts. Another question to consider is whether the Trump Administration intends to keep Janet Yellen as Fed Chair. As there are three open positions on the board, and three rumoured nominees, any potential new Fed Chair would come from the current list of new appointees. Of the three, the most likely candidate is Marvin Goodfriend. Current readings indicate that while U.S. economic conditions may appear to be a bit soft, the global outlook is strong. The Fed should continue on its path of monetary policy normalization, which translates into three rate hikes this year and the initiation of balance sheet reduction in either late 2017 or early 2018. However, should all three potential candidates be nominated and appointed to the Fed's Board of Governors, the direction of monetary policy will change quite dramatically, possibly as soon as Q4/17. At a minimum, the Fed is likely to become more hawkish and possibly downgrade the full employment part of its dual mandate. The biggest risk under a Goodfriend Fed is the economy will experience more frequent and deeper recessions, much like the way it did during the 19th Century.

In short, while the longer-term outlook for the Fed’s monetary policy direction is uncertain and fraught with risk, it is too early to panic. We prefer to wait for some signs of confirmation of policy changes when these potential candidates are actually nominated before reacting. For now, the current positive fundamental backdrop indicates that the intermediate-term trend for stocks is still up, and pullbacks should be relatively shallow. June 13, 2017 Quantitative & Strategy

Fed Preview: What Happens in 2018?

As the market looks to the upcoming FOMC meeting, it's time to consider not just what the Fed might do at its June meeting, but for the remainder of the year. The bigger question is how the Fed reaction function might change in 2018 as the new Trump nominees to the Board of Governors assume their posts.

Another question to consider is whether the Trump Administration intends to keep Janet Yellen as Fed Chair. As there are three open positions on the board, and there are three rumoured nominees, any potential new Fed Chair would come from the current list of new appointees. Of the three, the most likely candidate would be Marvin Goodfriend.

Current market expectations show December 2017 Fed Funds (black line) to be relatively steady, but December 2018 Fed Funds (red line) have been declining. Regardless of whether Goodfriend becomes the new Fed Chair, we examine how the influence of the three likely appointees may change the path of monetary policy in 2018 and beyond.

Exhibit 1: A Flattening 2/10 Treasury Yield Curve

Source: Datastream

Cam Hui, CFA | (604) 724-8404 Page 2 June 13, 2017 Quantitative & Strategy

The Fed’s Current Analytical Framework

Let's start with the analytical framework of the current Fed. There has been much hand wringing about the decline in inflation. However, it's measured, whether using the Fed's preferred metric of core PCE inflation, trimmed-mean PCE or sticky price inflation, inflation is falling.

Exhibit 2: Inflation Is Falling

Source: FRED, Federal Reserve Bank of St. Louis

For now, evidence of falling inflation is likely to be ignored. As Fed watcher Tim Duy pointed out:

The Fed's focus remains on the labor market. Hence, they remain focused on two rate hikes and balance sheet action still to come this year.

Here is how the employment picture looks like right now. Unemployment (black line) has fallen to the historically low level of 4.3%, while median nominal real earnings (blue line, quarterly data) has been accelerating, and the more timely average hourly earnings (red line, monthly data) has softened.

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Exhibit 3: A Mixed Picture from Unemployment and Wage Growth

Source: FRED, Federal Reserve Bank of St. Louis

As the Fed has traditionally been cautious, and believed that monetary policy operates with a lag, the natural tendency would be to hike the rate in June and wait for more data.

Transitory Weakness?

Moreover, the Fed is likely to interpret the current patch of soft economic conditions as "transitory". Sure, the Citigroup Economic Surprise Index has been falling, indicating that macro releases have mostly missed market expectations.

Exhibit 4: U.S. Macro Data Has Disappointed

Source: Datastream

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Looking around the world, however, the global economy remains robust. At the margin, buoyant non-U.S. economies are likely to provide a boost to the U.S. economic growth. As the chart below shows, a comparison of the S&P 500 and non-U.S. markets show that while the SPX led the rally in weeks after the November election, non-U.S. markets have caught up and have been outperforming since early March. Even if a case could be made that the U.S. equities were rallying because of the anticipation of Trump tax cuts and deregulation, the same argument would not hold for non-U.S. stocks. The Trump trade is dead, but the global reflation trade lives on.

Exhibit 5: The Trump Trade Is Dead, But the Global Reflation Trade Lives On

Source: Stockcharts

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Callum Thomas of Topdown Charts pointed out that indicators of global trade are rising, which is bullish for growth.

Exhibit 6: Global Trade Is Strong

Source: FactSet

Tom Orlik, Chief Asian Economist at Bloomberg, came to a similar conclusion when he analyzed the latest Chinese trade statistics.

Exhibit 7: Chinese Trade Growth Is Strong

Source: Bloomberg

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Across the Atlantic, eurozone growth was revised to the highest rate in two years.

Exhibit 8: Eurozone Growth Rebounding

Source: HIS Markit, Eurostat

In short, while U.S. economic conditions may appear to be a bit soft, the global outlook is strong. In the absence of strong evidence to the contrary, the Fed should continue on its path of monetary policy normalization, which translates into three rate hikes this year and the initiation of balance sheet reduction in either late 2017 or early 2018. Here Comes the New Fed Governors

So far, what we have described is the most likely outlook of the current Fed, which is likely to change soon. The New York Times reported that Trump is about to nominate Randy Quarles, a former Treasury official in the George W. Bush administration, and Marvin Goodfriend, former Richmond Fed economist and academic, to the Federal Reserve Board of Governors. Bloomberg also reported that Robert Jones, the chairman of a community bank, is being considered for a seat on the Fed Board.

If these nominations do proceed, it begs the question of who the next Fed Chair might be. Any new Fed Chair would have to be on the Board of Governors, and there are three vacancies with three potential nominees. We can either interpret the identification of these potential candidates as Trump's intention to keep Janet Yellen as Fed Chair, or her replacement will come from one of the three new governors.

Consider the functions of the three candidates as clues to Yellen's possible replacement. Jones would fill the seat reserved for small bank representation. Quarles' mandate is likely to be deregulation. By process of elimination, the most likely outside candidate to replace Janet Yellen is Marvin Goodfriend.

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Who Is Marvin Goodfriend?

The next question for investors is, "Who is Marvin Goodfriend?" Gavyn Davies recently wrote an endorsement of Goodfriend in the FT, "Marvin Goodfriend would be good for the Fed". Here is a brief summary:

 Goodfriend's conservative pedigree goes all the back to Reagan's Council of Economic Advisors. He is a typical member of his generation...in having a very profound distaste for inflationary monetary policies.

 Goodfriend believes in a formal inflation target, which he thinks should be approved by Congress, rather than being set entirely within the Fed. On the Taylor Rule, Professor Goodfriend has recently argued that the FOMC should explicitly compare its policy actions with the recommendations from such a rule, because this would reduce the tendency to wait too long before tightening policy.

 Goodfriend believes that interest rates are a much more effective instrument for stabilizing the economy than quantitative easing.

 Goodfriend has frequently argued forcibly against allowing an “independent” central bank to buy private sector securities such as mortgage-backed bonds, which he deems to be “credit policy”.

 Goodfriend has always been worried that “independent” central banks will develop a chronic tendency to tighten monetary policy too late in the expansion phase of the cycle.

In other words, Goodfriend has the academic credentials and ticks off all the boxes to be a good Republican Fed Chair in an old-fashioned monetarist mold. We believe the most important difference between Goodfriend and the current Fed is Goodfriend seems to favour price level targeting, instead of inflation targeting. Here is one explanation of the difference of the two approaches from VoxEU:

The main difference between inflation targeting and price-level targeting is the consequence of missing the target.

Unanticipated shocks to inflation lead to corrective action when the price is the target.

Under inflation targeting, past mistakes and shocks are treated as ‘bygones’.

If, for example, inflation is unexpectedly high today, this would be followed in the future by below average inflation under a price-level targeting regime. By contrast, inflation targeting aims for average (i.e. on-target) inflation in future years regardless of the level of current inflation.

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Exhibit 9: Inflation vs. Price Targeting

Source: VoxEU

Once you adopt a price level target, you try to play catch-up if you undershoot or overshoot inflation. Even with rates so low, Goodfriend doesn't believe the zero bound is a problem. He presented a paper at the Fed's 2016 Jackson Hole symposium with an unusual proposal to drive interest rates to highly negative levels:

The zero bound encumbrance on interest rate policy could be eliminated completely and expeditiously by discontinuing the central bank defense of the par deposit price of paper currency. The central bank would still stand ready to exchange bank reserves and commercial bank deposits at par; and it could stand ready to convert different denominations of paper currency at par. However, the central bank would no longer let the outstanding stock of paper currency vary elastically to accommodate the deposit demand for paper currency at par.

Instead the central bank could grow the aggregate stock of paper currency according to a rule designed to make the deposit price of paper currency fluctuate around par over time. The paper currency growth rule would utilize: i) historical evidence relating currency demand to GDP, ii) the estimated interest opportunity cost sensitivity of the demand for currency relative to GDP, and iii) the GDP growth rate.

In other words, a dollar doesn't have to be worth a dollar anymore under a Goodfriend Fed. FT Alphaville also reported that Goodfriend thinks the Fed's reaction function should be more decisive as a way of demonstrating the central bank's credibility:

We recently had the chance to chat with a former student who was in Goodfriend’s spring 2015 business school class on monetary policy. (We attempted to contact Goodfriend to confirm the recollection of the former student but have yet to get a response.)

Goodfriend repeatedly spoke about the importance of a public and legally-binding inflation target. In his view, the current “longer-run goal” for inflation is too mealy-mouthed.

Moreover, it lacks legislative authority. Current law instructs the Fed to promote “stable prices” and “maximum employment” without defining either term. Unelected policymakers get to interpret their mandate as they see fit. They also have considerable leeway to change their interpretations on a whim. (This includes ignoring the third part of the Fed’s legal mandate, which is to promote “moderate long-term interest rates.)

In Goodfriend’s view, all this weakens the Fed’s credibility and partly explains the slow rate of inflation since the downturn.

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The 2015 episode is a good example of a Fed policy error, according to Goodfriend [emphasis added]:

Goodfriend was also sceptical of the Fed’s decision to begin raising interest rates in 2015, when inflation was weak — even excluding commodities — and nothing indicated it would quickly return to 2 per cent. According to this former student, Goodfriend believed the Fed should make its moves over relatively short periods of time. Thus the 1994-5 tightening was close to ideal because it quickly recalibrated the level of short-term interest rates from 3 per cent to 5.25 per cent. (With an overshoot to 6 per cent in the middle, but still…)

The former student recalls Goodfriend saying that if the Fed were to raise interest rates in 2015 it would probably have to wait a long time before any additional rate increases, which would damage the Fed’s credibility and potentially worsen the downtrend in inflation expectations. That’s more or less exactly what happened. According to this student’s account, Goodfriend would have preferred the Fed waited until it could commit to a relatively short and uninterrupted campaign of “normalisation”.

The view that the Fed should move quickly and decisively and "commit to a relatively short and uninterrupted campaign" clashes with the general accepted wisdom of a gradual approach to changes in monetary policy. Consider this recent "docking the boat" metaphor voiced by San Francisco Fed President John Williams, who has been one of the more hawkish voices on the FOMC Board:

When you’re docking a boat, you don’t run it in fast towards shore and hope you can reverse the engine hard later on. That looks cool in a James Bond movie, but in the real world it relies on everything going perfectly and can easily run afoul. Instead, the cardinal rule of docking is: Never approach a dock any faster than you’re willing to hit it. Similarly, in achieving sustainable growth, it is better to close in on the target carefully and avoid substantial overshooting.

A Hawkish and Activist Fed: What Dual Mandate?

In short, should the three rumoured candidates be nominated and appointed to the Fed's Board of Governors, the direction of monetary policy will change quite dramatically, possibly as soon as Q4/17. At a minimum, the Fed is likely to become more hawkish. Quarles has stated that he favours a rules-based approach to monetary policy, and any rules-based model is sure to set a Fed Funds target that is significantly higher than what rates are today. Marvin Goodfriend said in a March interview that he believes the Fed is behind the curve.

The approach advocated by both Quarles and Goodfriend of explicit rules-based monetary policy also implies a downgrade of the Fed’s attention to the other half of its dual mandate of full employment. Moreover, should the Fed adopt Goodfriend's "relatively short and uninterrupted campaign" tactic to the monetary policy implementation, the likely outcome is a more volatile growth path for the economy.

Over the long run, the bigger risk is the economy will experience more frequent and deeper recessions and panics, much like the way it did during the 19th Century.

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Exhibit 10: A More Volatile Economic Growth Path?

Source: Business Insider, Reinhart and Rogoff

The current market environment features a high level of stock-bond correlation, which is an indication of investor complacency. In the past, such environments have been resolved with market disruptions. To be sure, not all disruptions were equity unfriendly.

Exhibit 11: More Volatile Times Ahead?

Source: Bianco Research

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Add Marvin Goodfriend's "decisive" approach to monetary policy and his singular focus on monetarism to the mix, and the risk of a volatility spike over the next few years rises significantly. None of that has been discounted by the markets.

Possible Market Potholes in Late 2017

Despite these potential bearish outcomes, possible changes in Fed policy is really an H2/17 investment story. The Trump Administration has not nominated any of these candidates yet.

So relax! For now, U.S. economic policy uncertainty remains low by historical standards.

Exhibit 12: Economic Policy Uncertainty Is Low

Source: Economic Policy Uncertainty

In addition, Wall Street continues to revise earnings estimates upwards, according to FactSet.

Exhibit 13: Wall Street Optimism: Consensus Forward 12-month EPS Is Rising

Source: FactSet

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The current positive fundamental backdrop is an indications that the intermediate-term trend for stocks is still up, and any pullbacks should be relatively shallow. However, balanced-fund investors who are concerned about the longer-term environment can take steps to lower equity weights back to investment policy weights. Equity long-only investors can take steps to avoid bankruptcy candidates in the next economic recession (see our report, How to Avoid the Blow-ups in the Next Recession).

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Disclaimer

I, Cam Hui, certify that the views expressed in this commentary accurately reflect my personal views about the subject company (ies). I am confident in my investment analysis skills, and I may buy or already own shares in those companies under discussion. I prepare and edit every report published under my name. I depend on my colleagues for constructive criticism on my research methods and conclusions but final responsibility is my own.

I also certify that I have not and will not be receiving direct or indirect compensation from the subject company(ies) in exchange for publishing this commentary.

This investment analysis excludes any target price, and is not a recommendation to buy or sell a stock. It is intended to provide a means for the author to share his experience and perspective exclusively for the benefit of the clients of Pennock Idea Hub (PIH). My articles may contain statements and projections that are forward-looking in nature, and therefore subject to numerous risks, uncertainties, and assumptions. The author does not assume any liability whatsoever for any direct or consequential loss arising from or relating to any use of the information contained in this note.

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