Is the Sky Falling?
This morning, we read with interest the views of Chris Watling from Longview Economics, who believes the Fed is underestimating the strength of the US economy.
He writes:
“Our view is that the Fed is far too complacent. Unemployment’s been falling sharply. Wage inflation has started to tick up and there’s this view at the Fed that there’s lots of slack in the labour market. We’ve been crunching the numbers and it seems to us that even on a benign view of the labour market the unemployment rate should hit 4% in 2016. 4% is totally full employment. It just doesn’t go any lower. So wage inflation is going up, cheap money has to go. And of course it’s cheap money that’s sustained high asset prices over the course of recent years. This is a pretty dangerous cocktail.”
Clearly, the Fed is not underestimating anything. They’re on top of all the numbers. Chris and the team however may be right in observing that the signs are getting stronger. But like an eager 20-something newlywed, he may be a little premature. It isn’t the study of economics that’s needed at this juncture. What’s needed is the study of the people at the Fed and a study of history.
As we’ve now been saying for many months, Janet Yellen is – more than likely – going to keep her foot on the accelerator for some time.
Take, for example, her speech to the Commonwealth Club of California as President and CEO, Federal Reserve Bank of San Francisco on 30 June, 2009.
“I don’t like taking the wind out of the sails of our economic expansion, but a few cautionary points should be considered. I expect the pace of the recovery will be frustratingly slow. It’s often the case that growth in the first year after a recession is very rapid. That’s what happened as we came out of a very deep downturn in the early 1980s. Although I sincerely wish we would repeat that performance, I don’t think we will. In past deep recessions, the Fed was able to step on the accelerator by cutting the federal funds rate sharply, causing the economy to shoot ahead. This time, we already have our foot planted firmly on the floor. We can’t take the federal funds rate any lower than zero. I believe that the Fed’s novel programs are stimulating the flow of credit, but they simply aren’t as powerful levers as large rate cuts, so this time monetary policy alone can’t power a rapid recovery.
History also teaches us that it often takes a long time to recover from downturns caused by financial crises. In particular, financial institutions and markets won’t heal overnight. Our major banks have made excellent progress in establishing the capital buffers needed to continue lending even through a downturn that is more serious than we anticipate. But they are still nursing their wounds and credit will remain tight for some time to come.”
And later in her speech:
“If anything, I’m more concerned that we will be tempted to tighten policy too soon, thereby aborting recovery. That’s just what happened in 1936 when, following two years of robust recovery, the Fed tightened policy because it was worried about large quantities of excess reserves in the banking system. The result? In 1937, the economy plunged back into a deep recession. Japan too learned that hard lesson in the 1990s, when both monetary and fiscal policies were tightened in the mistaken belief that the economy was rebounding.”
Moreover, the recent tapering of QE was instructive. You will remember that it was flagged well in advance. Any change to Fed policy (rate normalisation) will not come as a shock to markets. We expect instead, it will be well-flagged by the Fed well before it begins.
Despite what economic experts say, we don’t believe the sky is falling… yet.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Rohan Halfpenny
:
Hi Roger,
Very interested in your thoughts on 3PL the online education software provider. Is it and A1/A2 or B1/B2 company?
Cheers, Rohan
Roger Montgomery
:
Hi Rohan,
We’ll create some notes for a post this week. Stay tuned.
Bryant Bice
:
Based on what you have said above it would seem to be prudent to have a small but significant proportion of your assets in cash so as to take advantage of the opportunities that present themselves when there is the inevitable correction. So the question becomes what is a reasonable percentage of ones investment portfolio to have in cash at this time? My guess would be around 20 – 25%. Would this be in line with your thinking at Montgomery Investments at this time of the investment cycle and the state of other markets such as the Wall Street.
Roger Montgomery
:
Hi Bryant,
Coincidently that is about the weighting to cash currently held in The Montgomery Fund. You must understand however the cash weighting flows out of the process. We don’t stick a wetted finger in the air, get a bit of a gut feel and then guess at the amount of cash. The cash is a function of the margin of safety embedded in the portfolio
Jim Hasn
:
Great discussion. The other factor I always am reminded of are the gentle 0.25% changes of our RBA against the larger movements of the American Fed. They tend to wait until the last minute an then……bang. The recent public statements of the individual American Fed governors indicate this may well happen again. I’d love to know what Glenn Stevens really thinks of the American Fed’s position.
Aaron Somner
:
Well if a study in the history of fed policy is required then here is my take. You will notice that Yellen said that the fed “tightened”policy to early in 1936 not raised rates to early. This is because the feds funds rate remained unchanged at around 1.5% from 1935 untill WWII. So what Happened? The fed between August 1936 and May 1937 doubled the reserve requirement for banks! WOW!!! Combine that with the tax hikes from the Roosevelt administration and it’s no wonder a recession occured. These tightening measures happened because of the high amounts of funds being held by the banks due to bank runs. The fed feared inflation if the banks started lending those funds out. From early 1934 untill 1937 the dow, along with the economy, recovered from 90 points to over 190 points. Over 100% return during a depression! The dow then crashed to just over 100 points in 1938. During this whole boom and bust the feds funds rate remained unchanged! Now any objective study of this period must raise serious questions about demand side economics (raising/lowering of rates) versus the obvious impacts of supply side economics (raising/lowering of reserve ratio’s).
A more objective look at the role of interest rates is needed at this juncture. When an economy booms, rates historically rise and then decline in the following recession. So if rates rise the sky will not fall, it is a sign that the economy is improving! It’s bullish! A sign that the demand for credit is rising. Rates rose dramatically from 1925- 1929 just like they did from 2003-2007.
They effectively need to raise rates so that they can lower them again when the recession arrives so they don’t have to go negative like Europe.
Yellen will flag her intensions ahead of time however whatever she does will be behind the curve as central bankers review the data and then react. Forecasting is not their forte as evidenced by Glen Stevens raising rates twice in 2008 as a financial storm was knocking on our door.
So my point is this. Raise rates or leave them unchanged, the economy will boom and bust regardless. They have far less impact from these low levels than everyone thinks. At the moment all low interest rates are achieving is to wipe out the fixed income part of the economy (retirees & pension funds) and support overly indebted goverments. As a side note I would love for someone to explain what normalisation of rates means. The feds funds rate rose from 1.5% to 17% in 1981 and fell to 0.25 % in 2009. Whats normal? Half way in between. Á long term view of interest rates shows a rise and fall of about 30-35 years. It’s not a flat line and it’s never stable for long. So let rates move the sky is allways blue!
Roger Montgomery
:
Indeed. Reducing supply (of funds to banks, for example) raises the price of money..its an option that may be used soon too…In the pursuit of ‘normalisation’ the Fed can raise rates (a blunt ouch but probable), it can sell all the bonds that it has purchased (are you kidding!!!) or it can change the capital requirements of banks (most likely). Our recent examination of the stock market’s previous reactions to rising rates is that the market keeps rising in the early stages (because, as you note too, it reflects a growing/strengthening economy). If rates keep rising however…Normalisation has simply been coined to explain a return to levels that don’t reflect panic measures. In terms of what is normal, the screenshot I have now attached from Bridgewater to the post is more instructive…