The Federal Reserve concluded their two-day meeting on Thursday, announcing that rates will remain unchanged. Traders and investors were not expecting a rate increase, so the announcement was no surprise. Although for some time now the Fed has been hinting at starting on a path of increasing rates, Thursday’s announcement actually shows they are not likely to start this anytime soon, with more excuses ‘not to raise’ being added to the list.
The Fed has been talking a big game this past year of getting interest rates back to more normal levels, since they have been near zero since December of 2008 (almost seven years ago!). Therefore, it was previously thought that by the end of 2015, the Fed would start raising rates and that this September meeting – or at the very latest, December – would be the start of rate increases.
But as I have previously noted, the Fed has everything to lose and not much to gain by raising rates. Their preferred measure of inflation is still low, below their 2% target level, and the economic ‘recovery’ has continued to look pretty weak. So if they raise rates, they risk crashing the economy in the near-term and getting all of the blame. Leaving rates low will cause asset inflation, or maybe even price inflation eventually, but this won’t happen until much later, at which time those things can be blamed on a host of other factors.
While the Fed likes to say they are data-dependent, pretending they are completely objective, it is obvious their decisions on interest rates are completely discretionary and largely arbitrary. With unemployment now at 5.1%, we were supposed to have had rising interest rates long ago, but the Fed abandoned those guideposts, and it became clear they didn’t want to raise rates yet.
The Fed has added another factor they can use to delay further rate increases: global economic and financial developments. The WSJ has a tool that compares the Fed’s latest statement with their last one in June, so we can see they have now added the following lines (in italics):
“Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term. The Committee continues to see risks to the outlook for economic activity and the labor market as nearly balanced, but is monitoring developments abroad.”
Now that the dust has settled somewhat after Monday’s incredible market rout, it is helpful for investors to take stock of where we are in terms of equities, bonds, gold and other asset classes and to look at what to expect for the future and how to best position our portfolios.
Stocks undoubtedly had a wild ride over the past couple weeks. The S&P 500 is now down over 6% for the past month, even after clawing back about half of its severe losses from Monday. Year-to-date, the S&P is still down 4%, faring better than the Dow Jones Industrial Average which is down over 7% YTD, but worse than the Nasdaq composite which is still slightly positive for the year.
Gold has been the big out-performer over the last month, up over 3%. Compared to stocks, which are down over 6% in the same period, gold has outperformed by nearly 10% over the past month! As Anthem Blanchard, CEO of Anthem Vault, states:
“Given that gold has been the best performing major asset class in August, it is pretty amusing to see all of the negative reports.”
It certainly has been interesting to see the media continue to be so negative on gold, even as investors are obviously ignoring the pundits. Historically, negative media reports are actually a good contrary indicator for gold which may be forming a solid bottom. The out-performance of gold during this past month also confirms gold’s ability to act as a hedge or dampener to a portfolio which is why it is helpful to always have a small portion of gold as insurance.
The global stock market sell-off continued on Monday with a vengeance as Asian markets plunged, followed by one of the worst one-day sell-offs in U.S. market history. The Dow ended down nearly 600 points or just over 3.5%, but at the opening of trading, it was down nearly 1,100 points! While investors and market participants can never know all of the reasons for the sell-off, there is an underlying theme to the global market rout that will continue to play an outsized role in the coming months: central banks.
Monday’s turmoil was certainly severe, and although it doesn’t make the cut for some of the worst days in stock market history, that didn’t stop some from taking to Twitter with #BlackMonday trending (for comparison, on the Black Monday of 1987, the Dow lost nearly 23% in one day.) Monday’s drop put many indices in or near ‘a correction’ which is usually regarded as being 10% off their highs.
The first question on everyone’s lips is “Why?” or “What started it?” but that is like asking “Which straw was it that broke the camel’s back?” However, it is true that the U.S. was taking cues from China’s markets with the Shanghai composite index down 8.5% the previous night, the biggest drop since the beginning of the last crisis in 2007. China’s stock market bubble continues to deflate because the government has either decided not to, or is unable to, prop up the markets, this being something we have covered here in the past. Feeding the China decline was their government’s surprise announcement to devalue the yuan a couple of weeks ago, prompting fears their economy’s growth is slowing.
More important than trying to discern the snowflake that caused the avalanche is to assess why and how markets came into such a fragile state that they could be caught off guard. After all, the decline was incredibly sharp and fast, and yet it wasn’t due to a comparable world event shock such as 9-11. I personally believe investors had previously been lulled to sleep by low interest rates, easy money, and a warm feeling that the Fed and other central bankers around the world have things under control.
On Wednesday afternoon, the Federal Reserve released minutes from their July 28-29 Federal Open Market Committee meeting. Investors were looking forward to the minutes to discern if the Fed might start hiking rates this September, as previously expected. The minutes were somewhat muddled as they showed members continue to debate whether it is appropriate to start raising rates. But in the end, the minutes appeared to show a bias toward keeping rates low, largely due to inflation not being near the Fed’s target figure.
Conventional theory says the Fed, in trying to fulfill its dual mandate of stable prices and full employment, must try to interpret economic data to see which way the economy is tilting; is there slack in employment and therefore low rates are needed, or is inflation becoming a risk and therefore higher rates are needed? While this teeter-totter of prevailing conditions sounds good in theory, what we often find is the Fed is faced with contradictory data on economic conditions.
The recent release of July’s minutes is an example of this confusion. The Fed noted the labor markets have been improving with unemployment at 5.3%, the lowest rate so far since the recession. But historically, this isn’t that low; unemployment reached lows of 4.4% and 3.8% before the last two recessions in 2008 and the early 2000’s, respectively. Furthermore, the Fed itself admitted the labor force participation rate and the employment-to-population ratios both declined. Translation: the unemployment rate continues to decline, as less people look for work.
GDP remains tepid. Recall that growth estimates for GDP were well above 3% not too long ago, which is why many expected a rate hike as the Fed wouldn’t have as much trouble hiking rates going into a stronger economy. Meanwhile, the Fed continues to brush off the weak first half of the year as being ‘transitory.’
Inflation continues to sit below the Fed’s 2% target. The meeting minutes also labeled this as transitory, as the low inflation was attributed to lower energy prices and the decline in import prices due to past dollar appreciation.
China’s central bank has caught the markets off-guard by unexpectedly devaluing the yuan by nearly 2 percent against the U.S. dollar, roiling stocks as a result, especially those that sell to China. The central bank of China has tried to brush aside the magnitude of the move, calling it a ‘one-off depreciation’ and saying the change in policy will help drive the currency toward more market-driven movements. However, this is just another chapter in the worldwide currency war we are experiencing, and it should not come as a surprise at all.
First, it is helpful to examine more closely what China actually changed. The yuan has been pegged to the dollar for many years now, with Chinese officials allowing the yuan to trade 2% above or below a midpoint they set called the daily fixing. Officials can look at the daily trading when setting the midpoint, or they can arbitrarily set it higher or lower as they please.
The central bank has now changed its policy, saying it will base the midpoint off of the previous day’s closing price as well as market-makers’ quotes. As a result, it set the midpoint 2% lower than the previous day’s. This was the biggest devaluation of the yuan since 1994 when they let it fall by one-third as part of a breaking away from Communist state planning.
Because the rules are now more ‘market based’, it will be interesting to see if this really will be a one-off devaluation or if China will let the currency slide further. They could also continue to influence rates by entering the foreign exchange markets themselves with their reserves.
In the end, the mechanism or specifics are minor details compared to the real reason for the devaluation; participation in the global currency war. Almost nobody doubts that China is now fully engaged in the same game that developed countries have been playing for years now. Each one is devaluing their national currency as a last-ditch effort to stimulate more growth.
Top highlights from the interview.Five of the ways that inflation is misunderstood in today’s world:
1. “Demand pull” inflation (Keynesian concept) a.k.a. an “overheated economy”
2. “Cost push” inflation (Keynesian concept) e.g., increase in the price of oil can spark inflation.
3. Velocity can exacerbate or mitigate inflation (when it reality it does not exist and is a poor proxy for monetary demand).
4. Demographics directly impacts the price level (e.g., an aging population is “deflationary” per people like Harry Dent), the impact is really indirect and only results from the nature of fractional reserve banking
5. The Federal Reserve can not successfully control inflation, it can only contribute to the price increases with its ability to print money at its leisure.