Federal Reserve Governor Jerome Powell is widely quoted in the press. He spoke this past week about the timing of the Fed’s intended increases in interest rates: “My own forecast calls for lift-off in September and for an additional increase in December" (Reuters). And maybe he knows, since he is a voter on the Board of Governors and therefore will help to determine whether we get one, two, more, or less.
What is the argument he makes about this two-rate-hike approach? Governor Powell says that he sees conditions for interest rates lifting off as soon as September of this year. We agree. We have felt for several months that September would be the liftoff. There is no reason to change that expectation. The Federal Reserve (Fed) is broadcasting a quarter-point rate hike this September, and they have been doing so for a while. For more on Cumberland Advisors’ views, see this Bloomberg interview that Bob Eisenbeis, our Vice Chairman and Chief Monetary Economist, and I did with Mark Crumpton on Bloomberg. If we get a liftoff in September, what about the additional increase in December? That prospect is more difficult.
Governor Powell thinks that oil prices and the dollar have “broadly stabilized.” He estimates that the economy will grow at a pace of approximately 2% for the year. He sees positive signs in the economy, including a pickup in wages. We agree with the wage pickup, but it is very slow. When it comes to oil prices and the dollar, we question his opinions.
The Fed has a very poor track record (if any track record at all) of successfully forecasting the prices of anything, let alone oil. What was the Fed’s view when the oil price was above $100 per barrel? How did they then make policy? Why do they think oil prices are stable now? One thing we do know about oil prices is that they are unstable. In fact, there is a very good chance that the oil price could plummet to as low as $30 to $40 per barrel. And would Governor Powell retract his forecast of a second rate hike if oil went up $40 per barrel? We don’t know, and he did not say. But there is a very good chance that oil breaks to a lower bound, not a higher bound. And there is a very good chance that oil prices are not stable.
Let’s get to the dollar. Governor Powell thinks that the dollar has stabilized, a view reflected in his remark. One thing we know about the dollar is that it has not stabilized. At Cumberland Advisors, we think the yen and euro get weaker, the dollar gets stronger, and any Fed hike will exacerbate and intensify that trend.
Look at it simply. If an international company is located in Switzerland with a clearing operation for its currencies in Switzerland, the company faces a Swiss franc with an imbedded rate at the central bank clearing level of -0.75. If a global bank is in the US, it faces an embedded interest rate of +0.25. The difference between the two is 100 basis points, a full 1%. What happens when the differential widens to 1.25? What happens if it goes to 1.50? Does anybody in his or her wildest imagination think that the currency denominated as the US dollar gets weaker? Certainly not – it gets much stronger.
We appreciate the views and the optimism of Governor Powell. We like it. But the fact of the matter is that Governor Powell and the Fed do not know how markets, the economy, and the currency ratios will respond to these changes.
That is why we think that the Fed will make a first move of 0.25% and then stop and look around. They will take inventory and allow stabilization to occur. That is what Governor Powell would like to see. The reason they will need to do so is that volatilities remain extremely high and are likely to stay very high for a long time. Volatilities are being driven by a powerful force in Europe unlike anything we have seen before: the negative interest rate.
Negative interest rates are very bullish for asset pricing. If the interest rate is zero, the asset price is infinity. If the interest rate is negative, the asset price is infinity plus something else. Negative interest rates wield tremendous force, and they are at work in one of the large economic centers in the world.
We are optimistic. We have been fully invested. This has been a marvelous run for investors, and there are great opportunities to be seized.
When this is over, the outcome will be painful. But that is then, and this is now. It is time to play the music.
This weekend at Leen's Lodge the talk was about capital controls and the Greek referendum. Many options and more uncertainty as an ancient democracy will vote on a modern statist European construction. We will celebrate July 4 here in the US. Will Greece celebrate July 5?
P.S. on Greece — Eurozone finance ministers have rejected a Greek request to extend a bailout programme beyond 30 June.
Eurogroup head Jeroen Dijsselbloem said negotiations over a new bailout were ongoing late on Friday when Greece called a surprise referendum over the terms of any deal.
By doing so they broke off the process, he said.
He said finance ministers would reconvene to discuss the consequences of the latest developments.