Markets await the Fed’s next move

Arthur Wellesley, the Duke of Wellington, is reputed to have said that trying to write the history of a battle is like trying to write the history of a ball. I suspect that the members of the Federal Open Market Committee will today feel the same way and, to project that sentiment one day forward, so will the members of the Bank of England’s MPC when they convene tomorrow to review current monetary policy. Central bankers love to tell us that their rate decisions will be “data dependent” even though there is so much often conflicting data available, how are we or even they to know what data they should be putting at the top of their tick list and what at the bottom?

The Fed has of course made something of a rod for its own back with its 2% inflation target. John Maynard Keynes, always good for a quote in a column on finance and economics, added to the mess with his observation “When the facts change, I change my mind. What to you do, sir?”. There is little doubt that we are nearing the end of the current tightening cycle but that does not mean that the economic and political – geopolitical and domestic – backdrop against which monetary policy is about to be set is the same as it was when said tightening cycle began. Central bankers’ universal get-out clause and admission that they are at a loss is the one that any decision will be data dependent. And of that there is commonly more than enough to justify pretty much anything. Tracking how they used the data on hand to arrive at their decision is much like Wellington’s writing the history of a ball. 

If the objective of monetary is to maintain the external value of the currency which is the clever way of saying that inflation needs to be tamed, the Fed is looking at core US CPI of 4.1% and the wizards of the Bank of England’s MPC at UK CPI ex of 6.1%. How long does it take for today’s monetary policy decisions to feed into the economy? How long is a piece of string? We used to say that it took 18 months but that piece of wisdom dates back to an era before economic activity had at all levels become so completely dependent on credit and on its cost. The dynamics are changing, or even have changed, and sets of data that in the past might have swung the opinion one way might now help to swing it the other.

Overhanging the gentlefolk of the FOMC will be on one hand the staggering preliminary Q3 GDP release at 4.9%, well above anything which an economist would be able to squeeze within the boundaries of trend growth and on the other they will have the worrying delinquency statistics covering more or less all areas of sub-prime lending from auto loans to credit cards to student loans. In September, sub-prime car loans were running with a delinquency rate of 6.1% – that’s over 60 days past due – the highest level in nearly 30 years. I read of a young lady of 28 who makes US$ 17.50 an hour working at Costco but who drives a Honda Ridgeline pickup which even used can’t have cost her much less than US$ 30,000. Her payments including insurance are currently US$ 700 a month. On top of that she is carrying maxed-out credit card debt of US$ 20,000. Yikes! I cannot but suspect that the car payments have been going on the credit card.

Now, let’s assume that she was to get lucky and was to find herself at the end of every month with US$ 250 surplus in the account and was to begin to pay off the US$ 50,000 that she has on the liability side of her balance sheet. At US$ 250 a month it would take no less than 16 ½ years to clear the debt. I lived through the subprime mortgage crisis which was at the heart of the GFC. Who could forget the ubiquitous unemployed single mothers who had taken out self-certificated mortgages with next to zero first year teaser rates with which to buy their mobile home. Much was made of “It’s their own fault, they should have thought harder….”. That cut no ice and I wrote a piece during the darkest days of the crisis likening some of those situations to putting a bag of candy in front of a three year old and then blaming the kid for having scoffed them all and getting violently sick. At the end of the day, there was a value chain of greed that stretched from government, recipient of all the lovely tax money that the banks were paying, via the bankers to the local commission-earning mortgage brokers to the unemployed mortgagees who either believed or had been led to believe that they were getting something for nothing. And let us not forget the institutional investors who held the same economics degrees, CFAs and MBAs as the bankers and without whose yield hunger and misguided risk appetite none of all that would have been possible.

Should the FOMC be looking to slow the economy to a more reasonable level from what is effectively runaway GDP growth, or should it be looking at the many millions of “hardworking American families” who like the young lady in question are financially back to the wall? The market is betting odds-on that the Fed won’t move but that Chairman Jay Powell will after the meeting reassert that this is merely a pause and that at least one further tightening move remains on the list of possibilities. But will we when all is said and done know meaningfully more about the economic and financial trajectory? Methinks not. We will continue to roll from contradictory data set to contradictory data set and just as we do, the central banks will focus on the figures that match their preconceived intentions.

That makes life for investors very tricky. It is in uncertain times like the present during which the eternal debate emerges whether it is better to invest one’s faith in active managers or to stick to index trackers? Given that the S&P 500 yesterday closed its third consecutive down month, one would understand investors who might fancy an active manager. I am frequently reminded of one Felix Zurlauf who was wealth manager at UBS in Zurich at the time of the Crash of ’87. He came to global prominence for having stripped his clients’ portfolios of excess equity risk a few days before the crash and for having saved them fortunes. What is forgotten is that in the aftermath he was castigated by his employers for having diverged too far from the bank’s model portfolios and having therefore exposed the clients to unacceptable risks.

In an industry dominated by comparative rather than absolute performance, risk neutral is deemed to be matching the benchmark. One might hate one or the other company’s stock or bonds, but it is not permitted to simply kick them out. Owning them in equal proportion to the index is deemed to be zero risk. Owning too few is the same as owning too many; it is risk. It is not default risk with which the powers that be are concerned, it is benchmark risk. It is the tracking error which scares the risk managers. Although the Wall Street Journal found and feted Felix Zurlauf, his employer was unimpressed, and the episode effectively spelt the end of his career there. He went on to set up his own hedge fund of which I know nothing although when I was still in the industry, the word on the Street was that his performance was no more than pedestrian.

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