Say you're Fed Chair Yellen today. You face a truly a Dickensian tale of two economies. The unemployment rate is at target while inflation is far from it. Labor market internals suggest possible shadow slack potential while inflation internals imply upward pressures. Goods markets are flagging with global weakness while services are surging on the back of domestic acceleration. And there's an equally analogous duality in policy prescriptions given these confusing signals, with the likes of Vice Chair Stanley Fischer proposing liftoff and Bridgewater CIO Ray Dalio urging for patience.
The Dalio thesis
The latter has been expressing his concerns about risks stemming from Fed tightening ever since the taper tantrum. In a recent note, he suggested that the most likely next big Fed policy stance shift will be easing with more QE rather than a normal tightening cycle: "We are saying that we believe that there will be a big easing before a big tightening. We don't consider a 25-50 basis point tightening to be a big tightening ... To be clear, while we might see a tiny tightening akin to what was experienced in 1936, we doubt that we will see anything much larger before we see a major easing via QE."
This is premised upon the belief that by the time the Fed needs to ease again, financial asset yields and spreads will still be too low for conventional easing to succeed; hence, the need to restart QE (perhaps with assets further out the risk curve that still have spread). In my opinion, this is likely to be incorrect; I believe that rates, curves, and spreads will be more normalized by the time has to ease again.
Mr. Dalio seems to believe that higher rates will send shocks through financial markets that will manifest in a domestic growth downturn. As he says: "Since the 1980s ... lower interest rates were required to bring about each new re-leveraging and pick-up in growth and because secular disinflationary forces have been so strong." This is similar to Richard Koo's "QE trap" thesis. But I believe this is an inaccurate interpretation of how higher rates will impact the real economy. This is mainly due to the fact that housing equity, financial assets, and credit qualifications have such a higher distributional skew than in prior cycles. The people with Mr. Dalio's "leveraged long bias" are far removed from the economic situation of the median consumer.
Who is leveraged long?
Ever since the housing recovery began in 2012, low rates and spreads have not been really fueling real activity. There have been ample benefits for those who can access credit to borrow, like private equity firms borrowing to buy property and corporate CFOs borrowing to buyback shares. There have also been ample benefits for those who have a lot of financial assets; new QE deposits are credited to institutional prime brokerage accounts, and mainly circulate within financial market transactions. All this has done is drive up inflation in the FIRE sector: asset prices (think ETFs inflows as % NAV, low to negative UST term premia, corporate capital structure arbitrage), rents, luxury housing, & collectibles. To the median consumer, this just means rents and capital appreciation that far outpace wage growth. Without targeted easing (like LSAPs in muni debt or consumer ABS), there's little pass-through of loose financial conditions to the real economy when rates & spreads are already low.
If loose Fed policy has driven asset price inflation instead of consumer inflation, why would higher rates drive down consumer price inflation? The FX and commodities channels are very important in this regard, especially when the rest of the world is easing, as the commodities crash has shown. But US inflation rates have taken these shocks in stride, with 6mo annualized measures (which remove the base effects from the oil crash) already having rebounded back to target. Based on this base effect alone, by the time the Fed hikes in Q4 (if it does), YoY core inflation will likely be visibly on track to its target unless oil crashes again. Certainly, there are headwinds to inflation from abroad, particularly through imports and core goods. But domestic-facing inflation, the kind relevant to US monetary policy, like in wages, rents, and services, is accelerating without sign of an impact from tighter financial conditions. Most importantly, demographic impulses are reversing back to positive again for the first time in a decade (which matters, like, a lot), unlike Europe, China, & Japan.
Surely, a rate shock can impact the real economy temporarily, as the taper tantrum depressed housing activity for a short time. However, this was a sharp shock (partly due to the longevity of QE-induced levered carry position buildups, the exact type of situation Chair Yellen wants to avoid by taking a sooner-but-slower approach to hiking), and still new home sales and starts have rebounded back to cycle highs. In reality, the median consumer does not have access to abundant easy credit outside of auto loans, despite the pervading low rates and spreads, and does not have large exposure to financial assets. In this environment, as Mr. Dalio himself has stated, spending growth will converge down to income growth, which will be primarily driven by wage growth, which is indeed accelerating. Wealth effects and price-senitive credit growth matter much less.
How would market volatility & weakness abroad impact US real activity?
I do indeed expect higher rates to send shocks through financial markets. Ever since the taper tantrum, we have seen various shocks: in duration, oil, EMFX, and now China. This is clearly a result of the marginal relative tightening in US monetary policy, which is itself a function of the US's better policy responses to the Great Recession. However, each of these shocks blew up low-multiplier trades like the Fed forward guidance or OPEC production "puts". The most recent, the EMFX "carry trade", was another "artificial arbitrage" that was funneling loose Fed policy into EM credit growth (rather than in US mortgages for example). Unless spreads are very elevated, monetary easing has little pass-through to the Americans who need it most.
Certainly, there will be weakness in manufacturing and "shale state" employment. But this massive surge in the USD is also a boon to real incomes, and thus real spending. Indeed, real PCE growth is right back to its cycle highs and five out of the last seven quarters have seen consumption alone (without the other GDP components) account for 2% annualized real GDP growth. There is likely much more in the pipeline, due to elevated savings rates, which in my opinion are due to the gradual pace by which consumers gained faith that the gasoline savings were permanent (i.e. that gas prices won't surge right back higher). I think this is due to the availability heuristic: after massive price declines in 2008-2009, energy prices surged back to near pre-crisis levels. As consumers' expectations of future gas prices decline further, the retained gas savings will likely be spent further.
Higher rates will likely crimp corporate profitability as well, but again, unlike prior cycles, corporate profits have mattered less for real economic activity. Profits have surged to all-time highs, and with much of the growth coming from margin gains due to higher capital/labor ratios, this has partially been at the expense of the median consumer. Large corporates have deployed much of their accumulated profits in a capital structure arbitrage, borrowing to buyback shares and collecting the credit/equity yield spread to further boost profits. Furthermore, after almost two decades of rampant globalization, the US stock market has much more foreign sensitivity than the US consumer or real economy. Higher Fed rates will definitely hurt emerging markets, but this pass-through to US corporations is unlikely to impact the median US consumer seeing costs decline. Loose financial conditions have clearly played a significant role in corporate profitability, and although tightening policy will likely hurt earnings, it won't impact hiring or capex as much as things like buybacks, M&A, executive compensation.
The biggest risk from higher US rates is China, and I do expect China to continue to decelerate until leveling off around 3-5% real GDP growth. The PBoC will likely have to cut RRR sharply in order to stem the tide of capital outflows without constricting domestic money supply. It remains to be seen if Chinese policymakers have sufficient tools at their disposal to smoothly navigate the rebalancing. But higher US rates will only further destabilize the Chinese economy, thanks to its now-soft currency peg. Like the oil crash, this will likely materially negatively impact global growth, financial markets (including in the US), and corporate profits (including in the US), but not the median US consumer.
Even then, why not wait until seeing the whites of inflation's eyes?
If the Fed can normalize rates & spreads at least a little bit, without disrupting real growth, then it will have regained considerable policy potency for the next time it needs to ease. It makes complete sense to me that financial markets and the real economy can diverge; in fact, this has been my expectation since 2013. Additionally, because of the long lags between policy and its impact, waiting longer could be simply increasing the risks for a destabilizing normalization out of the Fed's control. Higher inflation = lower real rates even without hikes.
Blowing up ZIRP/QE trades, especially with an "avalanche patrol" method as described by Mark Dow, is likely beneficial from a financial stability perspective. Deeply-entrenched investor assumptions are the keys to leverage buildups, as the taper tantrum and EMFX routs have shown. I believe Chair Yellen finds similarities between 1997-98 and 2015-16, and doesn't want to repeat former Chair Alan Greenspan's mistake of engendering the perception of a "Fed put" in response to the financial volatility stemming from emerging markets and a higher USD. The eurodollar curve clearly shows that the market already doesn't have much faith in the Fed's willingness to look past market volatility. Further sacrificing credibility by reversing course on the stated hike path will only further convince investors that there's a Fed put.
Hiking rates may even provide an unexpected boost of confidence. If the Fed hikes rates and markets fall without disrupting the real economy, that would provide a strong positive signal to invest. It would also shake out rentiers for growth-oriented investors. As a recent example, loan growth began its marked acceleration in early 2014 right after the taper began, about six months after former Chair Bernanke hinted at it. I would not at all be surprised to see inflation and spending accelerate just before or as the Fed begins hiking; indeed, it is my base case.
With all this said, I still very much appreciate the risk of the end of the long-term debt cycle, especially due to the student loan boom, the only substantive impaired debt-driven household demand growth. If these liabilities aren't restructured, then the next downturn could unleash another wave of household deleveraging that could again constrain monetary policy. However, there is also the upside risk of looser fiscal policy in response to the next recession, and optimal fiscal stimulus (i.e. infrastructure spending, student loan forgiveness/restructuring, regressive tax cuts) could drive up money demand sufficiently to allow for a normal rates curve.
What's the trade?
In January, I expressed my expectation that the S&P would return to October lows in H1 2015. Now that it has, Chair Yellen has a choice to make whether or not to act on it; inflation rebounding by year-end would mean she won't. I think within the next six months, we could see a return to S&P 1600-1700 (2000 & 2007 highs) on the back of a Fed hike that surprises the market by looking past the impact abroad. If we get there, I think it will be an excellent time to buy domestic-facing cyclicals, particularly financials. Indeed, I think buying financials and discretionary versus shorting staples and healthcare is an excellent pair trade here. Healthcare has arguably been one of the strongest beneficiaries of loose monetary policy.
Because of the removal of the oil crash base effect by the end of the year, my base case is for a December hike. I am confident the Fed will at least signal a hike by the end of the year, making Q1 2016 my bear case. As long as my bear case is met at a minimum, I continue to think short SGD is a great trade. China cannot withstand higher US rates and Singapore banks' exposure to China is enormous, having intermediated EM Asia & Chinese flows for years. I also continue to like mid-curve eurodollar & short sterling steepeners / long GBP based on the same view of normalizing inflation and rates.
My preferred hedges to my views are long Aussie duration, long JPY, short CHF, and long MXN.