Fed Credibility at Risk as the Economic Illusion Begins to Vaporize

Fed Credibility at Risk as the Economic Illusion Begins to Vaporize  

As we have frequently stated, the current state of financial markets — including a gross over-valuation of financial assets and an unsustainable debt load — is deeply dependent on the belief that the Federal Reserve knows what it is doing and is able to stimulate economic growth. Amazingly, this belief has survived the Fed‚s repeated wrong projections of accelerated growth and its broken promises concerning normalization of monetary policy.

Now the Fed has raised the stakes. To protect its credibility, the Fed increased interest rates on December 16. Why? Because it had led the market to believe it would begin raising rates in 2015. To justify the move, the Fed had to pretend that the US economy is strong enough to require higher rates. At the time of the decision, Ms. Yellen therefore went all in, claiming that the economy is in danger of “overheating”, that labor markets were strong and getting stronger and that very low inflation was transitory. We believe that if the Fed's rationale proves to be wrong, financial markets will unwind in a big way, perceptions of risk will soar and gold will make a return to center stage as a preferred asset for western investors.

The market is now trying to decide if the Fed can be believed and the early signs are not positive. If the economy is strengthening, the US Treasury curve should be steepening. It is not, it is flattening. Also, the Fed Funds rate has been highly volatile, often trading well below the Fed's new target rate. But it is the economic news that most contradicts the Fed message.

On January 4th, the first trading day of 2016, the Atlanta Fed released its latest GDPNow forecast for the 4th quarter of 2015. This measure has proved to be most accurate predictor of GDP and it estimates US 4th quarter GDP at 0.7%, which would bring 2015 growth to just 1.8%, a 25% drop from the 2.4% GDP growth in 2014. This is supposedly the strong economy that supports the Fed's December rate hike?

Also on January 4th, the ISM Manufacturing index for December fell to 48.2, well below estimates, deep into contraction (below the 50 mark) and the weakest level since June 2009 when the economy was in recession. The Employment Subindex fell to its lowest level since September 2009, yet a strong labor market was highlighted to justify the Fed's rate hike. Manufacturing in the US contracted in December at the fastest pace in more than six years as factories hobbled by slow growth cut staff.

Mainstream economists say the ISM downturn is the result of a strong dollar depressing manufacturing exports. This is completely misleading. The Export Subindex actually increased to 51 in the December, up from 47.5 in November.

The mainstream cheerleaders nonetheless repeat the Fed mantra that the US economy is strong and the problems are all overseas. The ISM Import Subindex meanwhile dropped to nearly 45, a level only seen twice in the past 20 years during recessions. This observation is supported by the Prices Paid Subindex which, in December, hit an astonishingly low reading of 33.5 for the 14th straight sub-50 estimate. These readings can only be explained by weakness in US demand-hardly evidence of a strengthening economy.

The final excuse is that manufacturing doesn't really matter because it represents only 12% of the economy. Leave aside the fact that the 12%% figure is a misleading artefact of how GDP is calculated because it ignores intermediate goods. Collapsing domestic demand for manufactured goods is surely evidence of a weakening economy, not just a weakening manufacturing sector. Nor is the ISM data likely to turn around soon. The all-important New Orders Subindex shown below is firmly in a downtrend and well below the 50 mark, which indicates contraction.

The Fed has pinned its remaining credibility on an economic recovery that, in our view, is pure illusion. The consequences should not be long in coming.