The market has been beset by calm over the past few weeks, Nomura’s Chief Economist Richard Koo writes, but under the surface I see a great deal of pent-up energy waiting to erupt. Much of this eruption could take place in the context of central bank action (or inaction) before the US presidential election.

Nomura three stages

There are two camps at the Fed: Those concerned about market repression and those who are concerned about the US dollar and its implications

The market calm in August has been too calm, belying issues underneath that have complex cross-currents.

With a complex political landscape not just in the US but also Europe playing itself out, Koo notes the existence of two conflicting views inside the US Federal Reserve. As hawkish sounds come out of Jackson Hole, “a state of affairs that is seriously complicating the conduct of monetary policy” is at play.

Fed officials fall into one of two camps: those concerned about free market repression and those concerned about the repression of populism.

Koo, for his part, noted the two camps using slightly more delicate tone. The two camps consist of “those who believe that, given the current strength in the US economy, something very bad will happen unless monetary policy is quickly normalized; and those who believe that a rate hike under the present circumstances would send the dollar higher again, lending fresh momentum to the protectionist views reflected in the emergence of Donald Trump and setting in motion a chain of events that could ultimately lead to the demise of free trade in the global economy.”

Koo thinks the view about free market repression is prevailing inside the mystic walls where magic people make decisions. Arguments that bolster the need to hike rates off emergency levels have been made by the likes of New York Fed President William Dudley, San Francisco Fed President John Williams, and Atlanta Fed President Dennis Lockhart. St. Louis Fed President James Bullard.

This is offset by the second group. “The internationalists at the Treasury Department and Fed who want to keep dollar gains in check and stop the emergence of further protectionist sentiment remain circumspect about a rate hike, citing the weak global economy and the fact that domestic inflation has yet to touch 2%,” Koo noted, pointing to the traditionally “non-political” Fed.

Both camps are likely to be mollified, as a September rate hike is off the table and the hawks concern that free market repression might eventually lead to negative consequences is likely to be put on hold until after a populist US election concludes – but if inflation starts to appear, all bets are off.

“I suspect their resistance to a hike will fade after the presidential election on 8 November, and they may even decide to raise rates before that depending on the data,” Koo wrote in hedged fashion. “Once a central bank has implemented quantitative easing, it must do everything in its power to avoid the perception of having fallen behind the curve on inflation.”

Last September the thought of a Fed rate hike sent many investors scurrying to the sidelines in an August panic. The situation isn’t much different this time, with one exception.

Koo notes the “reported calls by a handful of famous investors to sell ‘everything’ (both stocks and bonds) make a certain amount of sense if they see a high likelihood of a rate hike,” but something isn’t happening, at least yet. Investors must not be buying the notion that a September rate hike is on the table because, unlike last August, stocks remain buoyed.

This pleasant stock market environment could be due to several issues, and one Koo addresses that is reasonably unique to his analysis. Investors exposed to currency risk don’t fear the rate hike.

“Foreign investors who are such large participants in the US bond market may believe that any losses due to a rate hike will be offset by dollar appreciation,” Koo wrote. When interest rates rise, typically due to strong economic activity in a region, currency values typically correlate. “Under these conditions, the markets and the authorities would prefer to see US economic data that is not too strong. Both stocks and bonds will almost certainly undergo a major correction if robust data force the Fed to raise rates.”

Nomura lewis turning point

Wage growth points to Lewis Turning Point analysis and a golden era in China

Driving inflation is wage growth, typically the sign used by central bankers that the economy is overheating more so than asset prices.

Here Koo pulls out an economic theory regarding the labor market and three states of economic development that are handy to understand Fed decision making and current positioning. “Today’s advanced economies were once agrarian economies in which the majority of the population lived in rural communities,” Koo said, setting up the positioning that points to favorable circumstances for capital. “Economic growth rates accelerated once the Industrial Revolution ushered in a period of steady technological innovations, but wages did not rise significantly in any of these countries because a huge pool of surplus labor existed in rural areas.”

Considering Lewis Turning Point analysis, Koo factors in globalization and considers a golden age in the 1960s were workers were earning high wages and the economy hummed. This led to the 1970s where inflation got out of control.

Fast forward to recent period where monetary policy is reaching its effectiveness endgame:

Under today’s circumstances, in which collapsed asset bubbles have thrown the majority of the advanced economies into balance sheet recessions, private-sector demand for funds is negative in all of these countries despite zero interest rates. That further emphasizes the tendency for monetary policy to become less effective and fiscal policy more so. Even if these countries were not in balance sheet recessions, it has been observed that in any pursued economy fiscal policy tends to work better than it did during the golden era, while monetary policy is less potent.

Wishing for a golden era explains much of today’s issues, Koo notes:

Many of those supporting the candidacy of Donald Trump in the US presidential election are blue-collar voters with relatively low incomes who look back with fondness on the nation’s golden era. Similarly, older voters who can recall the glory of the British Empire easily outnumbered younger voters among those who voted for Brexit in the UK. The external environments faced by both Britain and the US have changed remarkably, and a return to the days when a high school graduate could buy a spacious home and a large automobile on a single income is simply not possible. The arguments of Mr. Trump and the Brexit camp are well received by so many because they elicit nostalgia for the golden eras of the past. This is something that must be closely watched, because they are pushing the country to a goal that does not exist. Japan, too, needs to accept that there is no going back to the golden era, and that the accepted beliefs that worked then will no longer work today. It must engage in extensive reforms of its economy, society, and educational system to ensure that they remain relevant for today’s

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