This note was originally published at 8am on March 18, 2015 for Hedgeye subscribers.
"Indecision may or may not be my problem."
Per our friends at Wikipedia:
“Cognitive dissonance is the mental stress or discomfort experienced by an individual who holds two or more contradictory beliefs, ideas or values at the same time, or is confronted by new information that conflicts with existing beliefs, ideas or values… [H]umans strive for internal consistency. When inconsistency (dissonance) is experienced, individuals tend to become psychologically uncomfortable and they are motivated to attempt to reduce this dissonance, as well as actively avoiding situations and information which are likely to increase it.”
We use the term “friends” perhaps less loosely than one might think. Personally, I’m a sucker for their intermittent fundraising campaigns; I honestly can’t remember the last time I didn’t donate $5 dollars when prompted. This is likely because of my own dissonance reduction.
In their marketing language, there is a sentence that reads, “If Wikipedia is useful to you, take one minute to keep it online another year by donating whatever you can today.” The reason this command is so effective is because it induces feelings of cognitive dissonance in anyone who initially chooses not to donate. Of course the reader finds Wikipedia useful. As such, not donating and continuing to peruse the page puts the reader’s actions in direct conflict with each other. The more of the page consumed the more guilt he or she feels until, finally, the reader relieves that stress by recalling that all it takes is “one minute” to donate whatever small amount he or she feels like parting with.
I just avoid the stress altogether now by donating every time I’m prompted. Call me a sucker for dissonance reduction – which is typically achieved in four ways:
- Adapting one’s behavior or choice to the dominant cognition
- Justifying one’s behavior or choice by changing the conflicting cognition
- Justifying one’s behavior or choice by adding new cognitions
- Ignoring or denying any information that conflicts with existing beliefs
Back to the Global Macro Grind…
Poor Janet Yellen. There is no “donate” option when it comes to setting monetary policy. In fact, the Federal Reserve’s own dual mandate of “maximum employment” and “price stability” often sends conflicting signals as it pertains to the most appropriate path of monetary policy. Transforming all of the oft-conflicting legions of economic data into one policy prescription requires a fair amount of dissonance reduction along the way. In recent statements and testimonies, the Fed has achieved said dissonance reduction in the traditional manners:
- Adapting one’s behavior or choice to the dominant cognition (e.g. maintaining hawkish guidance amid forecasts for a pickup in wage growth and broader economic growth – despite emerging evidence that neither the domestic nor global economy can withstand “policy normalization”)
- Justifying one’s behavior or choice by changing the conflicting cognition (e.g. looking through price instability by deeming it “transitory” and sticking with existing guidance so long as policymakers can be “reasonably confident” that inflation will return to their +2% target)
- Justifying one’s behavior or choice by adding new cognitions (e.g. adding “international developments” to the list of factors the FOMC will consider in setting monetary policy)
- Ignoring or denying any information that conflicts with existing beliefs (e.g. blatantly ignoring market-based signals like trending yield curve compression and/or the impact of a rising USD on the demand for and prices of domestically produced goods and services)
Going back to the legions of economic data the Fed factors into its policy debate, yesterday we held a conference call to dissect the domestic labor market from both a cyclical and secular perspective. We also quantified the impact of job losses in the energy sector, which has been a key area of focus in our recent discussions with our buy-side clientele. Additionally, we included a deep dive on wages and offered a well-researched view on why we have yet to see meaningful wage growth in the current cycle.
In the latter half of the presentation, we make a fairly robust case for why the Fed should be tightening monetary policy and an equally, if not more robust case against said tightening. The presentation is concluded with an analysis of historical tightening cycles and what tightening may imply for key asset classes.
***CLICK HERE to access the video replay and accompanying presentation (77 charts and tables)***
The conclusions of the presentation were as simple as the supporting analysis was complex:
- Even beyond the headline numbers, the labor market is actually quite healthy. The current energy-related headwinds to employment growth are being drowned out by broad-based strength across other sectors.
- That said, however, we have not yet reached full employment and slack continues to dissipate in a painfully slow manner.
- While there are structural headwinds to wage growth, we may not understand their full impact on restraining wages for quite some time because wage growth typically doesn’t pick up until late in the economic cycle.
- The case for monetary tightening is supported by ample evidence of the U.S. economy being soundly in the middle stage of business cycle and that deflationary forces are indeed transitory.
- The case against monetary tightening is supported by ample evidence that the Fed is well ahead of the curve and the (growth and inflation) data, as well as emerging evidence that the U.S. economy is in the latter stage of the business cycle with increasingly probable catalysts to perpetuate a downturn.
- While the Fed has gone to painstaking lengths to reassure investors that the path to policy normalization will be “gradual” and “data dependent”, history would suggest otherwise. The median length of time and cumulative increase in the Fed Funds Rate over the last five tightening cycles is 47 weeks and +300bps, respectively.
- This is interesting given the current consensus positioning across the investment community: the U.S. dollar tends to weaken in the months following the initial rate hike, which is supportive of the tendency of the prices of crude oil and gold to appreciate after the initial rate hike. As it pertains to interest rates, the long end of the curve tends to back up fairly dramatically, particularly six and 12 months following the initial rate hike – with the noteworthy exception of the last tightening cycle which saw consistent spread compression. Lastly, the stock market (S&P 500) initially falters shortly after the first rate hike, but ultimately tends to recover six and 12 months later.
So what is an investor to do with this information? Our best advice is to remain “patient” and “data dependent”. Why attempt to front-run the Fed when the Fed itself doesn’t even know what it plans to do? Why not just follow the trends in the data, keeping in mind that A) the FOMC’s forecasts for both growth and inflation have experienced a large degree of tracking error in the post-crisis era and B) the voting constituency of the 2015 FOMC is much more dovish than the aggregate body (i.e. lots of hawkish commentary emanates from non-voters)?
While such a strategy obviously requires more active risk management of factor exposures, the recent breakout in cross-asset volatility leaves investors with little choice.
Our immediate-term Global Macro Risk Ranges are now:
UST 10yr Yield 1.98-2.24%
Oil (WTI) 41.59-47.05
Keep your head on a swivel,