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Federal Reserve, bank stocks and the Wall Street bears

The federal reserve could well raise its overnight borrowing rate at the next FOMC monetary policy conclave on September 17. Though contagion from China's 40 per cent stock market meltdown has triggered bear markets from Hong Kong to Frankfurt and plunged Asian/emerging markets equities into ta ghastly replay of 1998's epic meltdown (General Suharto's overthrow, the Russian rouble default, Malaysia's capital controls, the run on the Thai baht, the IMF's $57 billion South Korea bailout, $10 crude oil).
The smoke signals from the central bank suggest the $17 trillion US economic colossus (25 per cent of global GDP) exhibits strength, with 3.7 per cent second quarter GDP growth, 1.1 million housing starts, 17 million unit vehicle sales, a 5.1 per cent unemployment rates, record corporate profits and accelerating bank loan growth. US economic data unquestionably argues for "monetary normalisation", Fedspeak for higher US interest rates seven years after the failure of Lehman Brothers plunged the world into capital markets/banking Armageddon and the deepest economic slump since the Great Depression of the 1930's. It did not surprise me that Fed vice-chairman Stan Fischer chose CNBC to signal that the US economy's data momentum is strong enough to threaten the central bank's two per cent inflation target. After all, the Federal Reserve operates under a dual mandate, to maximise employment growth consistent with an inflation target below two per cent. The Presidents of the Dallas, Atlanta and Richmond regional Feds all echoed Dr Fischer's hawkish views.
However, the Yellen Fed cannot and will not ignore the global economy and the $10.4 trillion Chinese economy's financial carnage in its deliberations. The managing director of the IMF and the governor of India's Reserve Bank (a former IMF chief economist and University of Chicago monetarist!) have publicly asked the Fed not to raise interest rates during a time of financial market turbulence and deflation risk in emerging markets. Former Treasury Secretary and Harvard President Larry Summers even called on the Fed to ease, not raise, interest rates to fulfil its role as the world's de facto lender of the last resort.
After all, the Greenspan Fed responded to the Asian flu with three successive rate cuts in 1998-99. The Bernanke Fed responded to Lehman/Wall Street banking crises in 2008 via history's most epic experiment in unorthodox monetary easing and expanded the Fed's balance sheet from $900 billion to $4 trillion in the past seven years.
The 5.1 per cent unemployment rate and 173,000 payrolls growth data in August does not negate a September rate hike as average hourly earnings rose 0.3 per cent and aggregate hours worked rose 0.4 per cent. This led to steep equities losses on Wall Street and a fall in the ten-year US Treasury note to 2.11 per cent, thus flattening the US dollar yield curve. The ECB's Dr Draghi downgraded eurozone growth/inflation, raised limits on singe bond purchase and explicitly pointed to the China/commodities crash as a source of deflation risk. This raises the odds of a "shock and awe" ECB QE in October and a fall in euro/dollar to parity or lower by early 2016. This is exactly the scenario I had outlined in a column I published six weeks ago. A hawkish Fed, a dovish ECB and the Chinese Politburo in panic means King Dollar, risk aversion spasms in global markets and unwinding of the crude oil short covering trade.
I doubt if China chaos will offset the Yellen Fed's tightening bias. Unlike September 2008, there is no sign of systemic stress in the wholesale bank funding, loan syndication, commercial paper or bond new issue markets. The Chicago Volatility Index (VIX) has more than doubled to 27 but I cannot see the Fed "ease" unless the VIX spikes to 45, not on the eve of a US Presidential election.
However, Wall Street has priced out the scenario for aggressive Fed tightening (the Chicago futures markets predict the Fed Funds rate will be 1.25 per cent in September 2017). This is the reason Citigroup, Morgan Stanley, Goldman Sachs and J.P. Morgan shares have fallen 15-20 per cent from their recent peaks. As the yield curve flattens, bank interest rate margins compress. Dr Copper is at $5,000 per metric tonne on the LME and Uncle Carl's Freeport Stake did squat for commodities stocks.
If the Fed only considered US data strength, it is "behind the curve" on inflation risk. Yet the Fed is de facto lender of the last resort for a world in deep financial distress. China/Asia now joins subprime mortgages and Greek sovereign debt as the third global shock in the past decade and bank stocks have paid the price on Wall Street.