Call it a box, or perhaps even a paradox, but the Federal Reserve finds itself in an uncomfortable position heading into its first rate-hiking cycle in nearly a decade.
A central bank that has prided itself on transparency during its ultra-easy cycle following the financial crisis is now doing an awkward dance with a market not quite sure what to make of the road to tightening financial conditions.
The essential problem is this: When the Fed could have raised rates it didn't want to. Now that it wants to raise rates, it may not be able to, at least not without causing substantial turmoil in the same financial markets it has sought so strenuously to soothe.
The Fed hasn't raised rates since June 2006.
"There will never be a good time to raise rates off zero when you've been there for six years," Peter Boockvar, chief market analyst at The Lindsey Group, told CNBC. "The Fed's screwed, essentially."
The extension of the central bank's dilemma, or box, or paradox, goes like this, as highlighted in Boockvar's argument: Zero interest rates were a response to the worst U.S. economic crisis since the Great Depression. The economy, though, is far removed from its crisis days. The recession ended in mid-2009, gross domestic product has been on a steady if uninspiring march higher and financial markets, which have received by far the most benefit from Fed programs, have soared. While all that happened, the Fed could have begun the tightening process without disrupting the recovery.
What's left now, though, is a point where the Fed has indicated a desire to tighten at a time when its biggest global counterparts are easing. That's resulted in a firming of the dollar, a looming earnings recession in which U.S. profits are forecast to decline in two consecutive quarters—and could well turn negative for the year—and first-quarter GDP gains that could be anemic or nonexistent.
"Zero ... is just an unnatural rate six years into a recovery." Boockvar said. "But the problem is that GDP growth hasn't averaged more than 2.5 percent (during the recovery), so they're stuck in this lackluster, mediocre-type growth rate."
Investors have recoiled amid the current conditions.
Outflows from equity-based funds have reached their highest level since the darkest days of 2009, just as the recession was ending and the Fed was kicking its zero interest rate policy and quantitative easing into high gear. The central bank expanded its balance sheet to $4.5 trillion during QE as it bought bonds and injected liquidity into the capital markets.
However, this time the equity outflows are being met with Fed tightening, not easing. In fact, some on Wall Street believe the market has not come to terms yet with just what is about to happen with monetary policy.
Hans Mikkelsen, credit strategist at Bank of America Merrill Lynch, in a note to clients this week issued a warning about the dichotomy between market perception and Fed intention:
Our view that the market is underestimating the rate-hiking cycle is founded most importantly in New York Fed President (Bill) Dudley's speeches suggesting that the Fed wants to tighten financial conditions, which includes raising long-term interest rates...
In terms of short term interest rates we note that the market is pricing in a dramatically slower rate-hiking cycle than suggested by even the new lowered Fed dot plot (a diagram that depicts Fed members' rate expectations).
Thus we have a big gap between the Fed's view and what is priced into financial markets. This difference needs to be reconciled at the tail end of an unprecedented reach for yield trade, on the back of an extraordinary 5-6 years of zero interest rate policy (ZIRP) and QE, a collapse in dealer balance sheets and a much higher proportion of the market in less stable hands of mutual fund and ETFs. At the very least this means that risks are very high, and that we should position defensively against the possible technical headwinds associated with the coming shift in monetary policy.
Compounding the problem is that the Fed is left with precious little in its toolkit to combat any unexpected bouts of weakness. It certainly can't lower rates—though some other central banks actually have gone to negative nominal rates—and another round of QE is unlikely after the Fed just wrapped up the third round six months ago.
The Fed, then, is likely to rely on a communications strategy to make the market believe that it's not on a predetermined course. Chair Janet Yellen was set to deliver a speech Friday afternoon that will be closely watched for clues about future direction.
Joseph LaVorgna, chief U.S. economist at Deutsche Bank, believes the Fed will enact its first rate hike at the September meeting, which is the consensus view now. Dollar strength will moderate, the economy will shake off the first-quarter blues and consumers will propel growth going forward, factors that will combine to allow the central bank to begin raising rates at a gingerly pace, he said.
"Even with a strengthening dollar and the expectation of a rising fed funds rate," LaVorgna said in a note, "monetary policy will remain highly accommodative for the foreseeable future."