Posts tagged Fed And The Markets
Three years ago, one could have driven a fleet of semitrailers through the open space between the 2 year and the 10 year US Treasury benchmark note yields. While there still is some distance between the two, it would be somewhat more amenable to a single row of Priuses (Prii?) passing through. As the chart below shows, the shorter term note, which is generally more directly responsive to Fed policy, remains very close to its five year high. The intermediate 10 year yield, by contrast, has meandered along a largely directionless trajectory.
Untangling Policy, Demand and Expectations
The path of shorter term yields, for which the 2 year note is a useful proxy, is not hard to understand. The Fed began to make noises about tapering its QE policy in 2013 and then moved to a regime of reasonably explicit forward guidance on rates in 2015, resulting in the first increase at the end of that year. Despite falling sharply during the turmoil of early 2016, the 2 year resumed its upward path as conditions settled down and the case for a steady, if not spectacular, pace of economic recovery settled in as the default narrative. One should expect short term yields to continue tracking upwards in the absence of a reversal of the Fed’s stated intentions to keep raising rates.
For much of this time, the 10 year benchmark marched to a different drummer. Foreign demand was a key determinant of the consistently subdued yields experienced over this time – a trend that confounded no small number of bond pros. Rather than breaching 3 percent, as many expected, the 10 year actually set an all-time low – as in “since the founding of the American Republic all-time low” – in the immediate aftermath of Brexit.
The November election and the emergence of the so-called “reflation trade” brought about a shift in expectations, such that both intermediate and short yields moved largely in tandem. This was, as you will recall, when the prevailing mindset among investors imagined dramatic changes to the tax code and a sweeping new program of public spending on infrastructure. The spread between the 10 year and the 2 year in the weeks leading up to the election was mostly below 100 basis points, and it has not strayed very far from that level since.
Mind the Gap
The question now, of course, is whether there is still enough oomph in those reflationary expectations to send the 10 year into higher territory with a resulting steepening of the curve. This would be the putatively logical case to make for one who still believes there’s an infrastructure/tax reform pony out back with the capability to deliver the economic growth bump (however short-lived that might be) that is the administration’s central economic talking point. This view would consider the recent string of so-so hard data releases (including today’s six-of-one-half-dozen-of-the-other retail sales and inflation results) to be temporary and primed for near-term growth.
On the other hand, if the gap narrows still further – if the spread falls back into double digits as short term rates inch up while intermediates hold steady or fall again – investor brains could fall prey to the dark sentiments of an flat or inverted yield curve. That outcome would likely serve as a validation for those opining that bond yields represented the “smart view” while equity valuations soared on little more than a wing and a prayer.
The $4.5 Trillion Dollar Question
In the midst of all this is one very important and highly unpredictable variable: when and how the Fed plans to begin drawing down the $4.5 trillion balance sheet it racked up over the course of three quantitative easing programs. Observers will pay closer than usual attention to the forthcoming release of the FOMC’s minutes (scheduled for May 24) from its most recent policy meeting, scouring the language for clues about their intentions. The conventional wisdom is that the Fed believes there will eventually come a time when it needs to take rates back to zero and possibly launch another bout of QE. Having the dry powder to launch such a plan will necessitate a meaningful balance sheet reduction in the meantime. The tricky part, of course, will be to pull of this maneuver without roiling asset markets in so doing. Given the preternatural calm prevailing in risk asset markets currently, any hiccup could turn into a negative catalyst. Fed members will need to be practicing their triple-axel techniques to pull this off.
Fed-watching isn’t quite the sport it was one year ago. The investing herds these days tend to be more fixated on tweets than on dot-plots. Nonetheless, the FOMC will meet again in eleven days, and what they decide to do (or not do) in January and beyond will have an impact on fixed income portfolios. The consensus wisdom is that rates are likely to rise. But direction is only one aspect of managing interest rate exposure; the other is shape – as in shape of the yield curve. Short and intermediate term rates have done anything but move in lockstep over the past several years. We think it is a good time to step back and consider the variables that may be at play in influencing the shape of the curve in the coming months.
A very odd thing happened the last time the Fed engineered a sustained policy of rate increases. The chart below shows the Fed funds target rate going back to 2000, along with the 2-year and 10-year Treasury yields.
The Greenspan Fed began raising rates in June 2004, taking the Fed funds target rate from 1.0 percent to 5.25 percent over a two year period (the green dotted line on the chart shows this ascent). Short term market rates moved accordingly; the 2-year yield started moving up ahead of the Fed, probably due to the expectations game and a sense that economic recovery was at hand. Longer term rates, though, barely moved at all. In fact, by the time the policy action topped out, the yield curve was essentially flat between 2-year and 10-year maturities.
Greenspan pronounced himself confused by this and called it a “conundrum.” His successor Ben Bernanke had done his own homework, though, and figured out what was going on. Many central banks around the world, particularly in Asia, had been burned by the currency crisis of 1997 and subsequently embarked on disciplined programs of building up their foreign exchange reserves. Meanwhile China, which had emerged relatively unscathed from the ’97 crisis, had its own reasons for stockpiling FX reserves: it was a means of keeping its domestic currency from getting too expensive while the country’s value of exports soared. What are all those FX reserves comprised of? Treasury securities, mostly. So the Greenspan conundrum was nothing more than good old fashioned supply and demand; as foreign central banks built up ever-higher mountains of reserves, the demand kept Treasury prices up and yields down. The effect was more pronounced at the intermediate and long end of the curve, which tend to be less influenced by domestic monetary policy and more influenced by other economic variables.
As the above chart shows, the expectations game with short-term rates has had some crazy moments in the past few years. Note, first of all, that the 2-year did not follow the Fed funds rate all the way down to zero as the central bank responded to the 2008 recession and market crash. The 2-year hung around the one percent level for much of the time until the second half of 2010 – the time leading into when the Fed launched its second wave of quantitative easing. The 2-year finally converged with the Fed funds (the upper band of the zero – 0.25 percent range) after the Eurozone crisis and debt ceiling debacle of summer 2011.
But the expectations game began anew in 2013 when then-Chair Bernanke mused openly about tapering the QE activity, Since that time, despite a handful of reversals, the trend in short-term rates has been resolutely higher. Market expectations ran ahead of the Fed, falling back only in 2016 when the FOMC blinked on successive occasions and held off on rate increases.
Yellen and the Tweets
While short term rates moved decisively off their 2011 and 2013 lows, intermediate rates once again behaved very differently. The 10-year yield actually set an all-time low in 2016 – yes, that was the cheapest 10-year debt has ever been in the history of the American republic. Again, the culprit appears to be supply and demand. In an age of negative interest rates, the meager two percent yield is king. Demand from institutional investors like insurance companies and pension funds, pushed out of other sovereign markets from the Eurozone to Switzerland and Japan, allocated larger chunks to intermediate and long Treasuries.
What does this mean for the remainder of 2017? A rational assessment of short-term movements, based on where rates are today and assuming the Fed goes through with at least two more rate hikes over the year, is that short-term rates might nudge up another 50 basis points or so. At the short end of the curve we think floating rate exposure remains attractive as a defense, particularly if the expectations game gets ahead of itself again.
The bigger challenge lies in those intermediate exposures. Negative rates still persist in Swiss and Japanese 10-year paper, but intermediate Bunds have trended decisively higher in recent weeks. The reflation trade that took hold right after the US election has meanwhile pushed the 10-year Treasury within striking distance of three percent. If the first month or so of the new administration gives the market cause to wrap itself even more tightly around this theme, then it may be a very painful year for fixed income portfolios. On the other hand – and we tend to see this as a more likely possibility – if the Trump trade is already overextended then we would expect to see less drama in the middle and long end of the curve, and still-healthy demand from those yield-seeking institutions.
An orderly and gradual rate increase policy was no doubt at the top of Janet Yellen’s list of New Year wishes. The overall economic environment would seem ready to cooperate with that intention. But she will have to deal with the possibility that tweets will do more to shape the curve than will dot-plots.
Fiscal policy is where all the cool kids hang out now, as we noted in last week’s commentary. But the monetary policy nerds at the Fed got at least a modicum of attention this week as the dots settled on the Fed funds plot chart Wednesday afternoon. As was widely expected, the meeting resulted in a 0.25 percent target rate hike and some meaningful, if subtle, changes to the 2017 outlook. Three policy actions are on tap for next year, and this time the market seems to take this outlook seriously. Chair Yellen & Co. expect the recently favorable trends in output growth and employment to continue, while expecting to see headline prices reach the two percent target by 2018. These observations appear to be largely irrespective of what does or does not happen with all the hyped-up fiscal policy that has been driving markets of late. Be well advised: monetary policy will still matter, quite a bit, in 2017. It will have an impact on many things, not least of which will be the opportunity set of fiscal policy choices.
Divergent Today, Insurgent Tomorrow
Market watchers on Wednesday made much of the (temporary, as it turns out) pullback in stock indexes in post-FOMC trading. But the real action, as has often been the case in the last six weeks, was in the bond market. The yield spike is noteworthy in absolute terms, but even more striking on a relative basis. Consider the chart below, showing the spread between the 2-year U.S. Treasury note and its German Bund counterpart.
Short-term U.S. rates are at 52-week highs while German rates are at their 2016 lows. The spread between the two is wider, at 2.07 percent, than it has been at any time since 2003. Remember divergence? That was the big theme in the discourse one year ago, when the Fed followed through on its 2015 policy action last December. The Eurozone and Bank of Japan were full steam ahead with their respective stimulus programs as the Fed prepared to zag in the other direction. Then markets hit a speed bump in January, the Fed backed off any further action and rates came back down. As the above chart shows, U.S. and German short-term rates followed a more or less similar trajectory for most of the year.
But divergence is back with vengeance. Holders of U.S. dollar-denominated assets will be pleased, as the euro gets pushed ever closer to parity. Policy divergence leads to dollar insurgence. On the negative side, that insurgence looks set to redouble the FX headwinds that have clipped corporate top line revenue growth for much of the past two years. That, in turn, will make it challenging to achieve the kind of double-digit earnings growth investors are banking on to justify another couple laps of the bull market.
Three Times the Charm?
What we took away from Chair Yellen’s post-meeting press conference was a sense that the Fed’s world view has changed only modestly amid all the hoopla of the post-election environment. She took pains to note that the outlook shift to three possible rate changes in 2017 does not reflect a seismic change in thinking among the dot-plotters, but an incremental shift reflecting a somewhat more positive take on the latest growth, employment and price data.
And fiscal policy? Yellen could hardly avoid the topic; it was the point of the vast majority of the questions she fielded from the press. Over the course of her tenure at the Fed she has spoken many times of the need for monetary and fiscal policy to complement each other at appropriate times in the business cycle. This, however, may not be one of those times. Consider her comment in response to one question: “So I would say at this point that fiscal policy is not obviously needed to help get us back to full employment.” For the moment, at least, and in the absence of any tangible data to suggest otherwise, the Fed does not appear to be giving undue attention to the fiscal variable.
As Location Is To Real Estate, Productivity Is to Growth
Chair Yellen did make a point of emphasizing what kind of fiscal policy she does like: namely, that which directly helps boost productivity. That’s a point you have heard us make in this space ad nauseum, so it was good to hear it from the Eccles Building. What kind of fiscal policy could that be? Education, jobs and skills training programs and improving the quality of installed capital used by American workers were specifically called out by the Fed chair. Of course, there is no clarity of any kind that such productivity-friendly programs will make it through the legislative sausage factory. One can always hope, though.
In this space last week we presented a case for “guarded optimism” in risk asset markets, regardless of the outcome of the presidential election. Then the Tuesday Surprise happened. It would be reasonable for one to ask us whether we are still of that cautiously optimistic view we expressed one week ago, and that will be our theme this week.
Sound and Fury
First of all, let us be crystal clear about one thing. When the subject of politics comes up in any of our weekly commentaries, our discussion is limited to how we perceive the directional impact of political events on equities and other risk asset markets. Donald Trump’s Electoral College victory has major potential implications for the U.S. and the world at many levels. Both of us have our own personal views about the outcome. But our focus here, as it is with any subject we present in these pages, is simply to share with our clients and other readers our assessment of how this development may affect their long-term investment portfolios.
As of today, our view is very little changed from where it was one week ago. Yes – futures markets plummeted through circuit-breaker levels as the results trickling in from North Carolina and Florida illuminated Trump’s path to 270. And yes – a few inclusive-sounding words by the President-elect, delivered in a relatively calm, measured tone in the wee hours of the morning, succeeded in reversing those overnight losses ahead of a Wednesday rally. That’s short-term noise, and while we could see more of that play out over the next couple weeks, we do not see as likely any sustained directional trend one way or the other proceeding from the simple fact of Trump’s victory.
Beyond the short-term sound and fury, we see three critical questions that could set the tone of markets in the first half of next year and beyond. First, will the new administration insert itself into Fed Chair Janet Yellen’s realm of monetary policy in a way that upsets central bank-dependent asset markets? Second, how will the economic priorities of Team Trump impact particular industry sectors and, by extension, the sales and earnings prospects of publicly traded companies? Third, will those same economic priorities live up to the often inflammatory, dangerous rhetoric on foreign trade that came up in the course of the campaign?
The Last Democrat
Among her other claims to fame, Janet Yellen now has the dubious distinction of being the last Democrat in Washington, D.C. with any meaningful power. The President-elect’s personal distaste for her is well-known and was featured prominently in the campaign’s closing ad messages. We think it unlikely, though, that the new president would play footsie with a possible market crash by taking concrete action in his first year to limit the Fed’s ability to independently execute monetary policy. Yellen’s term expires in January 2018, and odds are better than not that she will be replaced then by a Republican Fed head. Trump would have little to gain, and a great deal to lose, by stirring up trouble in the Eccles Building any time before then.
That is not to say that the risk of a White House – Fed confrontation does not exist as a possible 2017 surprise. In particular, it will be interesting to see how Trump and his new economic advisors react if, as expected, the Fed reactivates its rate hike program starting in December. Notoriously unpredictable as a candidate, it remains to be seen how restrained Donald Trump will be as president. We will be studying the tea leaves of formal policy speeches and off-the-cuff Twitter remarks alike in the coming weeks to get a better sense; for the time being, anyway, we would expect a more pragmatic approach to relations with the Fed at least within the next twelve months.
The Return of Fiscal Policy?
One of the first ways we expect 2017 to be unlike every one of the last eight years is that fiscal policy – i.e. actual legislative action targeting areas of economic stimulus – will be a real part of the conversation. In 2009 the Republican Congressional leadership more or less designed a tactical program around denying the Obama administration opportunities to implement economic policy. They didn’t always succeed – most notably in the 2009 stimulus package responding to the Great Recession and then in the 2010 passage of the Affordable Care Act – but by the time of Obama’s reelection in 2012 fiscal policy was by and large not a viable part of the economic equation. That has changed with the looming imminence of one-party rule. When we hear various ideas floated around – infrastructure spending, corporate tax reform, and stimulus programs for coal and other non-renewable energy sources are examples currently making the rounds – we have to assume they can actually become law and have an impact for better or worse.
One practical consequence of this is that sector picking may be back in vogue, as armies of quants tinker around with algorithms designed to follow the direction of putative fiscal policy initiatives. We already see signs of how this will play out; just since Wednesday morning, for example, the healthcare sector has been cleaved into subsectors with very distinct, uncorrelated trading patterns. Republicans on the Hill are baying for an immediate repeal of the Affordable Care Act, with little sense of what if anything is to replace it. That exposes health insurers to much uncertainty. On the other hand, expectations of an ultra-light regulatory touch are boosting the shares of drug manufacturers and biotech firms.
Trade or No Trade?
Ultimately, corporate earnings will depend on far more than U.S. fiscal policy. The IMF revised its estimates for global growth next year down in its most recent quarterly assessment. Both output and demand remain below historical norms in most developed as well as emerging markets. Weak foreign demand and a strong U.S. dollar are likely to continue to weigh on earnings and profit margins. That was going to be true regardless of who won on Tuesday night. Both campaigns took a relatively hard line against global trade; again, though, the fact that the executive and legislative branches all went Republican means that – to be blunt about it – if the new administration wants to start a trade war then it will be well within the realm of possibility to implement protectionist legislation.
Somewhat along the lines of our thinking that Trump would not likely rush into an immediate monetary policy confrontation with Janet Yellen, we think it less than probable that he would strike up a trade confrontation with China as an opening economic policy salvo. We have to imagine that somewhere in his economic transition team are voices to convince him of the unfavorable cost-benefit equation of such action.
There will be plenty of pressure from outside Washington to live up to his campaign rhetoric, however. It is not lost on anyone, least of all on traditional conservative free-traders who populate D.C. redoubts like the American Enterprise Institute and the Heritage Foundation, that the margin for Trump’s victory was delivered by voters who have largely been on the losing side of the global economy’s distribution of fortunes. The President-elect will soon enough have to confront the dilemma of pro-trade, pro-growth policy versus the strong protectionist impulses of the newly-empowered working class Republican base.
So there they are: monetary policy, fiscal stimulus and approach to trade are the three open questions at the top of our list of priorities. As we said last week, connecting the dots between the current direction of macroeconomic trends and corporate sales & earnings – i.e. the overall narrative that long predated the election – offers enough grist for at least a cautiously optimistic take on asset markets as 2017 gets underway. Whether we stand by that view as the year progresses will depend in no small part on how we see the evidence shaping up to provide answers to these three questions.
It’s enough to make one sort of miss those crazy Octobers when goblins and other malevolent spirits wreak havoc on asset markets. Remember 2014? A weird flash crash in U.S. Treasury yields spooked investors already jittery about the Ebola virus making sensational front page headlines. The S&P 500 fell to just short of a technical correction in intraday trading before rebounding sharply as it became clear that there was no “there” there. A vigorous Santa rally carried the U.S. bellwether index up to a then-all time high right before the end of the year.
Mario Wins the Toss, Elects to Defer
At least that gave us something to write about. October 2016 thus far is a fine month for those who value calm and serenity, but for market scribes it is notably bereft of attention-grabbing headline events. Share trading volume this month on the New York Stock Exchange is somewhat below its average daily levels back in August. August, for heaven’s sake! It would appear that stock markets are catching the soporific vibes of the central banks they so assiduously follow, most recently the European Central Bank. On Thursday, ECB Chairman Mario Draghi summed up deliberations of the body’s governing council thus: We’ll talk again in six weeks. Ciao!
The ECB has a raft of unsolved problems, but this week was apparently not the time to provide any guidance as to their progress. Markets widely expect the bank will extend the current program of monthly €80 billion purchases beyond the current termination date of March 2017. However, the ECB’s rules on asset eligibility are at odds with the actual supply of viable paper in the market. Those rules probably will have to change in order to facilitate a meaningful extension of the program. Such change in turn will require agreement from the council’s German and other northern European hawks. Draghi’s deference to the December meeting likely stems from a lack of consensus today as to how to remedy asset eligibility rules to facilitate an extension of QE beyond March.
Earnings: Low Bar Well Cleared
Meanwhile, the third quarter earnings season is, rather predictably, serving up a nice dollop of upside surprises. With a bit more than 20 percent of S&P 500 companies reporting to date, both top-line revenues and mid-bottom line profits are mostly outperforming analysts’ expectations heading into the season. We expect that, when all is said and done, the average EPS growth number will be slightly positive as compared to the minus 2.6 percent consensus number projected a couple weeks back.
Yet, while upbeat earnings reports have helped a handful of individual names thus far, those low share volume figures and lackluster price drift for the S&P 500 overall indicate that, for the moment anyway, earnings season is not serving as much of a catalyst for a broad-based rally. Shares remain expensive by traditional valuation metrics, as we have frequently pointed out in these pages. Investors still have a more skeptical take on companies’ forward guidance projections, and headwinds including the dollar and weak foreign demand haven’t gone away. Until guidance announcements provide more evidence of a near-term future of double-digit EPS growth, a couple of quarters clearing a very low bar probably won’t do much to shake off the lethargy.
When Nothing Becomes Something
We still have six weeks to go before that next ECB conference, and even longer to wait for the white smoke to appear from the Eccles Building in Washington D.C. signifying the Fed’s next move. Six weeks is a long time for “nothing” – as reflected by sideways prices, low volatility and vanishingly thin trading – to continue. Some technical indicators including shorter term moving averages and 52-week highs vs. lows suggest some top-heaviness. While we don’t see any obvious lurking threats that could move from potential to kinetic (yes, including the U.S. election which, as we have pointed out before, is largely baked into current price levels), the current quiet does strike us as too quiet.
Often it is not one thing, but rather a random confluence of several things, which gives rise to sharp price reversals. The example we provided above of the October ’14 correction illustrates this well: a sudden data point anomaly (the Treasury yield flash crash), amidst a raft of vaguely disquieting, uncorrelated event headlines and a new wave of commodity price drawdowns, converged to trigger sell signals from trading program algorithms. More often than not, these turn out to be short-lived tempests. It’s been awhile since we had one, though.