Posts tagged Fed And The Markets
As we wind our way through the random twists and turns of the first quarter, a couple things seem to be taking on a higher degree of likelihood and importance than others: (a) the Fed is back in the game as the dice-roller’s best friend, and (b) corporate earnings are starting to look decidedly unfriendly for fiscal quarters ahead. And we got to thinking…have we seen this movie before? Why, yes we have! It’s called the Corridor Trade, and it was a feature of stock market performance for quite a long time in the middle of this decade. Consider the chart below, which shows the performance path of the S&P 500 throughout calendar years 2015 and 2016.
What the chart above shows is that from about February 2015 to July 2016, the S&P 500 mostly traded in a corridor range bounded roughly by a fairly narrow 100 points of difference: about 2130 on the upside, and 2030 or so on the downside. There were two major pullbacks of relatively brief duration during this period, both related to various concerns about growth and financial stability in China, but otherwise the corridor was the dominant trading pattern for this year and a half. Prices finally broke out on the upside, paradoxically enough, a few days after the UK’s Brexit vote in late June 2016. An overnight panic on the night of the Brexit vote promptly turned into a decisive relief rally because the world hadn’t actually ended, or something. A second relief rally followed the US 2016 elections when collective “wisdom” gelled around the whimsical “infrastructure-reflation” trade that in the end produced neither.
So what was this corridor all about? There are two parts: a valuation ceiling and a Fed floor.
Corridor Part 1: Valuation Ceiling
In 2015 concerns grew among investors about stretched asset valuations. Earnings and sales multiples on S&P 500 companies were at much higher levels than they had been during the peak years of the previous economic growth cycle in the mid-2000s. The chart below shows the price to earnings (P/E) and price to sales (P/S) ratios for the S&P 500 during this period.
Those valuation ratios were as high as they were during this time mostly because sales and earnings growth had not been keeping up with the fast pace of stock price growth in 2013 and 2014. While still not close to the stratospheric levels of the late-1990s, the stretched valuations were a cause of concern. In essence, the price of a stock is fundamentally nothing more and nothing less than a net present value summation of future potential free cash flows. Prices may rise in the short term for myriad other reasons, causing P/E and P/S ratios to trade above what the fundamentals might suggest, but at some point gravity reasserts itself. That was the valuation ceiling.
Corridor Part 2: The Fed Floor
The floor part of the corridor is just a different expression for our old friend, the “Fed put” begat by Alan Greenspan and bequeathed to Ben Bernanke, Janet Yellen and now Jerome Powell. Notice, in that earlier price chart, how prices recovered after both troughs of the double-dip China pullback to trade again just above that corridor floor level. The same thing seems to be happening now, with the extended relief rally that bounced off the Christmas Eve sell-off. The floor is a sign of confidence among market participants that the Fed won’t let them suffer unduly (which confidence seems quite deserved after Chair Powell’s capitulation at the end of last month). It is not clear yet where the floor might establish itself. Or the ceiling, for that matter. Might the S&P 500 reclaim its September 20 record close before hitting a valuation ceiling? Maybe, and then again maybe not.
What we do know is that bottom line earnings per share are expected to show negative growth for the first quarter (we won’t find out whether this is the case or not until companies start reporting first quarter earnings in April). Sales growth still looks a bit better, in mid-single digits, but we are already seeing corporate management teams guiding expectations lower on the assumption that global growth, particularly in Europe and China, will continue to slow. Meanwhile price growth for the S&P 500 is already in double digits for the year to date. That would appear to be a set-up for the valuation ceiling to kick in sooner rather than later.
Could stock prices soar another ten percent or even more? Sure they could. The stock market is no stranger to irrationality. A giddy melt-up is also not unknown as a last coda before a more far-reaching turning of the trend. But both elements are pretty solidly in place for a valuation ceiling and a Fed floor. A 2015-style Corridor Trade will not come as any surprise should one materialize in the near future.
There is something almost symmetrical about it all. On December 19 last year the Federal Reserve delivered a hawkish monetary policy statement that sent the stock market into a tailspin. Two days later the US government shut down. Fast forward to January 25 of this year. The US government reopened amid generally upbeat sentiment in asset markets. Several days later, the Fed surprised traders with a decidedly dovish policy statement hinting at a pause, not only in further interest rate hikes but in winding down the central bank’s balance sheet of bonds purchased during the quantitative easing (QE) era of 2008-14. Stocks surged in the aftermath of that announcement and closed out a January for the record books. Hallelujah, exclaims Mr. Market. The Fed put is back and better than ever!
What Exactly Changed?
The January Federal Reserve Open Market Committee (FOMC) statement was not just a tweak or two away from the December communiqué – no, this was closer to a full-blown U-turn. As much as investors thrilled to the news that the Fed was solidly back in their corner to privatize gains and socialize losses, there was quite a bit of head-scratching over what exactly was so momentously different in the world over this 30 day interval. The FOMC press release seemed to say little about changes in economic growth prospects, with a strong labor market and moderate inflation paving the way for a sustained run of this growth cycle. True, it chose the world “solid” to characterize growth, which may be a slight demotion from “strong” as the adjective of choice in December. And yes, muted inflation affords some leeway to adjust policy if actual data were to come to light. But real (inflation-adjusted) rates are nowhere near recent historical norms, as illustrated in the chart below.
“Muted inflation” is the Fed’s term to describe the current level – but is it really “muted?” The chart above shows the Consumer Price Index (the blue dotted line) to be squarely within a normal range consistent with growth market cycles in the late 1990s and the mid-2000s. Yet in both of those cycles real rates were much higher, as is clear from the gap between nominal 2-year and 10-year yields (green and crimson respectively) and the CPI. Is the Fed worried that real rates at those levels today would be harmful? If so, there must be some element of fragility to the current economy that wasn’t there before.
Oh, Right. That.
Or, maybe that’s not it at all, as the FOMC press release sort of gives away in the next sentence. “In light of global economic and financial developments…” Aha, there it is, the language of the 2016 Yellen put reborn as the 2019 Powell put. What, pray tell, could those “financial developments” possibly be? A stock market pullback, blame for which was almost entirely laid at the feet of those two FOMC press releases last September and December? Once again, monetary policy appears to be based principally on ensuring that market forces not be given free enough latitude to inflict actual damage on investment returns.
And maybe that’s fine – perhaps the pace of growth will continue to be slow enough to allow the Fed to ease off the monetary brakes without any collateral damage. If that turns out not to be the case, though, then we foresee some communication challenges ahead. The data continue to suggest the growth cycle has a way to go before petering out. Today’s jobs report was once again robust, with year-on-year wage growth solidifying a trend in the area of 3.2 percent year-on-year. Unfortunately we won’t know about Q4 2018 GDP for some time, as the Bureau of Economic Analysis was impacted by the government shutdown and does not yet have a date for when its analysis will be ready for release.
March is probably safe – the likelihood of a rate hike then is now close to zero. But if Powell has to go back to the market sometime later in the year and ask investors to get their heads around another rate hike – a U-turn from the U-turn, in effect – that would likely be problematic. This Fed still has a learning curve to master when it comes to clarity of communication.
It wasn’t all that long ago that Davos Week was a big deal. Confident, important communiqués about the state of the world delivered by important, impeccably tailored men (and a few women here and there). The rest of the world’s inhabitants might live out their quotidian habits in a perpetual fog, but the great and good who assembled in the little Swiss Alpine town every January were there to tell us that it was all going to be okay, that the wonders of the global wealth machine would soon be trickling their way. Now the fog has enshrouded them as well. While their status as influencers was getting sucked down into the lowest-common-denominator Twitterverse, their ability to explain the great trends of the day was upended by the improbable turn those trends were taking away from the comfortable Washington Consensus globalism of years past. “The mood here is subdued, cautious and apprehensive” reports Washington Post columnist (and Davos Man in good standing) Fareed Zakaria from the snowy slopes this year. Apprehensive, not confident, which is an apt way to sum up the present mindset of the world.
Never Underestimate the Power of Kick the Can
Yet, for all the fretting and fussing among the stewards of the world’s wealth pile, some of the key risks that have been plaguing investors in recent weeks seem to be turning rather benign. Consider as Exhibit A the state of the British pound, shown versus the US dollar in the chart below.
The pound has rallied strongly since plummeting in early December last year. If you go back and track the history of Brexit negotiations since that time, you find that the actual news about a Brexit resolution is almost all dismal. The deal PM Theresa May brought back from Brussels was panned as soon as it reached Westminster; that same deal formally went down to one of the most ignominious defeats in UK parliamentary history last week.
All the while – the pound sterling has rallied! Why? Because the Brexit deal’s unpopularity means that there are only two ways this whole sorry affair plays out between now and March, when the Article 50 deadline comes into effect. One is that the UK crashes hard out of the EU, which would be a disaster for the country. The other – and far and away the most likely, is to kick the can down the road. Extend the Article 50 deadline, probably to the end of the year, and see what kind of fudge can be worked out between now and then. Maybe (most likely, as we have been saying for some time now) a second referendum that scotches Brexit for once and all. Maybe something else. Maybe someone has to make a bold decision at some point. But not yet, not yet, as that fellow said in “Gladiator.” Thus the strong pound.
March Without the Madness
The month of March has in fact been looming large over Davos think-fests and cocktail parties this week. In addition to Article 50, there is that self-imposed deadline by Washington’s trade warriors to reach some kind of deal with China on the terms of cooperation going forward – absent which, according to Trump’s protectionist acolytes, there would be hell to pay in the form of new tariffs. Yet as the days go on, the evidence mounts that this administration’s tough talk on any number of fronts is all hat and no cowboy. This administration has plenty of other troubles with which to contend, and by now they know that actually following through with tough trade rhetoric will spark another pullback in the stock market. We don’t think it’s being Pollyanna to say that this trade showdown at high noon will likely not come to pass.
Finally, the other risk event that could befall markets after the Ides of March would be the Fed meeting that month with the potential for another interest rate hike. While that is a possibility, the Fed’s actions in recent weeks have been very cautious and non-confrontational with edgy markets. Recent inflation numbers have come in a bit below expectations. We’ll see what happens with Q4 GDP next week, but indications are that it will settle back somewhere in the 2-plus percent real growth range. In other words, the Fed will have plenty of flexibility if it decides to join in with the kick the can fun and hold off until next time. Even on the question of the Fed’s balance sheet there have been some recent indications that it may not wind down as quickly or deeply as previously thought.
“Never make tough decisions today that you can punt down the field for later” – this instinct is alive and well in the world of global policymaking. As long as that remains the case, Davos Man, you should take a deep breath and go back to enjoying your cocktails and canapés.
In the canons of Fed Scripture there was the Greenspan put, which begat the Bernanke put, which begat the Yellen put, and the Governors saw that it was good, and the Governors rested on the seventh day. And then came Jerome Powell, and the put was no more. Or was it?
You’ve Got a Friend at the Fed
For those not steeped in the arcane speech patterns of those who inhabit and/or observe the goings-on in the Eccles Building, the “Fed put” is the widely-held assumption among investors and traders that whenever risk asset markets get choppy, the Fed will be there to ease the pain with a fresh punch bowl of easy money.
Case in point: in the early months of 2016, just after the Fed had raised rates for the first time since the 2008 recession, global equities took a hit from some negative economic data from China. Now, nobody in the Yellen Fed at the time ever actually came out and said “the S&P 500 fell more than 10 percent, so we’re going shelve the rate hikes for a while.” But investors could draw their own conclusions – rates did stay on the shelf, not rising again until the end of 2016, a full year after the first increase.
For much of the current recovery cycle the colloquial Fed put was part and parcel of the formal monetary stimulus policy to get the economy back on its feet. Encouraging investors to shift out of low-risk assets like government bonds and into riskier things like equities was a central feature of the system. But those days are over. When stocks lurched into a downturn back in early October it seemed that the market finally got the memo – the FOMC (Federal Open Market Committee, the Fed’s monetary policy decision arm) had raised rates again in the September meeting, were on track to do so again in December, and Fed chair Powell was quoted in a speech as saying that current rates were still far away from the neutral interest rate. The economy’s doing well, corporate earnings are fine, no need to keep the training wheels on…right? Investors seemed to think otherwise, and Red October was on.
A Lighter Shade of Neutral
Let’s go back to that Powell comment about the neutral rate, because it figures very much into what the market has been up to this week. First of all, what exactly is the “neutral” rate of interest? Glad you asked, because even the cerebral Fed folk themselves can’t give you a clear answer. It’s supposed to be whatever rate of interest is neither stimulative (too low) nor restrictive (too high). The various members of the FOMC have their own ideas, which fall out into a range of about 2.5 to 3.5 percent based on the most recent “dot plot” assumptions the Fed releases periodically after the FOMC meets.
On Wednesday this week, Powell once again referenced the neutral rate. This time, though, rather than saying that rates were currently “far away” from neutral, he said they were “just below” the range of neutral rate estimates. The market went into a tizzy again, but this time in a good way with major indexes jumping more than 2 percent. And so the excited chatter resumed…is that a Powell put we see out there? We may well be wrong about this, but we tend to think not.
Do the Math
Currently, the Fed funds rate is in a target range of 2.0 to 2.25 percent, which puts rates…well, just like Powell said, “just below” the range of neutral rate estimates. The chart below illustrates this.
But why did investors obsess over those two words “just below?” Here’s how the math works. The midpoint of the current Fed funds range is 2.125 percent (i.e., halfway between the floor of 2 percent and ceiling of 2.25 percent). The FOMC generally likes to see the effective rate (i.e. the actual market rate banks charge each other for overnight loans) somewhere close to the midpoint.
So, to get that midpoint rate above the 2.5 percent lower boundary of the neutral rate range would require two additional rate hikes (presumably one later this month and one sometime next year). To get to the midpoint of the neutral range, a more likely outcome, would require three or four additional rate hikes to get to 2.875 percent or 3.125 percent (i.e., either side of the 3.0 percent midpoint neutral rate).
Three or four additional increases…wait, isn’t that what the Fed has already signaled it plans to do? Why, yes! One in December and then two or three in 2019 is the default assumption coming out of FOMC press releases and commentary since at least the middle of this year. So why all the fuss? Parsing what exactly Powell meant by “far away” or “just below” or any other combination of two words would seem silly, if the math seems obviously the same as it has been for months already.
One reason given for all the investor excitement was that Powell’s comments on Wednesday came right on the heels of another blast of word salad from the nation’s chief Twitterer complaining about the Fed and higher interest rates. Was the Fed chief bending the knee to Trump like so many other seemingly reasonable people have in the past two years? Is the Fed put back in the policy bowl because Trump wants low interest rates?
While one can never say never in this day and age, we see very little likelihood that the head of the Federal Reserve, charged among other things with maintaining the independence of the central bank, would immerse himself into the middle any political imbroglio. The timing may have seemed strange, but there just is no factual basis in which to read any kind of political message from Powell’s speech. He did say that there is no “preset” path for rates – which is what the Fed always says. Data about the health of the global economy will inform the pace of interest rate policy. If growth appears to be slowing or going into reverse then there will likely be fewer rate hikes, while if the pace continues to hum along at current levels there is no reason to assume anything other than the four rate hikes already baked into policy expectations.
We’ll get a preview of whether our analysis is correct or not in just a few short weeks when the FOMC meets for the last time this year. There are just a handful of macro data points coming out between now and then, and barring a very unexpected surprise either from the labor market or consumer price readouts, we don’t see anything to suggest the December Fed funds increase won’t happen. Hopefully Mr. Market will be able to figure this out in a relatively drama-free fashion.
It doesn’t take much these days. “Pretty bad market today, huh?!” came one comment from a fellow runner during a muggy 5K outing on Thursday evening. Was it? Apparently so. Thursday’s S&P 500 posting of minus 0.82 percent was the biggest daily drawdown since the second half of June, when the index shed close to 3 percent for some vague reason long forgotten. None of this in any reasonable way qualifies as a pullback of note – we tend not to raise an eyebrow until the 5 percent threshold approaches. But after three months during which the market climbed as relentlessly as the humidity index in the Washington DC swamplands, even a modest pullback of less than 1 percent seems as rare as actual fall weather in this weirdest of October climes. Blame it on the bonds.
The catalyst for the Thursday downdraft in equities was a surge in bond yields that gained steam on the back of a couple economic reports on Wednesday – in particular, a thing called the ISM Non-Manufacturing Index, which rose more than the consensus outlook. That report, suggesting that activity in the services sector (which accounts for the lion’s share of total GDP) was heating up, set the stage for expectations about a gangbusters monthly jobs report on Friday. The 10-year Treasury yield shot up by 10 basis points (0.1 percent), which is huge for a single day movement. The 10-year yield is now at its highest level since 2011, as shown in the chart below.
That blockbuster jobs report, as it turned out, never happened. We got a headline unemployment rate of 3.7 percent that is the lowest since – kid you not – 1969, that groovy year of moon landings and Woodstock. But payroll gains, the most closely watched indicator, rose by considerably less than the expected 185K while wage growth came in right at expectations with a 2.8 percent gain. Overall, a mixed bag. Equities are roughly flat in tentative trading as we write this, while the 10-year Treasury yield continues its advance. The yield spread between 10-year and 2-year Treasuries, which earlier this year appeared on the tipping point of an inversion (in the past a reliable signal of an approaching recession), has widened to about 35 basis points.
This widening spread would be consistent with the ideas we communicated in last week’s commentary about increased inflationary expectations on the back of an ever-tightening labor market and price creep from higher tariffs on an expanded array of consumer products. So far the numbers – in particular today’s jobs data and last week’s Personal Consumption Expenditures (PCE) reading – don’t bear out the hard evidence. But the bond market could be adjusting its expectations accordingly.
Doing It On the QT
Or, maybe not. There were a couple technical factors at play this week as well, including a jump in the cost of hedging dollar exposure which had the effect of reducing demand for US Treasuries by foreign investors. This is not the first time that we have seen a sudden back-up in yields, only to dissipate in relatively short order. As for the fabled bond bull market that has endured since the early 1980s, well, there is certainly no shortage of times this has been pronounced dead, only to rise again and again.
Ultimately, of course, it all comes down to supply and demand. We know one thing with confidence – the Fed is out of the market as a buyer. While last week’s FOMC meeting didn’t produce much in the way of surprises, it did codify the understanding that the age of QT – quantitative tightening – is at hand. The Fed’s assessment of the economy is quite upbeat. The cadence of rate increases and balance sheet reduction is likely to continue well into 2019.
None of which necessarily suggests that intermediate and long term rates will surge into the stratosphere. If the domestic economy stays healthy then domestic assets should be attractive to non-US investors – an important source of demand that could keep yields in check. Indicators like corporate sales (growing at a brisk 8 percent or so) and sentiment among businesses and consumers (leading to increased spending and business investment) suggest that there is more to the current state of the economy than a fiscal sugar high from last December’s tax cuts. For the near term, our sense is that the positives continue to largely outweigh the potential negative X-factors. We may be okay in 2019 – but 2020 could be an entirely different story.