Posts tagged Fed And The Markets
As 2017 draws to a close, two data points strike us as particularly noteworthy candidates for summing up the year in asset markets. The S&P 500 is up more than 20 percent in total return, and the Fed has raised interest rates three times. Investors have good cause to bemoan the exit of Janet Yellen at the end of next month, for the good professor has given us an extended seminar in how to handle interest rate policy with minimal collateral damage either in financial markets or the real economy of goods and services. Incoming Fed Chair Jerome Powell has some large shoes to fill; fortunately he, by all appearances, has been a diligent student under Yellen’s tutelage over the past several years. He will need all the benign tailwinds he can get, because the road ahead may not be quite so calm as that we leave behind heading into 2018.
Follow the Dots
This week’s 25 basis point increase in the Fed funds target range was widely anticipated by the market (again, thanks to clear and prudent forward guidance). Investors quickly skimmed past the headline announcement to see where Fed minds were regarding policy action for next year: the famous “dot-plot” showing where FOMC voting members think rates will be in the coming three years and beyond. Very little has changed since the dot-plot’s last iteration in September, with the mean expectation of three more rate hikes in 2018. The lack of upward movement on rate expectations came at the same time that the Fed raised somewhat its expectations about economic growth and labor market conditions.
Dr. Pangloss’s Market
From an investor’s standpoint the market would seem reminiscent of Dr. Pangloss in Voltaire’s “Candide” -- the best of all possible worlds, with growth supported by still-accommodative monetary policy. That pleasing state of affairs, of course, comes courtesy of inflation that refuses to budge out of its narrow range of about 1.3 to 1.8 percent, depending on which measure you prefer. Markets seem satisfied this best of all worlds will continue. Even now, Fed funds futures markets ascribe only a 20 percent or so chance of even those three rate hikes occurring next year. An unexpected surge in inflation is quite likely the most impactful variable that could upset the present state of things. It would cause a rethink in the pricing of most assets, starting with intermediate and long term bonds. Intermediate Treasuries, in particular the 10-year note, serve as a proxy for the “risk-free rate” calculations used in valuing and pricing most risk assets. Disrupt expectations for the 10-year, and you disrupt most everything else.
The Curvature of Markets
In July 2016 the 10-year yield dipped as low as 1.36 percent, which by some accounts was the lowest yield for a benchmark risk-free rate ever in the 800-plus year-history of recorded interest rates. Today, the 2-year yield -- a short term reference benchmark closely tied to monetary policy trends -- is over 1.8 percent. With today’s 10-year around 2.4 percent, the spread between short and intermediate yields is lower (flatter in yield curve-speak) than it has been any time since 2007. Intermediate yields are affected by many market variables, but inflationary expectations are prominent among them. Briefly put: if that inflationary surge were to happen, there would be plenty of upward curved space for the 10-year yield to occupy. Up go all those discount rates used to make present value computations for risk assets. All else being equal, a higher discount rate lowers the net present value of a future series of cash flows. The calm waters of 2017 would likely seem a distant memory.
All that being said, there is no hard evidence today suggesting that this kind of inflationary surge is around the corner. Other factors, such as low productivity growth and hitherto modest wage growth, continue to keep consumer prices in check. But sub-2 percent inflation in an economy where unemployment is just 4 percent runs counter to all the data and experience that have informed monetary policymakers for the past seventy years. It has been a pleasant, if confounding, feature of the Yellen years. Figuring out where it goes from here may well be incoming Chair Powell’s biggest challenge.
Today is the first day of the last month of 2017, which means that predictions about asset markets in 2018 will be flying about fast and furious over the coming three weeks. As practitioners of the art and science of investment management ourselves, we know that quite a bit of work goes into the analysis that eventually finds expression in the “bonds will do X, stocks will do Y” type of formulations characteristic of these holiday season prognostications. A layperson might be excused, though, for concluding that all the market pros do is dust off last year’s report, or the year before, for that matter, and repackage it with the same observations. “Rates will rise because of the Fed, stocks will rise because of a stable economy and good earnings” worked for 2016 and it worked for 2017. Here’s visual proof: the price appreciation of the S&P 500 and the trend in the 2-year Treasury yield since December 2015:
It wasn’t linear, of course. There was the technical correction in early 2016 when both stocks and rates pulled back. Still, though, investors positioned for rising short term rates and steady gains in large cap domestic stock prices would have had little about which to complain over the past two years. Which, of course, brings us to the point of today’s commentary: is it Groundhog Day again, or does 2018 have something entirely different in store?
At the heart of this curious Groundhog Day phenomenon over the past couple years is the remarkable sameness in the broader macroeconomic environment. “Moderate GDP growth, with a healthy labor market and modest inflation” is a phrase you could have uttered on literally any given day over this period and been right. The only thing measurably different about 2017 was that this “Goldilocks” set of conditions was true not just of the US, but of almost any part of the developed (and much of the emerging as well) global economy. Adding the word “synchronized” to “moderate GDP growth” gives the phrase a distinct 2017 flavor. Thus, the good news for equities disseminated into non-US markets and finally gave investors some measure of reward for diversification.
There is almost nothing in the way of macro data points today suggesting a deviation from this “synchronized moderate growth” mantra. The major question mark, as we have discussed in other commentaries, is whether inflation will ever get in line with what the Fed’s models call for and rise above that elusive 2 percent target. Now, if inflation were to suddenly go pedal-to-the-metal, that could change assumptions about risk assets and blow up the Groundhog Day framework. In particular, an inflationary leap would likely send shockwaves into the middle and longer end of the bond yield curve, where rates have remained complacently low even while short term rates advanced. The 10-year yield is right around 2.4 percent today, almost exactly where it was at the beginning of the year and in fact not far from where it was at the beginning of 2016.
The sideways trajectory of the 10-year, in fact, supplies the explanation as to why stocks could rise so comfortably alongside the jump in short-term rates. While short term rates are closely correlated to the Fed’s monetary policy machinations, longer yields reflect a broader array of assumptions – including, importantly, assumptions about inflation. The flatness of intermediate rates suggests that bond investors expect economic growth to remain moderate, and inflation low. The bond market is not priced for a high inflation environment – which is reasonable, given the scant evidence that such an environment is imminent.
Can Stocks Keep Going?
So far, so good: the economic picture seems supportive of another Groundhog Day. What about stocks? There are still plenty of alternative paths for equities to travel in 2017 (and they are going kind of helter-skelter today on some breaking political news), but a solid double-digit performance would be a reasonable prognosis (the S&P 500 is up just under 20 percent on a total return basis for the year thus far). The current bull market is already the second longest historically, and valuations are stretched. Is there more room to run?
As we write this, the tax bill which has riveted the market’s attention for most of the past two weeks has not formally passed the Senate, nor been reconciled with the earlier House version to a final bill to send to the White House. But the odds of all that coming to pass are quite good. As we have noted before, the market’s obsession with taxes has little or nothing to do with fundamental economic growth. The non-partisan Joint Committee on Taxation said as much in the report it released late yesterday on the proposed bill’s likely economic impact: at best, contributing no more than about 0.1 percent to annual GDP growth over the next ten years.
But the market’s interest in the fate of the tax bill has little to do with long-term economics, and much to do with shareholder givebacks. To the extent that the bill results in tangible cash flow benefits for corporations in the next 1-2 years (and the quantification of such benefits remains quite variable), precedent informs us that the vast bulk of such gains would flow right back to shareholders in the form of buybacks and dividends. Buybacks and dividends don’t help the economy, but they most assuredly do help shareholders. That fact, alone, could supply enough of a tailwind to keep the bulls running long enough to grab the “longest duration” mantle.
Everything’s the Same, Until It Changes
So if you read a bunch of reports over the next couple weeks that sound incredibly similar to what you read a year ago, don’t rush to the judgment that its authors are lazily phoning it in. There remain very good reasons for the Groundhog Day framework for yet another year. Gains in stocks, an increase in short term rates alongside monetary policy moves, and longer term rates tempered by modest inflation are all plausible default-case scenarios.
But never forget that any scenario is just one out of many alternative outcomes. Market forces do not pay heed to the calendar year predilections of the human species. There is no shortage of factors out there that could upend the benign sameness of today’s conditions, and they will continue to demand our vigilance and readiness to adapt.
The current bull market in US equities, the pundits tell us, is the second-longest on record. That may sound impressive, given that domestic stock exchange records go back to the late 19th century. But it doesn’t even hold a candle to the accomplishments of the current bull market in bonds. The bond bull started in 1981, when the 10-year US Treasury yield peaked at 15.84 percent on September 30 of that year. It’s still going strong 36 years later, and it’s already one for the record books of the ages.
According to a recent staff working paper by the Bank of England, our bond bull is winning or placing in just about every key measurement category going back to the Genoese and Venetian financial economies of the European Middle Ages. Lowest risk-free benchmark rate ever – gold medal! The 10 year Treasury yield of 1.37 percent on July 5, 2016 is the lowest benchmark reference rate ever recorded (as in ever in the history of money, and people). The intensity of the current bull – measured by the compression from the highest to the lowest yield – is second only to the bond bull of 1441-81 (what, you don’t remember those crazy mid-1400s days in Renaissance Italy??). And if the bull can make it another four years it will grab the silver medal from that ’41 bull in the duration category, second only to the 1605-72 bond bull when Dutch merchant fleets ruled the waves and the bourses.
Tales from the Curve
But does our bull still have the legs, or is the tank running close to empty? That question will be on the minds of every portfolio manager starting the annual ritual of strategic asset allocation for the year ahead. Let’s first of all consider the shape of things, meaning the relative movements of intermediate/long and short term rates.
We’ve talked about this dynamic before, but the spread between the two year and ten year yields is as tight as it has been at any time since the “Greenspan conundrum” of the mid-2000s. That was the time period when the Fed raised rates (causing short term yields to trend up), while the 10-year and other intermediate/long rates stayed pat. It was a “conundrum” because the Fed expected their monetary policy actions would push up rates (albeit at varying degrees) across all maturities. As it turned out, though, the flattening/inverting yield curve meant the same thing it had meant in other environments: the onset of recession.
An investor armed with data of flattening yield curves past could reasonably be concerned about the trend today, with the 10-year bond bull intact while short term rates trend ever higher. However, it would be hard to put together any kind of compelling recession scenario for the near future given all the macro data at hand. The first reading of Q3 GDP, released this morning, comfortably exceeded expectations at 3.0 percent quarter-on-quarter (translating to a somewhat above-trend 2.3 percent year-on-year measure). Employment is healthy, consumer confidence remains perky and most measures of output (supply) and spending (demand) have been in the black for some time. Whatever the narrowing yield curve is telling us, the recession alarms are not flashing orange, let alone red.
Where Thou Goest…
So if not recession, then what? Leave aside for a moment the gentle undulations in the 10-year and focus on the robust rise in the 2-year. There’s no surprise here – the Fed has raised rates four times in the past 22 months, and short term rates have followed suit. Historically, the 2-year yield closely tracks Fed funds, as the chart below shows.
The upper end of the Fed funds target range is currently 1.25 percent, while the 2-year note currently yields 1.63 percent (as of Thursday’s close). What happens going forward depends largely on that one macro variable still tripping up the Fed in its policy deliberations: inflation. We have two more readings of the core PCE (the Fed’s key inflation gauge) before they deliberate at the December FOMC meeting. If the PCE has not moved up much from the current reading of 1.3 percent – even as GDP, employment and other variables continue trending strong – then the odds would be better than not the Fed will stay put. We would expect short term rates, at some point, to settle perhaps a bit down from current levels into renewed “lower for longer” expectations.
But there’s always the chance the Fed will raise rates anyway, simply because it wants to have a more “normalized” Fed funds environment and keep more powder dry for when the next downturn does, inevitably, happen. What then with the 10-year and the fabulous centuries-defying bond bull? There are plenty of factors out there with the potential to impact bond yields other than inflationary expectations. But as long as those expectations are muted – as they currently are – the likelihood of a sudden spike in intermediate rates remains an outlier scenario. It is not our default assumption as we look ahead to next year.
As to what kept the bond bull going for 40 years in the 1400s and for 67 years in the 17th century – well, we were not there, and there is only so much hard data one can tease out of the history books. What would keep it going for at least a little while longer today, though, would likely be a combination of benign growth in output and attendant restraint in wages and consumer prices. Until another obvious growth catalyst comes along to change this scenario, we’ll refrain from writing the obituary on the Great Bond Bull of (19)81.
And the band plays on. Some random convergence of factors could conceivably interrupt and reverse today’s upward push in the S&P 500 before the benchmark index ends with its seventh straight record close…but those would likely be bad odds to take. Yesterday was the 30 year anniversary of 1987’s Black Monday, when stocks tanked by more than 20 percent in a single day. Financial pundits, with not much better to do, spent much of the day in college dorm-style bull sessions with each other, speculating about whether 10/19/87 could ever happen again. It certainly didn’t happen yesterday, even though lower overnight futures injected a frisson of excitement into the morning chatter that dissipated as the afternoon yielded a predictable recovery and small gain for share prices.
We feel for those journalists – it’s tough being a financial commentator these days! Nothing ever happens except for the market shrugging off any potentially disruptive event, while displaying brief spasms of ecstasy whenever the subject of tax cuts percolates to the top of the daily news feed. Now the chatter is homing in on what may well be the only remaining story of any note (from the market’s perspective) before the end of the year: the identity of the new Fed chair when Janet Yellen’s term ends next January. A decision is supposedly forthcoming in the next couple weeks (the incumbent administration suggests it will be before November 3). Our sense is that, regardless of who among the short-listed candidates is tapped, the impact on markets will likely be negligible.
If It Ain’t Broke…
There are two issues at stake here: first, who the winning candidate will be, and second, how that candidate would actually govern once ensconced in the Eccles Building. There are currently five names under consideration. On a spectrum from dove to hawk they read as follows: current Fed governor Jerome (Jay) Powell, current Fed chair Janet Yellen, former Fed governor Kevin Warsh, Stanford University economist John Taylor, and current Trump advisor Gary Cohn. Let’s say right off the top that we see next to no chance that Cohn will draw the winning ticket; among insiders close to the decision process, his name appears to still be in the mix for cosmetic reasons only.
That leaves four. Two, Powell and Yellen herself, reliably fall into the camp of “stay the course” – their votes on FOMC policy decisions, after all, are publicly documented and widely known. Speculation this week has Powell as the overall front-runner with considerable support both from the administration’s inner circle and among both Republican and Democratic senators who will be involved in the confirmation process. There would be a rational logic for Trump to ultimately thumbs-up Powell: in so doing, he would be making the safest choice for business as usual, while still getting to theatrically crow to his base that he dumped the Obama-era Fed head.
…Don’t Fix It
Just because Powell’s star seems ascendant this week, though, does not mean that the two more hawkish choices of Warsh or Taylor are out of the picture. This is not an administration known for predictably rational decision making. So what happens then? Speculation is particularly focused on John Taylor, the Stanford professor whose “Taylor rule” – a mathematical formulation of the responsiveness of interest rates to inflation and other economic inputs – suggests that rates should currently be higher than they are. Would a Taylor Fed necessarily mean a dramatic acceleration of rate hikes and attendant balance sheet normalization?
Perhaps not. It’s worth remembering that a Taylor Fed would be looking at the same data as the Yellen Fed, and that data include inflation readings, the danger-zone indicators of which are conspicuously absent. The Taylor rule is not immune to the inflation conundrum with which the Fed’s other analytical models have struggled. It’s also worth remembering that the Fed chair still has to take into account the positions of the other FOMC voting members. Whoever the new chair is, he or she will not be any less interested in building consensus towards unanimous decisions than past chairs. That’s how stable monetary policy is conducted.
The global economy is largely in sync with low to moderate growth, decently functioning labor markets and modest levels of inflation. That’s the real context in which stock prices can keep drifting up with no sizable upside headwinds. We think it is unlikely that, come 2018, a new Fed will be tempted to push their luck with policies that could choke off the growth before its time. For these reasons we think it unlikely that the identity of the new Fed chair will stand in the way of a business-as-usual mood in the market that, barring something currently unforeseen, could carry into and through the upcoming holiday season.
Where’s the inflation? That question has lurked behind most of the major headline stories about macroeconomic trends this year. Jobless rate falls to 4.3 percent. Where’s the inflation? GDP growth revised up to 3 percent. Where’s the inflation? The Fed has an official dual mandate of promoting price stability and the maximum level of employment achievable in a stable price environment. By all available measures, our central bank policymakers would appear to be living up to their mandate in spades. Inflation has remained subdued for pretty much the entire run of the recovery that began in 2009. Over the same time, unemployment has come crashing down from a post-recession high of 10 percent to the gentle undulations of 4 percent and change from month to month. And therein lies the problem, or rather the riddle that neither the Fed nor the rest of us can answer convincingly: why hasn’t a robust jobs recovery reignited inflation?
Math, Models and Markets
Those of us who do not hold Ph.D. degrees in economics from the nation’s most prestigious universities at least have one advantage over those maven economists on the Fed Open Market Committee: we can freely speculate about the perplexing absence of inflation. Here at MVF we have our own views, largely proceeding from the larger issue of long term growth that has been the central subject of our in-depth research for much of the past three years. The catalysts that drive growth over successive business cycles – productivity and labor force participation – have both chronically underperformed for many years. Quite simply, we may have reached a point of diminishing returns on the commercial innovations that powered a historically unique run of growth through the middle and mid-late portion of the last century. Without that growth, we shouldn’t expect wages and prices to do as they did before.
Which is fine for us to say, because – see above – we are not doctorate-level trained economists. But Janet Yellen is, and so are most of her colleagues. And unlike us, they do not have the freedom to brainstorm and speculate about what’s keeping inflation from showing up. All they have are models. Models with months, quarters and years of data providing quantitative insights into the relationship between the labor market and consumer prices. Models written in beautiful mathematical formulations, the legacy of giants who inhabited the “freshwater” (University of Chicago) and “salt water” (MIT and Harvard University) centers of economic research in the years after the Second World War. Models premised on the hyper-rational choices of economic actors, models that do not actively incorporate variables about capital and financial markets but that assume that money is just “there.”
Follow the Dots…Not
The models say that a higher uptrend in inflation is consistent with where the labor market is. Accordingly, the “dot plot” predictions by FOMC members continue to assume one more rate hike this year (most likely December) and three more next year. This despite the fact that the core personal consumption expenditure (PCE) rate that the Fed uses as its inflation gauge remains, at 1.4 percent, well below the Fed’s 2 percent target. Fixed income markets, though, continue to largely ignore FOMC dots (despite some of the usual post-event spasms after Wednesday’s press release). There remain about 100 basis points of difference between what the Fed thinks is a “normal” long term trend for the Fed funds rate (closer to 3 percent) and what the bond market thinks (closer to 2 percent).
In a nutshell, the bond market, and analysts such as ourselves, look at inflation trends and say, why rush? The Fed says, because the models say we have to act. If the models are right, there could be some very nasty shocks in fixed income markets that spill over into risk assets like equities. But for the rest of us, with our parlor game speculations about how the relationship between prices and jobs today may simply not be as statistically robust as it used to be, it is difficult indeed to spot the hard evidence supporting a major bout of inflation on the horizon.