Posts tagged Fed And The Markets
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.
The Federal Open Market Committee (FOMC) meeting this week came and went without much ado. The 25 basis point rate hike was fully expected, the assessment of economic risks remained “balanced” (Fed-speak for “nothing to write home about”) and the dot plots continued to suggest a total of four rate hikes in 2018 and three more in 2019 (though the market has not yet come around to full agreement on that view). A small spate of late selling seemed more technical than anything else, and on Thursday the S&P 500 resumed its customary winning ways. All quiet on the market front, or so it would seem. We will take this opportunity to call up some words we wrote way back in January of this year, in our Annual Outlook:
“Farmers know how to sense an approaching storm: the rustle of leaves, slight changes in the sky’s color. In the capital marketplace, those rustling leaves are likely to be found in the bond market, from which a broader asset repricing potentially springs forth. Pay attention to bonds in 2018.”
That “rustle of leaves” may take the pictorial form of a gentle, but steady, downward drift.
Nine months later, we have a somewhat better sense as to how this year’s tentative weakness in the bond market may spill over into bigger problems for a wider swath of asset classes. It calls into one’s head a phrase little used since the 1970s: wage-price spiral. There’s a plausible path to this outcome. It will require some careful attention to fixed income portfolios heading into 2019.
What’s Wrong With Being Confident?
The path to a wage-price spiral event starts with a couple pieces of what, on the face of things, should normally be good news. Both consumer confidence and business confidence – as measured by various “sentiment” indicators – are higher than they have been at any time since the clock struck January 1, 2000. In fact sentiment among small business owners is higher by some measures than it ever has been since people started measuring these things. Now, monthly jobs numbers have been strong almost without exception for many years now, but the one number that has not kept pace with the others is hourly wages. That seems to be changing. The monthly cadence was 2.5 percent (year-on-year growth) for the longest time, but now has quietly ticked up closer to 2.8 – 2.9 percent. The evidence for this cadence breaking out sharply on the upside is thus far anecdotal, seen in various business surveys rather than hard monthly numbers, but if current overall labor market patterns continue, we will not be surprised to see those hourly wage growth figures comfortably on the other side of 3 percent by, say, Q1 of next year.
Enter the Trade War
The other side of the wage-price formula – consumer prices – is already starting to feel the effects of the successive rounds of tariffs that show no signs of abating as trade war rhetoric ascends to a new level. Tariffs make imports more expensive. While the earlier rounds focused more on intermediate and industrial products, the expansion of tariffs to include just about everything shipped out of China for our shores invariably means that traditional consumer goods like electronics, clothes and toys are very much in the mix now.
What retailers will try to do is to pass on the higher cost of imports to end consumers. And here’s the rub – if consumers are those same workers whose paychecks are getting fatter from the hot labor market, then their willingness to pay more at the retail check-out will be commensurately higher. Presto! – wage price inflation, last seen under a disco ball, grooving out to Donna Summer in 1979.
Four Plus Four Equals Uncertainty
Recall that the Fed is projecting four rate hikes this year (i.e. the three already in the books plus one in December) and then three more next year as a baseline outlook. A sharp uptrend in inflation, the visible measure of a wage-price spiral, would conceivably tilt the 2019 rate case to four, or perhaps even more, increases to the Fed funds target rate. Right now the markets don’t even buy into the assumption of three hikes next year, although Eurodollar futures spreads are trending in that direction. That gentle downward drift in the bond market we illustrated in the chart above could turn into something far worse.
Moreover, the wage-price outcome would very likely have the additional effect of steepening the yield curve, as increased inflationary expectations push up intermediate and long term yields. Normally safe, long-duration fixed income exposures will look very unpleasant on portfolio statements in this scenario.
The wage-price spiral outcome, we should remind our readers, is just one possible scenario for the months ahead. But we see the factors that could produce this inflationary trend as already present, if not yet fully baked into macro data points. From a portfolio management standpoint, the near-term priorities for dealing with this scenario are: diversification of low-volatility exposures, and diversification of yield sources. Think in terms of alternative hedging strategies and yield-bearing securities that tend to exhibit low correlation with traditional credit instruments. These will be very much in focus as we start the allocation planning process for 2019.
Usually when we append a chart to one of our commentaries, the aim is to shed light on a particular trend. Sometimes, though, the trend in question is actually the lack of a trend, and such is the case this week. Behold the chart below and call up your metaphor of choice: a plate of spaghetti (that multicolored kind with beet, spinach, squid ink etc.), a few tangled skeins of knitting yarn, an attempt at abstract art by a hung-over wannabee Picasso.
Up, Down, All Around
What to make of that tangled web? Healthcare has performed rather well, for no particular reason. Energy has fared poorly of late, despite oil prices near their best levels of the year, just off $80. Otherwise it’s up one day, down the next. Information technology, which has been the main driver of the market’s performance for the better part of the last 18 months, is actually trailing the benchmark index in the most recent three month period.
It’s as if Ms. Market wakes up every morning and flips a coin – heads for risk-on, tails for risk-off. There’s no discernable leadership theme. Remember the “value rotation that wasn’t” about which we wrote earlier in the summer? The forensic evidence is there – note the sharp drawdown in the blue line (representing technology) around the 7/30 time period, which then bounced back up almost immediately. There was no value rotation then, nor in the immediate period after Labor Day when tech fell again while defensive favorites like consumer staples and utilities jumped.
Nowhere Else to Go
What happens in the S&P 500 is increasingly important, because there are few other refuges for risk-on portfolios. For much of this year we had a strong leadership trend in domestic small cap stocks. The Russell 2000 small cap index is still ahead of the S&P 500 year to date, but the outperformance trend ran out of steam a couple months back, as the chart below shows.
We do see something of an uptrend in non-US stocks over the past couple weeks, but there are reasons for not being too excited about an imminent mean reversion of any meaningful duration here. Most of the juice in the MSCI EAFE (gold) and Emerging Markets (purple) in this recent trend is coming from a weaker dollar versus other currencies. That in itself is counterintuitive. US interest rates have been rising, with the 10-year Treasury now comfortably over 3 percent and the 2-year steadily continuing its ascent ahead of an expected rate hike when the Federal Open Market Committee meets next week. Higher interest rates are normally a bullish signal for the home currency, attracting investment income from abroad. But no – the dollar has confounded rational investors by retreating while interest rates rise. We illustrate this in the chart below.
Going back to that first chart with the chaotic sector spaghetti, we can be thankful that the overall directional trend of US large cap stocks remains resolutely upwards. Who cares what’s ahead and what’s behind, as long as everything more or less moves in the same positive direction – right? And to be clear, the broader story remains largely the same. Good job numbers, good growth, strong corporate sales and earnings – the narrative, like The Dude Lebowski, abides. But at some point one wants to see that tangle of price trends turn into a clearer picture with a rational supporting narrative. Is it finally time for value investors to come into the sunshine? Could a value trend sustain the bull market for another cycle before it gives up the ghost? Or is this just a phase of directionlessness before the tech giants reassert themselves for yet another gravity-defying cycle of outperformance? Stay tuned. And happy autumnal equinox!
If you have paid any attention to the daily dose of financial media chatter over the past month or so (and we are of the firm opinion that there are many, many more productive ways to spend one’s time) you have no doubt come into contact with the phrase “flat yield curve.” If the phrase piqued your interest and you listened on, you would have learned that flat yield curves sometimes become inverted yield curves and that these are consistently accurate signals of imminent recession, going back at least to the beginning of the 1980s.
This topic is of particular interest today because the yield curve happens to be relatively flat. As we write this the spread (difference) between the 10-year Treasury yield and the 2-year Treasury yield – a common proxy for the yield curve – is just 0.25 percent. That is much tighter than usual. In fact the last time the yield curve was this flat was in August 2007 – and any financial pundit worth his or her salt will not hesitate to remind you what happened after that. The chart below diagrams the longer-term relationship between 10-year and 2-year Treasury yields going back to 1995.
Before the Fall
In the above chart we focus attention on two previous market cycle turns where a flat or inverted curve was followed by a recession and bear market environment: 2000-02, and 2007-09. It is true that in both these instances a recession followed the flattening of the curve (the red-shaded columns indicate the duration of the equity market drawdown). But it’s also important to pay attention to what happened before things turned south.
Both of these bear market environments were preceded by an extended period of growth during which the yield curve was also relatively flat. These “growth plus flat curve” periods are indicated by the green-shaded columns in the chart. As you can see the late 1990s – from about mid-late 1997 through the 2000 stock market peak – were characterized by very little daylight between the 2- and 10-year yields. The same is true from late 2005 through summer of 2007 (the S&P 500 peaked in October 2007 before starting its long day’s journey into night).
You Can Go Your Own Way
In both of those prior cases, in other words, a flattening yield curve wasn’t a signal of very much at all, and investors who took the cue to jump ship as soon as the spread went horizontal missed out on a considerable amount of equity market growth. In fact, the dynamic of “flat curve plus growth,” far from being unusual, is not unexpected. It has to do with what the respective movements of short term and long term yields tend to tell us about what’s going on in the world.
Short term rates are a much more accurate gauge of monetary policy than yields with more distant maturities. If bond investors anticipate an upcoming round of monetary tightening by the Fed, they will tend to move out of short-term fixed rate securities, sending yields on those securities higher. When does monetary policy normally turn tighter? When growth is heating up, of course – so it should be no surprise that short term rates will start trending up well before the growth cycle actually peaks.
Longer term yields, on the other hand, are much less predictable and tend to go their own way based on a variety of factors. For example, in that 2005-07 period when short term rates were trending up, the 10-year yield stayed relatively flat. Why? Because this period coincided with the height of China’s “supercycle” during which Beijing routinely bought gobs of Treasury bonds with its export earnings, building a massive war chest of dollar-denominated foreign exchange reserves.
To Every Cycle Its Own Story
At the same time, many other central banks were building up their FX reserves so as to not repeat the problems they experienced in the various currency crises of the late 1990s. Yes – the late 1990s, when economies from southeast Asia to the former Soviet Union to Latin America ran into liquidity difficulties and injected a massive amount of volatility into world markets. Global investors responded to the volatility by seeking out safe haven assets like – surprise! – longer-dated US Treasury bonds. Which partly explains why the yield curve was so flat from ’97 through the 2000 market peak.
So yes – at some point it is likelier than not that we will see another flat-to-inverted yield curve lead into another recession. Meanwhile, the dynamics driving longer-term bond issues today are not the same as the ones at play in the mid 2000s or the late 1990s. Maybe spreads will widen if a stronger than expected inflationary trend takes root. Maybe the 10-year yield will fall further if US assets are perceived to be the safest port in a global trade war storm. The important point for today, in our opinion, is that there is a resounding absence of data suggesting that this next recession is right around the corner. We believe there is a better chance than not for some more green shading on that chart between now and the next sustained downturn.