Posts tagged Interest Rate Trends
People, and markets, get fidgety in late August. It’s the time of year when summertime fun turns into tedium. Kids are actually looking forward to getting back into the school routine. Asset markets, meanwhile, jump at any tidbit of event-driven news that can make the time to Labor Day weekend pass by more quickly. Today’s distraction of choice was Fed Chair Janet Yellen’s speech at the annual Jackson Hole monetary policy confab. Did financial media pundits really want to hear about the contribution of the new IOER (interest paid on excess reserves) policy to the Fed’s ability to steer the Fed funds rate? Of course not! But they did want to spend a few minutes mining Yellen’s speech for any trace of a hint of a possible “live” meeting in September, i.e. one with a rate hike on the table.
That hint, predictably, remains as elusive as the Yeti. Bond yields spiked very briefly when the phrase “case for an increase in the federal funds rate has strengthened in recent months” tumbled onto the CNBC news banner. But asset indexes of all stripes, from stocks to bonds to currencies and volatility, soon realized that there was nothing new under the sun in terms of specific rate timing. Dog days tedium resumed.
For those whose investment horizons extend beyond the next one or two FOMC meetings, though, there is plenty in Janet Yellen’s thoughtful and probing words worth mulling over, and worth being concerned about.
The Politics of September
Before we focus on the longer term picture emerging from Yellen’s speech, though, we should get the business of September out of the way. There has been a great deal of renewed speculation this week about the possibility of a live move when the FOMC meets on September 20-21.
We have argued several times recently about the highly unlikely nature of any such move. Nothing said by any Fed personalities this week, up to and including today’s speech, changes our view on this for the following simple reason. In the absence of inflationary threats, with continued softness in domestic capital formation and weak foreign demand (the biggest drags on this morning’s underwhelming 1.1 percent GDP revision, called out by Yellen specifically), nobody’s feet are held to the fire for an immediate rate hike. On the other hand, 9/21 is just a few days away from the first Presidential debate in the most highly charged, toxic political environment of recent memory. Yellen’s Fed is a cautious Fed, and a conflict averse Fed that will likely not insert itself into the politics of the moment – as a rate hike would almost certainly do – without an immediately urgent reason to do so. We stand by our view.
Where Do We Go From Here?
We’re not sure if Yellen was actually channeling the Alan Parsons Project song “Games People Play” when she made “where do we go from here” – the opening line of that song – the subtitle of the most important part of her speech today. But the tone of this part of the speech was, in our opinion, quite in line with the somewhat dark musings of that 1980 song. “Games people play, you take it or you leave it / Things that they say just don’t make it right / If I promise you the moon and the stars would you believe it / Games people play in the middle of the night.”
Yellen appears to envision a world where an expanded toolkit of creative, envelope-pushing monetary policy solutions must be ever at the ready to “respond to whatever disturbances may buffet the economy.” Such policies could, in the future, not just retain quantitative easing as a firefighting tool for the next economic recession, but actually expand the range of assets targeted in a future QE program. Expand to what? We already have a preview of such a world in Japan, where the Bank of Japan is the country’s largest institutional shareholder via its outright purchases of domestic equities. Of course, she says, nothing of the sort is in any way on the table for immediate action by the Fed, but a bevy of such alternative approaches are very much part of the research effort underway in anticipation of future conditions requiring more than the current batch of approved measures.
A Little Help, Please?
The other thing one cannot help but see in Yellen’s musings here is a well-deserved frustration over the apparent inability of any other policymaking entities to lend a hand in addressing today’s economic challenges. To wit: “…these tools [monetary policy] are not a panacea…policymakers and society more broadly may want to explore additional options for helping to foster a strong economy.” That, as we read it, is a polite way of saying that a bit less dysfunction in other parts of the government could make it possible for the Fed to not have to distort the natural workings of asset markets in moving the economy towards positive growth. Finally, she concludes that nothing can replace good old-fashioned organic productivity growth as a way for the economy to deliver actual, meaningful improvements in the standard of living: “…as a society we should explore ways to raise productivity growth.”
To sum up: there is very little in today’s Jackson Hole speech that should change the calculus for what the Fed may or may not do before the end of the year. We fail to see any likely case for live action in the political cauldron of September. December is simply too far away to even speculate: all it would take would be for one more technical correction in the interim – a pullback of 10 percent or more in the S&P 500 or an out-of-the-blue spike in bond yields – to take a holiday hike off the table. Yellen speculates that there is a “70 percent chance that the federal funds rate will be between 0 and 3-1/4 percent at the end of next year,” a non-prediction which of course does not preclude the possibility that rates may not move at all or even go down again.
But most of the portfolios under our management have a time horizon well beyond the next handful of FOMC meetings, and to that end Yellen’s longer term concerns are our concerns. Political dysfunction and persistent underperformance in productivity growth loom large indeed as forces that keep us up at night. Where do we go from here?
It is perhaps appropriate that jobs reports in the middle months of 2016, the Year of Anything Goes, confound the consensus expectations to a much greater degree than they did in the comparatively sane world of 2015. Last month the FactSet analyst consensus projected payroll gains of 160,000 for May; the BLS report delivered 38,000 (subsequently revised down to 11,000). This month, the consensus plodded right along with a 180,000 estimate. In a reversal of fortune (or, statistically speaking, trading places with the other end of the margin of error) the payroll gains for June shot up to 287,000. That’s 2016 in a nutshell: you never know what version of reality will show up on the day, but the experts will be reliably wrong in either case.
All Well, Move Along
The chart above, our go-to headline snapshot of payroll gains and the unemployment rate, shows that, despite the wider fluctuations of the last couple months and fewer incidents of 200,000-plus gains compared to previous years, there is not much in the US jobs picture to suggest a worsening domestic economic picture. That remains true below the headline numbers: the participation rate is steady (if well below historical norms), wages continue to outpace inflation, and weekly unemployment benefits claims remain at very low levels. Other measures like reluctant part-time workers (looking for full-time work) and the long-term unemployed show little change from month to month. In the context of other key data points like inflation, GDP, consumer confidence and retail spending, the overarching story remains more or less the same: growth that is slow by post-World War II long-term trendlines, but growth nonetheless. And better, more consistent growth than elsewhere in the developed world.
Stocks Have a Say…
US stocks signal a positive reaction to the jobs data, though it is still too early in the day to call a win. That pesky S&P 500 valuation ceiling of 2130 looms ever closer – just a rally or two away. US stocks seem to have been caught up in the post-Brexit flight to quality story, mixed up with the usual safe haven plays of Treasuries, gold and the yen, and today’s jobs report may play easily into that sentiment. Money has to go somewhere, and even at rich valuation levels US stocks make a more compelling story than other geographies. Central banks have had some measure of success in pushing bond investors out of their once-safe habitats into riskier assets. If you’re a traditional bond investor forced to make a bigger allocation to equities, your first port of call would logically be blue-chip US names with high dividend payouts. This trend could continue to suggest relative outperformance by US equities.
…And So Do Bonds
The bond market is communicating a view as well; the problem is that the language can seem as intelligible to the average investor as Ixcatec or Tharkarri . What does it say about the world when precisely every single maturity for Swiss government bonds, right out to 50 years – 50 years! – carries a negative interest rate? Think about the logic behind those yields: is there really no better way to invest one’s savings than to pay the Swiss government for the privilege of holding its debt for half a century? The only rational economic argument to make for the viral spread of negative interest rates is that, if general price levels in the economy fall over a long time, it sorta-kinda makes sense to hold a security that falls in value by less. That’s a pretty pessimistic take on the next 50 years, though.
And it’s not just in Europe or Japan – Treasury rates here in the relatively strong US are also at all-time lows, if at least still breaking positive. This goes back to the point we made a couple paragraphs above: domestic stocks and bonds both seem to be tagged as safety assets, unlike the usual situation where stocks and bonds move in opposite directions. The normal rules appear to no longer apply. But hey, it’s 2016. Anything goes.
Today’s WMF is brought to you by the number 10. It’s the tenth day of the month, and it’s a day when 10-year debt is front and center on the capital markets stage. Switzerland and Japan have already crossed over into 10-year NIRP Wonderland, offering investors the curious opportunity to lock in losses for a whole decade. Now Germany is flirting at the event horizon; the yield on the 10-year Bund is just one basis point on the positive side of the line. One year ago all three benchmark yields were above zero, and Germany’s comfortably so. The chart below shows that the zero boundary, once breached, has proven difficult to cross back into normal territory.
Why do yields continue to plumb the depths? This comes down, as always, to a supply and demand question. In Europe, in particular, a big part of the problem lies on the supply side. The ECB is the big player (or, less charitably, the Greater Fool), but there are limits on its bond buying activities. Specifically, the ECB cannot purchase bond issues when their yields fall below the ECB’s own deposit rate, which is currently set at negative 40 basis points. That requirement cuts the ECB off from an increasingly large chunk of Eurozone debt; consider that the yield on German five year Bunds is now minus 0.43%. So further out the curve the ECB goes, and down come the yields.
Additionally, the ECB can purchase a maximum of one third of any individual bond issue, so it is constrained by the supply of new debt coming onto the market. Some observers estimate that the inventory of German debt for which the ECB is eligible to purchase will run out in a matter of months. If the ECB wants to continue monthly QE purchases according to its current program it will then have to consider (and persuade ornery German policymakers to agree to) changes to the current rules.
Meet the New Risks, Same as the Old Risks
Of course, technical issues of bond inventories and ECB regulations are not the only factors at play. The risk sentiment dial appears to be pointing somewhat back towards the risk-off end, if not for any particularly new set of reasons. Brexit polls continue to occupy the attention of the financial chattering class, with the vote looming in 13 days and a close result expected. Investors seem to be digesting last week’s US jobs report from a glass half-empty standpoint – slower payroll gains bad for growth, while improving wages mean higher labor costs which are bad for corporate earnings. Japan delivered up some negative headline numbers this week including an 11 percent fall in core machinery orders. Again, none of this is new (and for what it is worth, we continue to think it more likely that we will wake up on June 24 to find Britain still in the EU). But animal spirits appear to be laying low for the moment.
The Stock-Bond Tango
The recent risk-off pullback in overseas equity markets, though, is having less impact here at home. Yes, the S&P 500 is off today – but earlier in the week the benchmark index topped its previous year-to-date high and remains just a couple rally days away from last year’s all-time high. The really curious thing about this rally though – and why it is very much relevant to what is going on in global bond markets – is that recently stock prices and bond prices have moved largely in tandem. This weird tango has resulted in 10-year Treasury yields at a four-year low while stocks graze record highs. As the chart below shows, this is a highly unusual correlation.
This chart serves as a useful reminder that just because something hasn’t happened before doesn’t mean that it can’t happen. In fact, what is going on in US stocks and bonds is arguably not all that difficult to understand. Investors are in risk-off mode but are being pushed out of core Eurozone debt in a desperate search for any yield at all. US Treasury debt looks attractive compared to anything stuck on the other side of that NIRP event horizon. And that demand is largely impervious to expectations about what the Fed will or will not do. Short term Treasuries will bounce around more on Fed rumors, but the jitters will be less pronounced farther down the curve.
And stocks? There is plenty of commentary that sees a significant retreat as right around the corner. Perhaps that is true, perhaps not. Pullbacks of five or 10 percent are not uncommon and can appear out of nowhere like sandstorms in the desert. But – as we have said many times over in recent weeks – we do not see a compelling case to make for a sustained retreat into bear country. The economy does not appear headed for recession, money has to go somewhere, and negative interest rates have the continuing potential to turn bond buyers into stock buyers. If a pullback does happen over the summer, we are inclined to see it more as a buying opportunity than anything else.
After the three year bear market of 2000 to 2002, stock indexes around the world enjoyed a sustained bull cycle with broad participation across all major regions from the US to Europe, from Latin America to developed and emerging Asia. Most major markets set all-time highs in October 2007. Then came winter, and then another spring.
We broadly think of the period from the 2009 market bottom to the present as another single, uninterrupted bull market. Indeed, as measured by the standard of the S&P 500 or any other major US stock index, that moniker fits. But – unlike 2000-02 and most prior bull markets – the same cannot be said for the rest of the world. For example the MSCI Europe, All Country Asia and Emerging Markets indexes, as shown in the chart below, have all failed to recapture their October 2007 high water marks. For much of the non-US world, the post-2009 period can be divided into two periods: a recovery from the 3/09 trough into the summer of 2011; and then a listless sideways performance from then to the present. In fact, all three of these non-US indexes remain today below their post-recovery 2011 high points.
As anybody with a diversified portfolio knows, the S&P 500 has been a devilishly unforgiving benchmark for most of the last four years, the bane of many an asset allocator and active stock picker alike. Is there anything about the unusual contours of this time period that suggests what might lie in store? Is it time to anticipate mean reversion and load up on non-US assets, or is it better to hunker down for ever more years of Pax Americana? We consider three alternative scenarios below.
#1: Central Banks Rule , World Catches Up
This scenario starts with the largely uncontroversial observation that central banks have been the headline story in risk asset markets since 2009 and especially since the Fed announced its second quantitative easing program – QE2 – in 2010, following up with QE3 in fall 2012. QE2 in particular is a textbook case study in how central banks move markets; one can picture then-Fed chair Ben Bernanke simulating an all-net jump shot with a smug “that’s how it’s done.” That year started off poorly for US stocks, with lots of volatility and a handful of pullbacks of 5 percent or more throughout the spring and summer. In August the Fed hinted that it was considering a second QE program, after QE1 ran out in June. That was all markets needed hear to stage a robust second-half rally (the formal QE2 announcement only came in November). QE2 firmly established the playbook for the Bernanke put: more liquidity from the Fed whenever markets run into trouble. Thus there was no great amount of surprise when QE3 played out in almost exactly the same way, in fall 2012, guiding markets over the so-called “fiscal cliff” and safely into the solid double-digit returns of the next two years.
Other central bankers came later to the stimulus party, but almost all eventually showed up at the punch bowl. The “world catches up” scenario posits that non-US markets will benefit from being in the springtime of their policy stimulus programs while the US settles into autumn. Even with a more dovish Fed stance on the cadence of rate hikes this year, policy divergence is still very much a reality. The key question is whether central bank stimulus today packs the same punch as it did in 2010 and 2012. If not, we may be looking at a second scenario.
#2: Central Banks Wane, World Swoons
It would be fair to say that market reaction to monetary stimulus policies this year has been all over the place, and perhaps nowhere more so than in Japan. When the Bank of Japan moved into negative interest rate territory last month there was a very brief moment when everything went according to plan: stocks up, domestic currency down. That reversed quickly, though. In the week following the BoJ announcement the Nikkei 225 plunged and the yen soared. The currency has set successive twelve month highs against the dollar since the policy decision was announced. Over in Europe, ECB showman Mario Draghi had somewhat better luck with the markets when he announced that the ECB would essentially pay banks to make loans through a loosening of terms for the existing long term refinancing operations (LTRO) policy.
But the ECB’s move raises the expectations bar. If cheap LTRO winds up not making much of a dent in real economic activity in Europe it will reinforce a growing belief among investors that central bank stimulus amounts to not much more than a temporary reprieve for risk asset markets. The Fed is in the crosshairs on this point as well. Much editorial chatter has been expended this week on the apparent divisions among FOMC members about the appropriate pace of rate decisions this year. If the market’s collective consciousness wraps itself around the idea that central bank puts have slipped out of the money, it will then be forced – heaven forbid – to take stock of growth and earnings prospects in the real economy. That could lead Mr. Market straight to the fainting couch. Or, alternatively, things could start looking up for growth and profits, producing a third possible scenario.
#3: Valuation Matters Again
The US economy is doing okay – not great, but okay. China has not (yet) lived down to fears of a hard landing in its economic transition. Europe is staying out of recession while some Eurozone economies such as Spain are doing quite alright, thank you very much. Brazil remains a basket case, but its neighbor Argentina is coming back into the mix after a long winter. India continues to grow nicely. Commodities markets are recovering. It is not out of the question that the world economy could emerge as a more pleasant place for companies to ply their trade. If this happens, we would expect a closer focus on valuation levels that in turn could favor bargain-hunting in those world markets that have underperformed the S&P 500 in recent years. This would be especially true if a strong dollar continues to be the major revenue and profits headwind for US companies (though we should note that the dollar has lost some of its force as of late, particularly against the yen and the Aussie dollar).
Of course, it is just as plausible that none of these scenarios will come to pass. Associating cause with effect is never easy in financial markets, and this year has been particularly problematic for the professional soothsayers of our industry. The fact is, though, that in a global economy it is unlikely that the asset performance of one country will dominate the landscape forever, even if that country is the largest and most influential. Sooner or later, those geographically diversified portfolios will likely have their day. Some advance preparation may not be a bad idea.
Amid the volatility and daily event fetishes that have driven asset markets hither and yon this year, the US economy continues to steadily plod along. The data points are a mixed bag: missed GDP and productivity numbers here, consumer confidence and retail gains there. But the overall picture is relatively healthy. Importantly, there are some bright spots in the long-elusive area of wage and price gains. Hourly wage growth was, in fact, the one positive takeaway in an otherwise unimpressive jobs report at the beginning of this month. Now this morning’s January inflation report shows prices growing slightly ahead of consensus. Core inflation (excluding food and energy) is up 2.2 percent on a non-seasonally adjusted year-on-year basis, its highest level in four years.
The oil price collapse has kept the all-inclusive headline inflation number well below core inflation for the past year and a half. That may be changing. The energy index component of today’s CPI report was negative 6.5 percent – the lowest decline since November 2014. Year-on-year headline CPI for January was twice the December level: 1.4 percent up from 0.7 percent. The chart below illustrates the recent trend in prices. If oil prices manage to stabilize, we can expect to see the headline number converge ever closer to core CPI.
Stay, Raise or Cut?
It is somewhat ironic that the next FOMC meeting concludes on March 16, the very same day on which the BLS will release the February CPI data. It is not totally implausible to imagine that headline CPI will be close to or even at that magic 2 percent threshold when FOMC members peruse the 8:30 am BLS release that day. They will already have digested new information on personal consumption expenditure (PCE – 2/26) and hourly wages (3/4) by then. Recent data on retail sales, industrial production, capacity utilization and consumer confidence indicate the potential for an upside surprise in those PCE and wage numbers.
On balance the news is net-positive for the economy, but that may not translate to a much-desired adrenaline boost for the stock market. The Fed is not sitting on the “horns of a dilemma”, as the fella said, but on the shaky tripod of a trilemma. Should they stand pat with rates where they are now? Push ahead with another 25 basis point hike as a sign of confidence in the economy’s continued recovery? Or – and this is highly unlikely but at least in the realm of possibility given global developments – contemplate a reversal? Interest rate policy divergence among leading economies has not gone down well with markets since the Fed’s last move in December. The global stampede towards the Pleasure Island of negative interest rates makes the Fed’s decision all the more tricky, irrespective of the conclusions they would normally draw from domestic data.
El Niño and Mr. Market
Lurking behind this policy trilemma is a capital market environment that perhaps resembles nothing more than US East Coast weather patterns this winter. We’ve had heat waves along with record levels of snowfall here in the nation’s capital, and temperatures that fluctuate from frigid to tropical seemingly overnight (we woke up in the teens today and are preparing for upper sixties tomorrow). That’s intraday volatility worthy of the S&P 500 – which registered three consecutive days of gains over one percent earlier this week after falling by more than one percent in three of the previous five days. Now, to be sure, we have not yet seen the displays of outright panic that so often accompany pullback environments. In the first eleven trading days of August 2011 the market gained or lost more than four percent five times. And the maximum peak-trough drawdown to date remains far short of the minus 19 percent low point of the 2011 event. So far.
But the threat of a deeper downturn lurks behind every X-factor that pops into and out of existence each day. The FOMC explicitly called out their concerns in January’s post-meeting communiqué, referring to the “global economic and financial developments” keeping them up at night. It is a pretty good bet that these “developments” are not going away between now and March 15-16. If more US economic data surprise on the upside between now and then, it is going to be a very difficult call for Chairwoman Yellen & Co.