Posts tagged Interest Rate Trends
Investors who like nice, clean narratives keep getting flummoxed by the global economy’s refusal to serve up steady sequences of consistent data points. This was a week, after all, when bond markets around the world took a Super Mario-sized beating in the wake of the ECB chairman’s musings about recovery and reflation in the Eurozone. The bond carnage even spilled into the seemingly Teflon stock market on Thursday. And yet, where did it all end? In the US, the latest reading on personal consumption expenditures (PCE), the Fed’s go-to inflation gauge, posted a weaker than expected year-on-year growth rate of 1.4 percent (both headline and ex-food & energy) on Friday. That same day the latest Eurozone flash CPI showed a 1.3 percent year on year gain, in line with expectations but down from the previous month. Reflation? Or could the bond market just possibly have jumped the gun a tad?
Phillips Curve to Nowhere
The May inflation numbers are, of course, representative of just one month. But there is very little in the longer term trend to suggest that this mythic reflation is anywhere on the horizon. The chart below shows the headline and core (ex-food & energy) PCE along with the US unemployment rate trend for the past five years.
The Fed pays closest attention to the core PCE rate (the green solid line) because it excludes the volatile categories of food and energy, and thus presents a steadier picture of underlying trends. As the chart shows, core PCE has fallen over the past five years from a high of 1.9 percent to the current level of 1.4 percent. Not once during this period has this rate surpassed the Fed’s desired target of 2.0 percent (the headline number was briefly above 2 percent, almost entirely on account of a commensurate rise in oil prices).
While prices have largely gone nowhere over this period, the complexion of the labor market has changed considerably. The unemployment rate (red dotted line) was over 8 percent in June 2012, and currently resides at 4.3 percent. Private nonfarm payrolls have made gains every single month over this period, the longest streak since the Bureau of Labor Statistics started recording this data shortly after the end of the Second World War. Normally, economists would expect this brisk pace of labor market growth to put upward pressure on wages and consumer prices. The Phillips Curve, bane of every Econ 101 student, came into existence to quantify this relationship, but its explanatory powers would appear to have diminished to the point of irrelevance.
Low Growth, Lowflation
When the “reflation trade” theme became the dominant market sentiment at the end of last year we expended a considerable number of words musing about just where all this growth was supposed to come from. Even the most wildly optimistic assumptions about a new bout of pro-growth fiscal policies from Washington, in our opinion, was not likely to change the basic growth equation: declining population growth, a smaller percentage of the population in the labor force and chronically low productivity together comprise a speed limit on how fast the economy can grow. If and when productivity were to return, it would quite plausibly come at the expense of jobs, as nonlinear advances in artificial intelligence and deep machine learning make real inroads into companies’ business operations. Why should we expect to see a major bout of reflation if this is the case?
This week’s bond market activity was significant. We are far from convinced that it marked the start of a paradigm shift away from the low rate environment of the past few years. The Fed may well raise rates again this year – it really, really wants to, and absent a major deviation from headline macro trends it could probably do so without too much risk of collateral damage. But unless some catalyst that we don’t see today shows up to push prices significantly higher, the urgency for the Fed to act again (or the ECB to start tapering) just won’t be there. And we are always just one unexpected market crisis away from the Greenspan-Bernanke-Yellen put coming out of the desk drawer and back into action.
Another week, another record for stocks. Sadly for those of us inclined to jump at “buy the dip” opportunities, the window now appears to bangs shut almost before we even know it’s open. It took a mere five trading days to fully atone for last Wednesday’s mini-squall, with two new all-time highs following in quick succession. C’mon stockpickers, haven’t you ever heard the phrase “sell in May?” Throw us bargain hunters a bone or two!
Bond Bears, Beleaguered
Whatever is in the water in equity-world still has not made it over to the more subdued climes of fixed income. While the S&P 500 is just shy of eight percent in price appreciation this year, the yield on 10 year Treasury securities ambles along in the neighborhood of 2.25 percent, well below where it started the year and further still below the 52 week high of 2.6 percent. The chart below illustrates the alternative mentalities driving stock and bond trends this year.
The dourness is showing up in other credit markets as well. Average rates for 30 year mortgages finished this week at their lowest level for the year. Long-dated Eurodollar futures contracts, which reflect what traders think Libor levels will be up to 10 years in the future, indicate that we should expect a world of low inflation and low real interest rates well into our senescent years. The “10-2 spread” – the difference between intermediate and short term yields that we discussed in some detail a couple weeks back – is narrower than at any time since last November’s election. Reflation trade, we hardly knew ye!
On one level, the bond market’s lackadaisical drift is not all that surprising. It dovetails with the relentless monotony of an overall macroeconomic narrative that – at least according to the usual “hard” data points of labor, prices and output – has barely changed over the past twelve months. Low growth and restrained inflation are entirely consistent with sub-3 percent 10 year yields (unsurprisingly, the forecasting mandarins at banks such as JP Morgan and Goldman Sachs have lowered their 2017 expectations accordingly). The shiny veneer of the reflation trade has been wiped clean to reveal the same old undercoat of modest growth, with no evidence of a productivity-driven catalyst to bring the growth trend closer to the norms of decades past. Yes, the world’s major economies are aligned to a remarkable extent in their growth trajectories – GDP growth rates are trending in near-lockstep in the US, Europe and Japan. That alignment alone, though, does not suggest some emergent property to drive the trend higher.
And then there was the other dog that didn’t bark this week to send yields soaring. The minutes from the FOMC’s last meeting earlier this month made their way into public hands on Wednesday, offering a peek into the Fed’s thinking about starting to wind down its $4.5 trillion balance sheet in the coming months (the vast majority of which is in the form of Treasuries and mortgage backed securities). This winding down, many have noted, will involve some fancy footwork on the Fed’s part to avoid the kind of tantrums that sent bond markets into a tizzy back in 2013.
As it happened, though, the minutes gave little indication of anything other than that the Fed feels comfortable getting the process underway sometime in 2017. There’s also a question about how much “winding down” will actually happen. A recent study by the New York Fed suggests that a “normalized” balance sheet of $2.8 trillion should be achieved by 2021. Now, in 2010, before the second and third quantitative easing programs kicked in, the Fed had about $2.1 trillion on its balance sheet. So “winding down” would not mean going back to anything close to earlier “normal” balance sheet levels. Higher for longer. Tantrum fears may once again be somewhat overblown.
Red Bull and Tech Stocks
So what’s still driving equities? “No reason to sell” is about as good an answer as any, and that sentiment was clear in the market’s quick snap-back from last week. Tech stocks continue to lead the way while the former reflation trade darlings – financials, industrials and materials – lag. We appear to have reached the point where politics and global events are utterly irrelevant to market movements (the VIX’s retreat from last Wednesday’s spike was even brisker than the stock market recovery). Q2 earnings are expected to be decent, no recessions as far as the eye can see…what’s not to love? As Jo Dee Messina would say – “it’s a beautiful day, not a cloud in sight so I guess I’m doin’ alright.” For now, at least.
Three years ago, one could have driven a fleet of semitrailers through the open space between the 2 year and the 10 year US Treasury benchmark note yields. While there still is some distance between the two, it would be somewhat more amenable to a single row of Priuses (Prii?) passing through. As the chart below shows, the shorter term note, which is generally more directly responsive to Fed policy, remains very close to its five year high. The intermediate 10 year yield, by contrast, has meandered along a largely directionless trajectory.
Untangling Policy, Demand and Expectations
The path of shorter term yields, for which the 2 year note is a useful proxy, is not hard to understand. The Fed began to make noises about tapering its QE policy in 2013 and then moved to a regime of reasonably explicit forward guidance on rates in 2015, resulting in the first increase at the end of that year. Despite falling sharply during the turmoil of early 2016, the 2 year resumed its upward path as conditions settled down and the case for a steady, if not spectacular, pace of economic recovery settled in as the default narrative. One should expect short term yields to continue tracking upwards in the absence of a reversal of the Fed’s stated intentions to keep raising rates.
For much of this time, the 10 year benchmark marched to a different drummer. Foreign demand was a key determinant of the consistently subdued yields experienced over this time – a trend that confounded no small number of bond pros. Rather than breaching 3 percent, as many expected, the 10 year actually set an all-time low – as in “since the founding of the American Republic all-time low” – in the immediate aftermath of Brexit.
The November election and the emergence of the so-called “reflation trade” brought about a shift in expectations, such that both intermediate and short yields moved largely in tandem. This was, as you will recall, when the prevailing mindset among investors imagined dramatic changes to the tax code and a sweeping new program of public spending on infrastructure. The spread between the 10 year and the 2 year in the weeks leading up to the election was mostly below 100 basis points, and it has not strayed very far from that level since.
Mind the Gap
The question now, of course, is whether there is still enough oomph in those reflationary expectations to send the 10 year into higher territory with a resulting steepening of the curve. This would be the putatively logical case to make for one who still believes there’s an infrastructure/tax reform pony out back with the capability to deliver the economic growth bump (however short-lived that might be) that is the administration’s central economic talking point. This view would consider the recent string of so-so hard data releases (including today’s six-of-one-half-dozen-of-the-other retail sales and inflation results) to be temporary and primed for near-term growth.
On the other hand, if the gap narrows still further – if the spread falls back into double digits as short term rates inch up while intermediates hold steady or fall again – investor brains could fall prey to the dark sentiments of an flat or inverted yield curve. That outcome would likely serve as a validation for those opining that bond yields represented the “smart view” while equity valuations soared on little more than a wing and a prayer.
The $4.5 Trillion Dollar Question
In the midst of all this is one very important and highly unpredictable variable: when and how the Fed plans to begin drawing down the $4.5 trillion balance sheet it racked up over the course of three quantitative easing programs. Observers will pay closer than usual attention to the forthcoming release of the FOMC’s minutes (scheduled for May 24) from its most recent policy meeting, scouring the language for clues about their intentions. The conventional wisdom is that the Fed believes there will eventually come a time when it needs to take rates back to zero and possibly launch another bout of QE. Having the dry powder to launch such a plan will necessitate a meaningful balance sheet reduction in the meantime. The tricky part, of course, will be to pull of this maneuver without roiling asset markets in so doing. Given the preternatural calm prevailing in risk asset markets currently, any hiccup could turn into a negative catalyst. Fed members will need to be practicing their triple-axel techniques to pull this off.
In this space last week we presented a case for “guarded optimism” in risk asset markets, regardless of the outcome of the presidential election. Then the Tuesday Surprise happened. It would be reasonable for one to ask us whether we are still of that cautiously optimistic view we expressed one week ago, and that will be our theme this week.
Sound and Fury
First of all, let us be crystal clear about one thing. When the subject of politics comes up in any of our weekly commentaries, our discussion is limited to how we perceive the directional impact of political events on equities and other risk asset markets. Donald Trump’s Electoral College victory has major potential implications for the U.S. and the world at many levels. Both of us have our own personal views about the outcome. But our focus here, as it is with any subject we present in these pages, is simply to share with our clients and other readers our assessment of how this development may affect their long-term investment portfolios.
As of today, our view is very little changed from where it was one week ago. Yes – futures markets plummeted through circuit-breaker levels as the results trickling in from North Carolina and Florida illuminated Trump’s path to 270. And yes – a few inclusive-sounding words by the President-elect, delivered in a relatively calm, measured tone in the wee hours of the morning, succeeded in reversing those overnight losses ahead of a Wednesday rally. That’s short-term noise, and while we could see more of that play out over the next couple weeks, we do not see as likely any sustained directional trend one way or the other proceeding from the simple fact of Trump’s victory.
Beyond the short-term sound and fury, we see three critical questions that could set the tone of markets in the first half of next year and beyond. First, will the new administration insert itself into Fed Chair Janet Yellen’s realm of monetary policy in a way that upsets central bank-dependent asset markets? Second, how will the economic priorities of Team Trump impact particular industry sectors and, by extension, the sales and earnings prospects of publicly traded companies? Third, will those same economic priorities live up to the often inflammatory, dangerous rhetoric on foreign trade that came up in the course of the campaign?
The Last Democrat
Among her other claims to fame, Janet Yellen now has the dubious distinction of being the last Democrat in Washington, D.C. with any meaningful power. The President-elect’s personal distaste for her is well-known and was featured prominently in the campaign’s closing ad messages. We think it unlikely, though, that the new president would play footsie with a possible market crash by taking concrete action in his first year to limit the Fed’s ability to independently execute monetary policy. Yellen’s term expires in January 2018, and odds are better than not that she will be replaced then by a Republican Fed head. Trump would have little to gain, and a great deal to lose, by stirring up trouble in the Eccles Building any time before then.
That is not to say that the risk of a White House – Fed confrontation does not exist as a possible 2017 surprise. In particular, it will be interesting to see how Trump and his new economic advisors react if, as expected, the Fed reactivates its rate hike program starting in December. Notoriously unpredictable as a candidate, it remains to be seen how restrained Donald Trump will be as president. We will be studying the tea leaves of formal policy speeches and off-the-cuff Twitter remarks alike in the coming weeks to get a better sense; for the time being, anyway, we would expect a more pragmatic approach to relations with the Fed at least within the next twelve months.
The Return of Fiscal Policy?
One of the first ways we expect 2017 to be unlike every one of the last eight years is that fiscal policy – i.e. actual legislative action targeting areas of economic stimulus – will be a real part of the conversation. In 2009 the Republican Congressional leadership more or less designed a tactical program around denying the Obama administration opportunities to implement economic policy. They didn’t always succeed – most notably in the 2009 stimulus package responding to the Great Recession and then in the 2010 passage of the Affordable Care Act – but by the time of Obama’s reelection in 2012 fiscal policy was by and large not a viable part of the economic equation. That has changed with the looming imminence of one-party rule. When we hear various ideas floated around – infrastructure spending, corporate tax reform, and stimulus programs for coal and other non-renewable energy sources are examples currently making the rounds – we have to assume they can actually become law and have an impact for better or worse.
One practical consequence of this is that sector picking may be back in vogue, as armies of quants tinker around with algorithms designed to follow the direction of putative fiscal policy initiatives. We already see signs of how this will play out; just since Wednesday morning, for example, the healthcare sector has been cleaved into subsectors with very distinct, uncorrelated trading patterns. Republicans on the Hill are baying for an immediate repeal of the Affordable Care Act, with little sense of what if anything is to replace it. That exposes health insurers to much uncertainty. On the other hand, expectations of an ultra-light regulatory touch are boosting the shares of drug manufacturers and biotech firms.
Trade or No Trade?
Ultimately, corporate earnings will depend on far more than U.S. fiscal policy. The IMF revised its estimates for global growth next year down in its most recent quarterly assessment. Both output and demand remain below historical norms in most developed as well as emerging markets. Weak foreign demand and a strong U.S. dollar are likely to continue to weigh on earnings and profit margins. That was going to be true regardless of who won on Tuesday night. Both campaigns took a relatively hard line against global trade; again, though, the fact that the executive and legislative branches all went Republican means that – to be blunt about it – if the new administration wants to start a trade war then it will be well within the realm of possibility to implement protectionist legislation.
Somewhat along the lines of our thinking that Trump would not likely rush into an immediate monetary policy confrontation with Janet Yellen, we think it less than probable that he would strike up a trade confrontation with China as an opening economic policy salvo. We have to imagine that somewhere in his economic transition team are voices to convince him of the unfavorable cost-benefit equation of such action.
There will be plenty of pressure from outside Washington to live up to his campaign rhetoric, however. It is not lost on anyone, least of all on traditional conservative free-traders who populate D.C. redoubts like the American Enterprise Institute and the Heritage Foundation, that the margin for Trump’s victory was delivered by voters who have largely been on the losing side of the global economy’s distribution of fortunes. The President-elect will soon enough have to confront the dilemma of pro-trade, pro-growth policy versus the strong protectionist impulses of the newly-empowered working class Republican base.
So there they are: monetary policy, fiscal stimulus and approach to trade are the three open questions at the top of our list of priorities. As we said last week, connecting the dots between the current direction of macroeconomic trends and corporate sales & earnings – i.e. the overall narrative that long predated the election – offers enough grist for at least a cautiously optimistic take on asset markets as 2017 gets underway. Whether we stand by that view as the year progresses will depend in no small part on how we see the evidence shaping up to provide answers to these three questions.
The tumult and the shouting dies, the Captains and the Kings depart. Rudyard Kipling’s 1897 “Recessional” comes to mind as we contemplate the remarkably quiet aftermath to September’s much-hyped marquee policy events. Yes, there was a frisson of excitement in equity markets after the Fed lived up to its reputation as the definitive cautious, controversy-avoiding institution of our time. And the yen went hither and yon in the immediate aftermath of the latest blast of new policies from the Bank of Japan.
But as the brief tumult subsides, the S&P 500 is back in its July-August corridor while the VIX has crawled into yet another low-teens slumber. The yen, meanwhile, has blithely brushed aside any notion of bite in the BoJ’s bark and is resuming its winning ways to the consternation of the nation’s policymakers. September is not yet over. With just one week left, though, this oftentimes fearsome month appears poised to go quietly into the night. So is it smooth sailing from now to New Year’s Eve? Is the overhang of policy risk off the table?
Dissent and Stern Words
We start with the Fed, where the policy debate was a simple will-they-or-won’t-they (we thought the matter was settled some time ago for reasons articulated in previous weeks’ commentaries, but still). Chair Yellen pronounced herself happy with the economy and the karmic “balance” of near-term economic risks, and put out a placeholder for December. A pair of hawks (Kansas City’s George and Cleveland’s Mester) were joined by habitual dove Rosengren of Boston in arguing for moving now.
That higher than usual dissent, along with a reasonable likelihood that headline economic numbers won’t deliver much in the way of surprises in the coming months, does raise the likelihood of a December move. In the absence of some global shock manifesting itself between now and the December FOMC meeting, in fact, a 25 basis point move would be our default assumption for the outcome of that meeting.
Unlike last December, though, when a quarter-point move led the way into a sharp risk-off environment in January, we think the Fed could get away with a move without roiling markets. The difference between this year and last? Those silly, yet telling, dot-plots showing where FOMC members see rates one, two and more years down the road. Last year, the consensus view was a Fed funds rate of 3.4 percent by the end of 2018. Reality took a bite out of that, though, down to what is now a 1.9 percent end-2018 view. In fact, apart from two outliers (anyone out there from KC or Cleveland? anyone?), nobody sees rates going above 3 percent for as far ahead as the eye can see. A benign, historically low cost of capital world appears to be our collective future.
The Drunk Archer
If there is a fly in the balm, though, the identity of that fly may well be the other party heard from in Policy Week. The Bank of Japan gave no clear indication going into deliberations as to what it intended to do. On the other side, it left no clear consensus as to what its flurry of policy measures actually meant: was it stimulative, or neutral, or maybe even restrictive in its practical implications? At least one clear winner emerged: Japanese financial institutions. By not further lowering already-negative interest rates, and adding a twist to the current QQE program likely to favor a steepening of the yield curve, the BoJ is sending a little love to its beleaguered member banks. The Topix Bank index jumped about seven percent in the aftermath of the announcement.
The problem with anything the Bank of Japan says, though, is that it has a credibility problem. That problem was very much on display with the other main platform of the Wednesday policy announcement, namely the stated intention to overshoot the longstanding two percent inflation target. The Bank hopes that by explicitly targeting an inflation rate higher than two percent (how high? not clear) it will finally be able to deliver on that monetary policy “arrow” in the original Abenomics blueprint: pull the economy out of its chronic flirtation with deflation.
The problem is that inflation in Japan has been nowhere near two percent for a very, very long time. The idea that a new mindset of inflationary expectations could suddenly take hold to reverse this longstanding trend is extremely hard to take seriously. To use the “arrow” metaphor of Abenomics, it’s as if a stone-cold drunk archer, wildly shooting at and missing a bulls-eye target, decides that the best way to hit the target is to move it even further away! It will take more than words to convince markets of any real change to Japan’s price environment – as evidenced by the yen’s prompt return to strength in the second half of this week.
Hence that “fly in the balm” comment we made a couple paragraphs above. The main risk we see in asset markets today is the credibility risk of the central banks that collectively have been holding things more or less together since the Great Recession. Lose that credibility and you lose a lot. Japan’s economy has been stagnant for 26 years, and policymakers there are still throwing pasta at the wall to see what sticks. In the absence of either normal levels of organic economic growth or intelligent economic policymaking by national governments, a loss of confidence in the ability of central banks to deliver effective monetary policy is not something we can afford to indulge. This is not a risk we see as likely to actualize in the very near-term, but it is a key concern looking ahead to next year and beyond.