Posts tagged Interest Rate Trends
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.
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.