Posts tagged Interest Rate Trends
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.
Be careful what you wish for, because it might come true. A couple weeks ago, bond investors were wishing upon their stars for a retreat in yields from the 3.25 percent the 10-year Treasury had just breached. Well, retreat it did, falling below 3.1 percent in early Friday morning trading. But these falling yields were clearly of the risk-off variety, dragging down everything else with them. The S&P 500 is flirting in and out of correction territory (a peak to trough decline of 10 percent or more) and may well have settled there by the end of the day, while the Nasdaq has already gone full correction.
As we noted in our commentary a couple weeks ago, corrections aren’t particularly rare events. We also noted the Tolstoyan flavor of these events – each one has its own unique story of dysfunction to narrate. “Okay, fine, so what’s the sad story accompanying the current situation?” is thus quite naturally a question that has come up in conversations with our clients this week. The narrative for the glass-half-empty crowd has indeed started to gel, but it is yet by no means clear that this will be the narrative that dominates for the remainder of the quarter (we will remain on record here as believing that it will not).
What we still have is a battle between two narratives, each looking at the same set of facts and drawing different conclusions, as if they were so many Rorschach inkblots. Let’s look first at the case for negativity.
Europe and China and Rates, Oh My
Several strands of thought weave together the bears’ case. In last week’s commentary we had an extensive discussion about the malaise in Europe, first with the Italian budget standoff that has sent yield spreads on sovereign debt soaring, and second with the spread of political unrest from the continent’s periphery to its dead center. Germany will have another round of regional elections this weekend, this time in Hesse (the region that includes financial capital Frankfurt as well as a delightful-sounding tart apple wine called Ebbelwei). The establishment center-left party, the SPD, is expected to fare poorly as they did two weeks ago in Bavaria. A really bad drubbing for the SPD could lead to the party’s exit from being the junior partner in Angela Merkel’s national grand coalition. That in turn could ratchet up the growing uncertainty about Merkel herself at a time when steady leadership from the EU’s strongest member is of critical importance.
China forms the second strand of the pessimist case. The national currency, the renminbi, is at its lowest level in a decade and poised to break through a major technical resistance level at RMB 7 to the dollar. After China’s GDP growth numbers last week came in slightly below expectations (6.5 percent versus the 6.7 percent consensus) Beijing economic officials coordinated a set of emphatic verbal assurances to investors that renewed growth measures were in place. That was enough to give beleaguered Chinese stocks an upward jolt for one day, but the lack of any specificity in the officials’ assurances didn’t hold up for a rally of more extended duration, and shares resumed their downward trend.
With the rest of the world looking particularly unappetizing, attention then turns back to the domestic environment, specifically the prospects for continued monetary tightening by the Fed and concerns that the run of news for corporate financial performance – capped off by earnings growth expected to top 20 percent for 2018 – is about as good as it’s going to get. Higher rates will tamp down the currently rambunctious confidence among consumers and small businesses, while widening spreads will also spell trouble for the corporate debt market at a time when S&P 500 companies have record levels of debt on their books. Margins will be under pressure from upward creep in wages and input costs, and weaker economies around the globe will have a negative effect on overall demand for their products and services. Faltering leadership from high-profile tech and consumer discretionary shares is the canary in the coal mine, portending a more protracted period of market weakness.
It’s not a weak case, to be sure. But there is a strong argument on the other side as well, with opportunists scouring an expensive stock market for bargains made available in a 10 – 15 percent correction environment. This is the “song remains the same” crowd.
The Big Picture Hasn’t Changed
The glass-half-full argument always starts from the same point: the unrelenting sameness of US macroeconomic data month in and month out. The latest of these is fresh off the presses of the Bureau of Economic Analysis as of this morning: a Q3 real GDP growth reading of 3.5 percent, which translates to a 3.0 percent year-on-year trajectory. Same old, same old – healthy labor market with unemployment at decades-low levels, prices modestly but not dangerously above the Fed’s 2 percent target, zippy consumer spending and continued growth in business investment.
On the subject of corporate earnings, the optimists will point out that top-line sales expectations for 2019 are actually increasing. Yes – the tax cut sugar high will lapse once December comes and goes, so bottom-line earnings won’t repeat their 20 percent gains of ’18. But if sales continue to grow at a 6-7 percent clip it underscores the ongoing health in consumer demand, here as well as abroad. And yes – to that point about weakness in China, the adverse effects of the trade war have yet to show up in actual data. China’s exports grew at a 14 percent clip in September, and the $34.1 billion trade surplus it recorded with the US for the same month was an all-time record.
The Fed is likely to continue raising rates. The reason for that, as Fed officials themselves repeat time and again, is because the economy is growing well and (in their view) cans sustain growth while interest rates rise gradually to more normal levels. It’s worth remembering that yields on the 10-year Treasury averaged over 6 percent during the growth market of the mid-late 1990s, and around 4.5 percent during the mid-2000s. There is no particular reason (despite many reports to the contrary) that money managers “have to” rotate out of equities into bonds at some notional 10-year yield threshold (3.7 percent being the number bandied about in a recent Merrill Lynch / Bank of America survey).
To be sure, there are plenty of X-factors out there with the potential to add fuel to the present nervousness in risk asset markets. There are plenty of others that could accelerate a pronounced recovery of nerve heading into the peak retail season that begins next month.
It is also possible that we are seeing the first early hints of the next real downturn – much like those occasional days in August where there’s enough crispness in the air to suggest a seasonal change, even while knowing that autumn is still many weeks away. Just remember that while the timing of seasonal equinoxes is predictable, market transitions do not operate on any fixed calendar.
So here we are, with a full array of tricks and treats to test investors’ nerves as the month of October gets rolling. A quick brush-up for our clients and readers on the nature of pullbacks is in order.
Since the current bull market began in 2009 there have been 20 occasions (including the present) where the S&P 500 has retreated by 5 percent or more from its previous high (translating to roughly 2 per year). Of those 20 pullbacks, four met the definition of a technical correction, i.e. 10 percent or more from the high. On one occasion, in 2011, the index fell by more than 18 percent before recovering. As of the Thursday market close, the S&P 500 was down 6.9 percent from its September 20 record high of 2930.
These things happen. As we like to say, paraphrasing Tolstoy, every pullback is dysfunctional in its own special way. With the caveat that the final word on the current reversal has yet to be written, here are four observations we think are worth keeping in mind as this one plays out.
They Finally Got the Memo
As we wrote about in last week’s commentary, the market has been willfully slow, for a very long time, in accepting that the Fed really intends to raise rates consistent with its view of an economy gaining strength. Last week the bond market got the memo with a sudden midweek jump in intermediate yields. It seems that the bond market sat on the memo for a few days before passing it over to the stock market. In any case, we can say with a bit more confidence now that the memo has been received. Barring any significant changes in the macroeconomic landscape – which changes have yet to surface in the form of hard data – the reasonable expectation is for a final 2018 rate hike in December, followed by at least three in 2019.
More Bond Confusion Likely
Despite better alignment between market expectations and the Fed, we do foresee further confusion in fixed income, particularly with intermediate and long duration asset classes. Consider the multiple forces at work on the 10-year Treasury, a widely used proxy for intermediate-long bonds. Heightened inflationary expectations could push yields much higher. On the other hand, relatively attractive yields (compared to Eurobonds or Japanese government bonds, for example) could keep a lid on how high rates go. Any kind of emergent financial crisis could widen spreads between Treasuries, corporate bond and other fixed income classes.
During the economic growth cycle of the late 1990s, from 1995-2000, the average yield on the 10-year Treasury was 6.1 percent and it never fell below 4 percent. What should the “natural” yield be in the current growth cycle? Nobody, not the world’s leading economists and not the trader plugging buy and sell triggers into an algorithmic trading strategy, knows for sure. We’re likely to learn this from whatever we experience over the coming months, not from theoretical foresight.
Post-Sugar High Growth
Come December, we will lap the tax cuts implemented one year earlier. That will make 20 percent corporate earnings growth a thing of the past – a good part of the growth in earnings per share this year was based on the lower tax rate that flowed through to the bottom line of the corporate income statement. Right now, the consensus analyst group used by FactSet, a market research company, expects earnings per share growth for S&P 500 companies to be 7 percent in the first quarter of 2019. Now, the same consensus group predicts that top line sales for these companies in Q1 2019 will come to 6.9 percent. That tells us two things. First, it tells us that the overall global demand environment (reflected by sales) is not expected to worsen much from where it is currently. That’s good news.
The second thing it tells us is that analysts will be focusing obsessively on corporate profit margins in 2019. Sales growth is good, but in the long run sales without profits are not good. Closer parity between top line growth rates and trends further down the income statement suggests that companies will need to be increasingly creative in finding ways to make money, particularly if cost pressures (e.g. on raw materials and labor) continue to trend up.
How will this factor play out? The next few weeks will be very important as the Q3 2018 earnings season gets under way. Analysts will be digesting the most recent growth and profit numbers from corporate America. The narrative could shape up positively – more growth! – or negatively – peak margin! How you as an investor approach 2019 will have much to do with whether you think profit margins really have reached their Everest once and for all. There will be plenty of excitable commentary to that effect. We suggest tuning out the commentary and paying attention to the actual data.
As in, “market leaders going around in circles.” So far the industry sectors bearing the brunt of the October ’18 pullback are the ones that did the lion’s share of the lifting for the past couple years: tech, first and foremost, communications services and consumer discretionary. More broadly, growth stocks have been absolutely dominant for much of the latter period of this bull market. So it is reasonable to ask what might happen if the growth stock leadership falters.
We’ve seen this play out a couple times this year (see our previous commentaries here and here for additional insights on this topic). One of the considerations is that because the tech sector comprises about 25 percent of the total market cap of large cap US stocks, it has an outsize effect on overall direction. That works well when the sector is going up. But if, say, consumer staples stocks in total go up by as much as tech stocks go down, the net result is a down market (since consumer goods stocks make up less than 8 percent of the index). An orderly growth to value rotation might be a better outcome than outright confusion, but investors who have gotten used to the growth-led returns of recent years might be in for a disappointment.
So there’s a lot at play right now. As usual, there will be no shortage of “experts” claiming to understand precisely what it all means (as they claim, after the fact, how “obvious” it was that this pullback was going to happen at exactly this time for exactly this or that reason). As for us, we simply plan on doing what we always do. Study the data, think through the possible alternative outcomes based on the scenarios we have described here as well as others, and always remind ourselves of those numbers we cited at the beginning of this commentary. Pullbacks are a fixture of bull markets and they happen for any number of reasons, logical or not. Actual bear market reversals are much rarer events. In our opinion it is not time to call an end to this bull.
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.