Posts tagged Interest Rate Trends
Watch the bond market: that was a core theme of our recent Annual Outlook and earlier commentaries in this brief, suddenly volatile year to date. Benchmark Treasury yields jumped on the first day of the year and never looked back. For the first month equities kept pace with rising yields, delivering the strongest January for the broad US stock market since 1987. Then it all went pear-shaped. Yields kept rising, while risk-on investors developed a case of the chills and sent stocks into a sharp retreat. The S&P 500 saw its biggest intraday declines since 2011, and the fastest move from high to 10 percent correction – 9 trading days – since 1980. Investors, naturally, want to know if this is just a long-overdue hiccup on the way to ever-greener pastures, or the start of a new, less benign reality.
The Expectations Game
The chart below shows the performance of the S&P 500 and the 10-year yield for the past 12 months through the market close on Thursday.
What caused that abrupt change in sentiment? Investors seemed perfectly happy to watch the 10-year yield rise from 2.05 to 2.45 percent last September and October, and again from 2.4 to 2.7 percent over the course of January. What was it about the move from 2.7 to 2.86 percent to precipitate the freak-out in stocks? The most widely cited catalyst has been the wage growth number that came out in last Friday’s jobs report; after growing at a steady rate of 2.5 percent for seemingly forever, the wage rate ticked up to 2.9 percent in January. According to this train of thought, the wage number raised inflationary expectations, which in turn raised the likelihood of a faster than expected rate move by the Fed, which in turn led to portfolio managers adjusting their cash flow models with higher discount rates, which in turn led to the sell-off in equities this week.
Algos Travel in Packs
There is a kernel of truth to that analysis, but it doesn’t really explain the magnitude or the speed of the pullback. For more insight on that, we turn to the mechanics of what forces are at play behind the actual shares that trade hands on stock exchanges every day. In fact, very few shares trade between actual human hands, while the vast majority (as high as 90 percent by some estimates) trade between algorithm-driven computer models. The “algos,” as they are affectionately known, are wired to respond automatically to triggers coded into the models.
On most days these models tend to cancel each other out, sort of like the interference effect of one wave’s crest colliding with another’s trough. But a key feature of many of these models is to start building a cash position (by selling risk assets) when a certain level of volatility is reached. Even before the selling kicked in last week, the internal volatility of the S&P 500 had climbed steadily for several weeks, while the long-dormant VIX was also slowly creeping up. The wage number may or may not have been a direct trigger, but enough of these models read a sell signal to start the carnage. Rather than waves canceling out, it was more like crests meeting and growing exponentially. More volatility then begat more selling.
The Case for Promise
So we’ve been given a taste of the peril that can come from higher rates. What about the promise? Here we leave the mechanics of short-term market movements and return to the fundamental context. The synchronized growth in the global economy has not changed over the past two weeks. The Q4 earnings season currently under way continues to deliver upside in both sales and earnings growth, while the outlook for Q1 remains promising. If wages and prices grow modestly from current levels – say, for example, so that the Personal Consumption Expenditure index actually rises to the Fed’s 2 percent target – well, that is in no way indicative of runaway inflation.
This should all be good news; in other words, if the current global macro trend is sustainable, it would strongly suggest that the current pullback in risk assets is more like a typical correction (remember that these normally happen relatively frequently) and less like the onset of a bear market (remember that these happen very infrequently). Higher rates have an upside as well, when they reflect positive underlying economic health. With one caveat.
The Debt Factor
Call it the dark side of the “reflation-infrastructure trade” that caught investors’ fancy in late 2016. The US is set to borrow nearly $1 trillion in 2018, much of which is to pay for the fiscal stimulus delivered in the administration’s tax cut package. That borrowing, of course, takes the form of Treasury bond auctions. A weak auction of 10-year Treasuries on Wednesday is credited for pushing yields up (and stocks down) late Wednesday into Thursday. These auctions, of course, are all about supply and demand. Remember that brief freak-out in early January when rumors floated about China scaling back its Treasury purchases? Supply and demand trends stand to weigh heavily on investor sentiment as the year progresses.
Now, a great many other factors will be at play influencing demand for Treasuries, including what other central banks decide to do, or not do, about their own monetary stimulus programs. Higher borrowing by the US may be offset if overseas demand is strong enough to absorb the expected new issuance. Time will tell. In the meantime, we think it quite likely that the surreal quiet we saw in markets last year will give way to more volatility, and to sentiment that may shift several times more as the year goes on between the peril and the promise of higher interest rates.
We will be publishing and distributing our Annual Outlook next week, a 24-page opus reflecting not only our analysis of the quotidian variables likely to be at play in the economy over the coming twelve months, but also a commentary on today’s world in a larger historical context. Meanwhile, we will use the opportunity of this week’s regular commentary to share with you the executive summary from the forthcoming Outlook, to give you an advance look of what you will read in further detail next week.
• “Moderate growth, low inflation, improving labor market”: this would have been a reasonable way to characterize US economic trends in 2013. And in 2014, 2015 and 2016. So it was not exactly an earth-shaking surprise when 2017 delivered…yes, moderate growth, low inflation and a still-improving labor market, if the latter slowed down just a bit in net new job creation. Tracking the macroeconomy has become something akin to watching daily episodes of Seinfeld. Not much of any consequence ever happens, and every now and then some amusing diversion appears to briefly engage one’s attention. Try as we might to unearth some new piece of information suggesting the approaching end of this placid state of affairs, we cannot. The data say what the data say. 2018, for the moment, looks set to deliver more of the same.
• The key difference between 2017 and earlier years in this recovery cycle was that the rest of the developed world came on board. Organic demand and consumer confidence perked up in the Eurozone, Britain managed to at least temporarily forestall a reckoning with the consequences of Brexit, Japan stayed positive while ex-Japan Asia Pacific countries did just fine. China, meanwhile, met its growth benchmarks by initially going back to the tried and true mix of debt-sourced spending on infrastructure and property. Beijing reversed course midyear, though, with a concerted program to reduce borrowing and recommit to economic rebalancing (this coincided with a further consolidation of power by President Xi Jinping). Elsewhere in emerging Asia and beyond, concerns about looming trade wars faded and domestic assets, including long-beleaguered currencies, perked up for a winner of a year. Again – while there are plenty of geopolitical variables that could form into tangible threats at any time – the basic macroeconomic variables appear stable. Markets ignored geopolitics last year, we expect them to do the same in the year ahead.
• Calendar-gazers are filling up the airwaves with the observation that the current recovery – from July 2009 to the present – is one of the longest on record. If we manage to avoid a recession between now and May, the current growth cycle will move ahead of that of 1961-70 as the second-longest, trailing only the ten years of good times from 1991 to 2001. To those nervously ticking off elapsed calendar days we offer two ripostes. First, markets and economies don’t pay attention to calendars, which are entirely a human construct. Second, there are potentially valid reasons why the current uptrend could go on for longer. From 2009 to 2014, arguably the main force behind continued growth was the Fed and its quantitative easing mechanics that flooded the world with money. Only more recently has the growth started to look more traditional – more like actual improvements in business and consumer sentiment begetting a virtuous cycle of increased supply feeding increased demand. If anything, the perky demand trends we see today more resemble those of an early than of a late stage in the cycle. The uniqueness of that multi-year experiment in unorthodox monetary policy may make comparisons with other growth periods less meaningful.
• So if the default assumption is that 2018 will be a year of very few changes to the presiding macroeconomic trends, what alternative scenarios could upend the base case? The key X-factor, we believe, is the one that nobody from Fed governors to that fellow holding court at the end of the bar completely understands; namely, the curious absence of inflation. The inflation rate has fallen short of the Fed’s explicit target of 2 percent throughout the entire recovery to date (when excluding the volatile categories of energy and foodstuffs). This despite the dramatic fall in the unemployment rate from 10 percent at its peak to just 4.1 percent today. The economic models built over the decades following the Second World War baked in the fundamental assumption of a trade-off between inflation and employment: be prepared to sacrifice one in pursuit of the other. That assumption has not held up at all in recent years. But before pronouncing last rites on the Phillips Curve, we again draw your attention to our observation in the previous bullet point: the kind of growth one normally sees early in a recovery cycle may only now be showing up. If so, then a sudden surge of higher than expected inflation would not be entirely implausible.
• The second alternative scenario that could disrupt the smooth sailing of most capital markets asset classes would be, perhaps, the other end of the spectrum from a growth-fueled resurgence of inflation. The Fed intends to raise rates again this year – three times if the stated expectations of the FOMC’s voting members are to be believed – and to begin winding down the balance sheet that grew to $4.5 trillion over the course of the QE years. These intentions reflect a confidence that the economy is fully ready to stand on its own two feet – which confidence, of course, proceeds from those same steady macro trends we described a few bullet points ago. But there is still a chance, and not necessarily a small one, that today’s bubbly sentiment is ephemeral and will dissipate once the crutch of monetary policy is finally and conclusively removed. Specifically, not one of the three structural drivers of long-term growth – population, labor force participation and productivity – are demonstrably stronger now than they were two years ago when we devoted some number of pages in our Annual Outlook to the concept of secular stagnation. There may be less to the current growth uptick than meets the eye. If so, a Fed misstep on the pace of unwinding easy money – too much, too soon – could be the trigger that boots the Goldilocks economy to the exit door.
• What both those alternative scenarios – an unexpected inflation surge and a Fed policy fumble – have in common is the potential to wreak havoc on credit markets. From an asset markets perspective, credit markets hold the key to how virtually any asset class – debt, equity or alternative – will perform. Here’s why. The risk-free rate – in general practice the yield on intermediate / long Treasury notes – is employed in just about every standard asset valuation model. All else being equal, an increase in interest rates has the effect of decreasing the present value of future cash flows. Asset managers will reprice their models if reality outstrips expectations about yields. A likely ripple effect resulting from a Treasury rate repricing would be widened risk spreads (affecting, for example, corporate investment grade and high yield bonds), a pullback in equity prices and a commensurate uptick in volatility. Whether the riskier conditions persist would be situation-specific, but there would very likely be at least some damage done.
• Again, we view these as alternative scenarios to be a more benign base case. Even if one of the other were to come to pass, though, it would not necessarily start the clock on a countdown to the end of this long bull market. For that to occur, we believe one of three events would have to emerge: a full-blown recession (which is different in nature from a periodic surge in inflation), a crisis such as the implosion of the financial system that led to the 2008 crash, or the outbreak of an actual hot war somewhere in the world that significantly involved the US and/or other large powers. The risk of any of these things happening in 2018 is not zero, but we would ascribe a probability of less than 25 percent to any of them.
• US equity valuations are stretched, particularly for the large cap growth segment of the total market that has consistently outperformed over the past several years. Relying on relative valuations alone would potentially lead investors to other areas, like Europe or emerging markets, that still have some catching up to do even after a strong performance in 2017. In the long run valuations matter – there is no coherent way to view a share price as anything other than the present value of a series of future cash flows. In the short run, valuations don’t always matter. Relative geographic performance in 2018 will be subject to other influences, not least of which will be the direction of the US dollar.
• The dollar was one of the big surprise stories of 2017. Long before equity shares in financial institutions or resource companies snapped out of their “reflation-infrastructure trade” myopia, the US currency had done a U-turn from its rapid post-election ascent. The dollar fell by nearly 10 percent against a basket of other major currencies last year, and that soft trend has continued thus far into 2018. Currency strength was a major force driving performance for developed and emerging market equities and debt last year. Whether a reprise of that trade is in store for the year ahead depends – again – on that tricky combination of alternative economic scenarios. If US interest rates rise substantially, with the ECB and the BoJ at the same time proceeding more cautiously, then a stronger dollar would be a rational expectation as investors pursue higher yields. That outcome is not set in stone, however. Major foreign investors – most notably China – may look to diversify their foreign exchange assets if their perception of US risk changes, which would, all else being equal, have a negative effect on the dollar.
• Commodities may stand on the other side of the dollar’s fortunes. A weaker dollar makes commodities more affordable in other currencies; that, along with the return of strong organic demand, may supply a tailwind to a range of energy and industrial commodities. But oil, which has recently surged to its highest levels in three years, remains vulnerable to the prospect of increased shale production in the US. As with currencies, there are many factors at play that could work either for or against key commodity classes.
• In conclusion, we could sum up the essence of our views thus: Things Don’t Change, Until They Do. The benign tailwinds of moderate, steady global growth will not last forever. Neither we nor anyone else can point with certainty to the date when the sea change happens. What we can do is pay close attention to the things that matter more. 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.
The S&P 500 has appreciated 3.6 percent in price terms in the first eight days of trading this year. It seems highly unlikely that the index will match this pace for the year’s remaining 242 trading days, so it’s reasonable to wonder what’s going to happen next. It’s always a fool’s errand to predict the timing and magnitude of future price movements; for clues, though, one’s best bet would probably be to follow the bond market. Amid all the exuberance in equities, there is a palpable edginess in the once staid world of fixed income. That edginess was on full display for a few hours Wednesday morning. A rumor floated out that China’s monetary authorities (who also happen to be the world’s principal consumers of US Treasury debt) were considering scaling back their purchases of US sovereigns, presumably as a cautionary move to diversify the composition of their foreign exchange reserves. Bond yields spiked immediately, and the 10-year yield shot up perilously close to last year’s high mark of 2.63 percent. That’s also the 10-year’s peak yield since the crazy days of 2013’s “taper tantrum” – remember those good times? The chart below shows the 10-year yield trend over the past five years.
At the Mercy of Supply and Demand
Wednesday’s mini-panic dissipated soon enough; the 10-year yield fell back and remains, as we close out the week, around 5 to 8 basis points below that 2.63 percent threshold (a handful of bond pros out there believe markets will all go haywire if that threshold is breached, for reasons with which we don’t necessarily agree). The Chinese put out an anodyne denial of any intentions to scale back Treasury purchases. The S&P 500, which Wednesday morning futures indicated could suffer a meaningful pullback, briskly resumed its winning ways. And all the while volatility has remained in the fetal position which has been its custom for the last year.
But that hair-trigger reaction to the China rumor underscored just how antsy the bond market is right now, and how exposed it is to the basic laws of supply and demand. Bear in mind that intermediate and long term bond prices are subject to many variables, while short term bonds tend to much more closely track the Fed. One of the key drivers keeping yields in check for the past several years has been robust demand from overseas – robust enough to make up for the reduction in demand at home when the Fed ended its quantitative easing program. If international investors turn sour on US credit – for whatever reason, be it inflationary concerns, a bearish outlook on the dollar or even jitters over our chaotic politics – that has the potential to push yields well past the notional 2.63 percent ceiling. A subsequent move towards 3 percent would not be out of the question.
Visions of 1994 Dancing In Their Heads
The bond market angst has its own mantra: “Remember 1994!” That, of course, was the year the Greenspan Fed surprised the markets with an unexpectedly aggressive interest rate policy, starting with a rate hike nobody was anticipating in February of that year. Investors will remember 1994 as being a particularly roller-coaster one for stocks, as the surprise rate hikes caught an ebullient bull market off guard. The chart below illustrates the volatile peaks and valleys experienced by the S&P 500 that year.
Now, the conventional wisdom in 2018 is that the Fed will do its utmost to avoid the kind of surprises the Greenspan Fed engineered over the course of 1994 (which included a surprise 50 basis point hike in the middle of the year). But investors are also cognizant of the reality that there are new faces populating the Open Market Commission, which of course will feature a new chair in the person of Jerome Powell. All else being equal, the new Fed is likely to proceed cautiously and not risk unnerving markets with a policy surprise. But all else may not be equal, particularly if we get that inflationary surprise we’ve been discussing in a number of these weekly commentaries. Then, a new Fed trying to get its sea legs may face the urgency of making decisions amid a tempest not of its own making.
We’ve had some reasonably benign price numbers come out this week: core producer and consumer prices largely within expectations. Bond investors appear relieved – yields have been fairly muted yesterday and today even while equities keep up their frenetic go-go dance routine. But there is not much complacency behind the surface calm.
As 2017 draws to a close, two data points strike us as particularly noteworthy candidates for summing up the year in asset markets. The S&P 500 is up more than 20 percent in total return, and the Fed has raised interest rates three times. Investors have good cause to bemoan the exit of Janet Yellen at the end of next month, for the good professor has given us an extended seminar in how to handle interest rate policy with minimal collateral damage either in financial markets or the real economy of goods and services. Incoming Fed Chair Jerome Powell has some large shoes to fill; fortunately he, by all appearances, has been a diligent student under Yellen’s tutelage over the past several years. He will need all the benign tailwinds he can get, because the road ahead may not be quite so calm as that we leave behind heading into 2018.
Follow the Dots
This week’s 25 basis point increase in the Fed funds target range was widely anticipated by the market (again, thanks to clear and prudent forward guidance). Investors quickly skimmed past the headline announcement to see where Fed minds were regarding policy action for next year: the famous “dot-plot” showing where FOMC voting members think rates will be in the coming three years and beyond. Very little has changed since the dot-plot’s last iteration in September, with the mean expectation of three more rate hikes in 2018. The lack of upward movement on rate expectations came at the same time that the Fed raised somewhat its expectations about economic growth and labor market conditions.
Dr. Pangloss’s Market
From an investor’s standpoint the market would seem reminiscent of Dr. Pangloss in Voltaire’s “Candide” -- the best of all possible worlds, with growth supported by still-accommodative monetary policy. That pleasing state of affairs, of course, comes courtesy of inflation that refuses to budge out of its narrow range of about 1.3 to 1.8 percent, depending on which measure you prefer. Markets seem satisfied this best of all worlds will continue. Even now, Fed funds futures markets ascribe only a 20 percent or so chance of even those three rate hikes occurring next year. An unexpected surge in inflation is quite likely the most impactful variable that could upset the present state of things. It would cause a rethink in the pricing of most assets, starting with intermediate and long term bonds. Intermediate Treasuries, in particular the 10-year note, serve as a proxy for the “risk-free rate” calculations used in valuing and pricing most risk assets. Disrupt expectations for the 10-year, and you disrupt most everything else.
The Curvature of Markets
In July 2016 the 10-year yield dipped as low as 1.36 percent, which by some accounts was the lowest yield for a benchmark risk-free rate ever in the 800-plus year-history of recorded interest rates. Today, the 2-year yield -- a short term reference benchmark closely tied to monetary policy trends -- is over 1.8 percent. With today’s 10-year around 2.4 percent, the spread between short and intermediate yields is lower (flatter in yield curve-speak) than it has been any time since 2007. Intermediate yields are affected by many market variables, but inflationary expectations are prominent among them. Briefly put: if that inflationary surge were to happen, there would be plenty of upward curved space for the 10-year yield to occupy. Up go all those discount rates used to make present value computations for risk assets. All else being equal, a higher discount rate lowers the net present value of a future series of cash flows. The calm waters of 2017 would likely seem a distant memory.
All that being said, there is no hard evidence today suggesting that this kind of inflationary surge is around the corner. Other factors, such as low productivity growth and hitherto modest wage growth, continue to keep consumer prices in check. But sub-2 percent inflation in an economy where unemployment is just 4 percent runs counter to all the data and experience that have informed monetary policymakers for the past seventy years. It has been a pleasant, if confounding, feature of the Yellen years. Figuring out where it goes from here may well be incoming Chair Powell’s biggest challenge.
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.