January 2012

January 31, 2012  |   Monthly Commentary   |     |   0 Comment

The storm clouds of worry that hung over the capital markets at year-end yielded to cautious optimism in January. Evidence of the improved sentiment could be found across nearly all asset classes. The S&P 500 index rallied more than 4% and the SPX volatility index (VIX) closed the month below 20% for the first time since June 2010. In the fixed income market, U.S. Treasury notes were largely unchanged while credit markets of all quality rallied.


The initial catalyst for the improved market tone was a reversal of the near-panic that gripped the markets as 2011 came to an end. That relief rally was buttressed by better than expected economic fundamentals. A robust manufacturing sector translated into better-than-expected sales of aircraft, machinery, electronics, and automobiles. Even more encouraging has been the improving employment situation. Investors were cheered by the 1.6 million non-farm payroll jobs gained in 2011. The just released jobs report for January was even more encouraging, with the economy adding a much better than expected 243,000 non-farm payroll jobs. Even more surprising was the 641,000 increase in employment, as measured by the Household survey. Regardless of the measure employed, job growth is strengthening and the “naysayers” forecasting a return to recession are dwindling in number.


However, not everyone is ready to signal the “all clear” yet, with the loudest and most consistent doubter being Federal Reserve Chairman Bernanke. In what many deemed to be a foolish move, the FOMC released the interest rate and inflation forecasts of each Federal Reserve governor and president. From those forecasts, we found three inconsistencies. Immediately apparent is, despite Fed Chairman Bernanke’s proclamation to hold overnight rates at zero through 2014, it’s hardly a unanimous opinion. In fact, of the seventeen members polled, only six are forecasting such an outcome. Three of the forecasters are expecting a rate rise this year and six of them expect a rate hike sometime next year. Clearly, there is not a consensus within the Fed! Second, using a weighted average of the forecasts as the “best guess” forecast for interest rates, we believe that market-implied Fed Fund futures are too expensive, which is the rationale for why we have positioned them as part of our hedging strategy. Lastly, the Fed forecast, under each scenario is that inflation will rise to, but not above, 2.0%. Of the various measures of inflation, the Fed prefers the Personal Consumption Expenditure (PCE) core index, which rose 1.8% YOY in December. However, the entire PCE universe increased 2.4% year over year for the same period. Before the Fed can maintain inflation below 2% they’ll need to first get it below that level. Given the excessively easy monetary policy currently in place and the promise to stay accommodative for years, the Fed is asking investors to suspend conventional wisdom in accepting their inflation forecast.


At the press conference following the FOMC meeting Chairman Bernanke stumbled when questioned about the impact of the zero interest rate policy on purchasing power in an environment of 2% inflation. Scott Spoerry from CNN asked “…There are people out there who are going to say the Federal Reserve have finally just admitted it. Their policy is to destroy 2 percent of the value of my dollars every year.”


One would think the Chairman would be prepared for such a “curve ball” and have a concise answer prepared. Instead, a clearly frazzled Bernanke delivered an inarticulate and nearly indecipherable response. The last few sentences, as per the Federal Reserve website, are as follows:


“I think the argument that, you know, the value of your dollar, the declines at 2 percent a year is not really a very good one unless you’re one of those people who does their lifetime saving in the mattress. Most people invest in various kinds of instruments receiving rate of interest. And now it’s true as been pointed out that for the moment that interest rates are pretty low they’re still positive but over a longer period of time if you–even if you have money in a CD or some other investment vehicle, the interest rate will compensate you for the–for inflation. I mean the two will be tied together. And so, they really shouldn’t be, you know, levels of inflation this low, interest rates should pretty much fully compensate for the losses to savers. But I would reiterate that we are not unaware of the problems that low interest rates cause for savers, cause for pension fund contributions, insurance companies, and other parts of the economy and we do try to take that into account as we think about other ramifications of our policy.”


It’s the assumption at Halyard that despite public attestations to the contrary, Chairman Bernanke is expecting inflation to rise and that interest rates will rise to levels in line with the elevated inflation rate.