November 2015

Conditions are now in place for the Federal Reserve to finally raise interest rates at the December 16th meeting. On Friday, the BLS released the second consecutive robust jobs report, after softer reports for August and September. The unemployment rate has fallen to 5%, and wages are now rising at approximately a 2.3% annual rate. Moreover, there are 5.5 million unfilled jobs, just a shade below the all time high, which should keep job growth strong. Core Inflation, as measured by the consumer price index (CPI) ex food and energy, rose 1.9% year-over-year in October, essential matching the 2.0% target of the Federal Reserve. Analysts look to CPI ex food and energy, as opposed to headline CPI, as it’s a less volatile series and more indicative of consumer behavior. Food and energy are subject to supply and demand idiosyncrasies such as the weather on crops and OPEC on energy. Energy prices have fallen 17% over the last twelve months through October due to the plunge in oil and gas. When that drop is included in headline CPI, the year-over-year increase was only 0.2%. On the other hand, prices for goods and services, excluding energy, which represents 58% of the CPI basket, rose 2.8% year over year. That measure, when paired with the 2.5% increase in wages noted in the October employment report illustrate that inflation appears to have bottomed and is now rising.

Of course, expectations of how the markets will react once the Fed finally raised rates vary widely. There are those that expect that even a 25 basis point rate hike will be too much for the economy to endure and are forecasting a recession. Their concern is not necessarily that 25 basis points would choke off lending. Instead they argue that raising rates while the European Central Bank and the Bank of Japan are easing policy is going to cause the value of the U.S. Dollar to rise versus our trading partners, having a deleterious effect on U.S. exports. There is some truth to that logic and the manufacturing sector seems to be suffering at the current exchange rate. However, given that the U.S. is primarily a service-based economy, we think the drag from a weakening trade sector will be minimal.

Another worry is that rate hikes will stifle the corporate practice of selling debt to buy back stock while simultaneously causing the borrowing costs of corporations to rise, neither of which would be supportive for stocks. With that pillar of support gone, stock prices would tumble from their lofty valuations and that would dampen economic growth. Again, it’s a plausible scenario, but we deem it not likely. First, the fixed income community continues to be starved for yield and will likely increase their allocation to corporate debt as rates rise. Second, marginally higher borrowing rates are not likely to slow the “issue debt to buy stock” alchemy, as it allows companies to show improving earnings per share without an increase in revenue. Finally, corporations have been locking in their borrowing costs, so while higher rates will increase borrowing costs, it’s likely to be only at the margin. Instead, we think that job growth and low energy prices have created a virtuous circle of personal consumption, with robust job growth and consumers having more discretionary income. Ironically, the fear of the scenarios just discussed has resulted in a “one and done” consensus view that after initially raising interest rates, the Federal Reserve will be slow to raise rates subsequently. The current view is that there will be two additional rate hikes in 2016, with Fed Funds ending the year with a 0.75% – 1.00% range. That view doesn’t comport with our view that unemployment rate continues to fall and wages continue to rise. Under that scenario, we suspect that the FOMC will find itself again coming under scrutiny and the rhetorical battling among members to intensify.

September 2015

While forecasters had handicapped the probability of a rate hike at the September 17th FOMC meeting at less than 50%, it seems that the expectation was much higher. On the back of the unchanged rate and the conciliatory tone of the Chair at the post-meeting press conference, stocks plunged around the globe as did emerging market foreign exchange rates and commodity prices. Driving commodity prices was the falloff in demand from a slowing China. That coupled with the supply driven drop in oil prices weighed heavily on the economies of energy producers like Mexico, Brazil and Canada. Brazil, especially, has fallen mightily. The one-time darling of many diversified investment models, touted as being a better credit than the United States, the Brazilian Real has plunged 81% in the last year. Meanwhile, back in the U.S., the economy is doing quite well. Unemployment has fallen to 5.1% and is likely to dip below 5% in the coming months. Auto dealers are selling cars at a record pace and with the average age of the car on the road touching a record 11.5 years, the replacement cycle should support cars sales for years to come. Moreover, average hourly earnings are growing at 2.2% year-on-year and new home sales have touched a post-crisis high. Yet Chair Yellen articulated that she is worried about heightened market volatility and the slowdown in economic growth in China. I can understand her concern surrounding those issues, but am perplexed at her ignorance of the problem the Fed has created in the money markets. Simply put, there is too much money chasing too few securities. At the time of this writing, every Treasury-Bill maturing now through the end of the year is trading at a negative yield to maturity. At the September auction of one month Treasury bills, the auction result was a yield to maturity of 0.00%, and it was nine times oversubscribed. Earlier this year we wrote about impending changes in SEC rules governing money market mutual funds. To summarize, Prime money market funds were required to hold 80% of portfolio assets in U.S. government paper prior to the rule change. The balance could be held in various credit securities including commercial paper, corporate bonds, or general collateral repurchase agreements. Deeming 20% of “other” paper as posing a liquidity risk, the SEC mandated that those funds must have a floating daily NAV and under certain times of panic, must implement a 2% redemption fee. To avoid those harsh terms, funds must increase the holding of U.S. Government paper to 99%, and the changes must be implemented by October 2016. However, earlier this year, several of the largest funds announced plans to implement the change by the fourth quarter of this year. As those funds boost their government exposure to 100% they will likely drive T-Bill yields further into negative territory.

The Fed has flooded the money markets with so much liquidity that we don’t know if they’ll be able to raise interest rates when they finally decide to. It’s not widely understood that when they ultimately decide to raise rates, they don’t simply do so by mandate. Instead, the committee needs to balance the supply and demand of capital such that the marginal demand and marginal supply changes hands at the targeted rate. Prior to the crisis, the amount of intervention to raise interest rates was as little as $2 Billion in asset sales, technically referred to as “reverse repo’s.” But with excess bank reserves amounting to approximately $2 trillion, those reverse repo’s will need to be much larger. Exactly how much? There is no way to model that, nor has the Central Bank suggested an amount. It is widely expected that the Fed will implement an overnight rate corridor with Reverse Repos setting the floor and Interest on Excess Reserves representing the cap. Considering a 25 basis point hike, we expect the range would be a 0.25% floor and a 0.50% cap. Our suspicion is that there is so much liquidity that Fed Funds will rise only to the floor rate. Under that scenario the rate tightening in Fed Funds will only be 11 basis point higher from the 14 basis points at which they are currently trading. Equally unknown is what will happen to the T-Bill market. Our guess is that Bills will continue to trade at a significant premium to the Fed Funds rate. Given the complexities in raising interest rates, it’s no wonder that the markets don’t like a confused message from the Fed.

July 2015

The capital markets continued to demonstrate heightened volatility as investor appetite for risk vacillated between insatiable and intolerant.

Given the surprisingly hawkish tone of the July Federal Open Market Committee statement, we were surprised that the news took a back seat to the plunge in Chinese stocks. The Chinese stock market had been on a tear since late last year, with the broad indices rising more than 50% through June. The Chinese media has reported that there had been an explosion in the growth of retail trading accounts as the Chinese population rushed to get in on what seemed to be easy money. Reminiscent of the dot-com trading boom in the U.S., participants ranged from uneducated workers mortgaging their homes for trading capital to dirt poor farmers abandoning the fields to trade stocks. The buying frenzy peaked in June and almost immediately fell into freefall. By July 6th, the major indices had given nearly all of the gains back. Fearful of the effect of further losses on broad economy, Chinese government officials suspended the trading of most issues and banned selling of those stocks still trading. Several institutional asset managers were told they were no longer permitted to trade Chinese shares. Coinciding with the selloff in Chinese shares, commodity prices have fallen sharply. The assumption is that the commodity swoon was related to the Chinese market with two differing explanations. The first was that macro hedge funds were betting that the Chinese stock market crash would further slow growth in that economy which, in turn, would ultimately crush demand for commodities. The second theory also pointed to hedge funds with the assumption that the funds held leveraged derivative positions in Chinese stocks and were forced to sell their commodities to meet margin calls. We suspect there is a bit of truth to both. What’s certain is that the Chinese government has fully assumed control of their capital markets. In addition to mandating that equity prices don’t go down, they are again maintaining absolute control of the Yuan versus the U.S. dollar.

The dislocation comes at an inconvenient time for the Chinese, as they have applied to the International Money Fund (IMF) to be included in the IMF Special Drawing Rights (SDR) basket. Inclusion in the SDR would afford China the prestige of being considered a reserve currency. Given that they have become a leading exporter and hold significant amounts of foreign reserves would argue that they meet the requirements of being a reserve currency. IMF Managing Director, Christine Lagarde has said that she is in favor of the inclusion of the Yuan in the basket. The trouble is that explicitly rigging their equity and currency markets is not emblematic of a reserve currency. The IMF had until the end of this year to decide on inclusion. Deciding that it would be unlikely to include the Yuan in the SDR with the Chinese markets in such disarray, the IMF announced that they are considering extending the review until September 2016. Such an extension would give the Chinese central planners time to step back from market and currency manipulation. The problem, as we see it, is that there likely remains pent up selling that would cause further losses should the government allow the markets to trade freely and, hence, the government will be very slow to end the tactic. Their actions lead us to conclude that they don’t understand the role confidence plays in the determination of asset prices. In banning selling, they have removed that element of confidence, and with it people’s desire to invest. That loss of confidence may cost them inclusion in the SDR for the time being.

Economic activity continued to accelerate in May, as the weather finally stabilized and recession concerns abated. Despite the improvement, the bond market was mixed, with credit spreads generally wider, especially in the municipal bond market. The continued acceleration in economic activity was underscored by the robust jobs report released on June 5th. Hours after the release of the report, New York Fed President Bill Dudley commented that the Fed is likely to raise interest rates this year, resulting in selling across all maturities of the yield curve.

Aside from employment, there’s no better gauge of economic activity than automobiles and homes. When people are getting jobs, raises, and feeling optimistic about their economic future, they buy cars and homes, and last month they bought a lot of them. During the month, consumers purchased new cars at a 17.7 million annualized rate, exceeding expectations by more than one million vehicles and registering the highest monthly sales level in ten years. Coincidentally, the average age of the cars on the road reached a record 11.4 years, portending that the sales rate should stay high as those older cars are replaced. Similarly, housing starts jumped by 20.2% compared to the prior month, and 9.2% compared to the year earlier period. After the brief hiatus in March, the U.S. economy is again adding in excess of 200,000 jobs a month, which should put us back in the virtuous circle that we’ve been experiencing for the last several years.

While the U.S. bond market continued to experience heightened volatility, the real action lately has been in Europe where local bond markets suffered steep losses. Hedge Funds had been on a buying spree since the European Central Bank announced that it would buy Euro area government bonds in the secondary market. The stated goal was to drive down interest rates and encourage investors to move into riskier debt, which they hoped would stimulate economic activity. The ECB is following the same money printing exercise that the U.S. Federal Reserve and Japanese Central Bank have pursued. The only difference is that the ECB has vowed to buy debt even if it had a negative yield to maturity, effectively paying debtor governments for the privilege of borrowing from them. With that pledge, yields plunged below 0% for many European nations as traders speculated that ECB would drive yield levels ever lower. Days after the program was announced, one trader was quoted as saying that -0.05% offered good value because the price would go higher still as the ECB bought. That would have been correct, unless investors concluded that ultra low rates aren’t worth the risk, which is exactly what happened last month. Yield curves across Europe entered into a “bear steepener,” which is to say that prices sold off across the maturity spectrum with the price of longer maturities falling faster than shorter maturities. For example, the German 10-year note which yielded 0.15% at the end of April, rose to 0.86% in early June, resulting in a 7% drop in price. The price action in the 30-year bond was even worse, falling more than 20% as the yield shot up from 0.62% to 1.50%. Adding to the confusion, ECB Chairman Mario Draghi announced mid-month that the ECB would front-end load their open market purchases this summer citing the lack of liquidity and wish to avoid subjecting the market to heightened volatility during the August holiday season. However, we wonder if by announcing the change in their buying schedule to avoid volatility, they aren’t ensuring it. Opportunistic traders, knowing that the ECB won’t be buying as volume falls in August may be tempted to sell aggressively. Once again, it seems that markets would be better served if Central Banks didn’t “tinker” with policy.

The Fixed Income markets were hampered by weakness in the municipal bond market, as bonds issued by Illinois and Chicago came under selling pressure due to pre-mayoral election jitters and by the seasonal uptick in new issue supply. The concern was that Mayor Rham Emanuel was at risk of losing to the Cook County Commissioner, Jesus Garcia. Investors anticipated that if Garcia were to be elected Mayor, he would cave to union pension and compensation demands and would, thereby, worsen Chicago’s already stressed financial situation. In short, investors feared the city would ultimately go the way of Detroit. While Emanuel certainly cannot be described as a fiscal conservative, since taking the job of Mayor, he’s taken steps to stabilize the city’s shaky finances.   The worry was for naught as Mayor Emmanuel was elected for another four year term. With that, the price of City of Chicago and State of Illinois bonds have rallied somewhat.

The bond market continued to suffer heightened volatility, with the 30-year bond plunging more than five points early in the month, followed by an eight point bounce before settling a little more than a point higher for the period. The heightened volatility has become a source of concern for investors. With the Volker rule sharply curtailing trading desk activity among money center banks, large trades are causing outsized moves. The result has been wild price swings across the yield curve.

The first week of March witnessed two monumental changes in finance; the removal of AT&T from the Dow Jones Industrial Index, and the usurpation of bank supervision by the Board of Governors of the Federal Reserve Board. Dow Jones’ removal means that AT&T will not be part of the index for the first time since 1938. The guardians of the index concluded that Apple better represented a blue chip company than AT&T. The move is inconsequential, as the Dow Jones has long been overshadowed by the broader Standard & Poors 500 Index as a gauge of market performance.

The second change is monumental. The Federal Reserve Bank of New York Fed has long held supervisory oversight over money center banks. Since the financial crisis, the New York Fed has been under criticism for cronyism with the management of those banks. The criticism reached a crescendo several months ago when a former Fed employee produced recordings of senior management directing her to ignore questionable polices that she had discovered at Goldman Sachs. Bill Dudley, the current President of the New York Fed, and former Goldman partner, was grilled by Congress where it was suggested there is a “culture problem” at the Fed. One Senator went so far as to say “either you need to fix it, Mr. Dudley, or we need to get someone who will.” Apparently, the Board of Governors agreed because the change was made without public discussion. We interpret the move as a toughening of oversight and comes on the back of already onerous oversight. For now, the New York Fed will continue oversee monetary policy through the Open Market Desk, but there is speculation that may change as well.