October 2019 Last month we wrote of the technical hiccup in the Repo market, the financing mechanism Wall Street utilizes to borrow money to pay for securities. We identified it as a symptom of too much government borrowing as the U.S. runs wider and wider deficits. To reiterate, the repo market is a little-followed, but […]
September 2019 An esoteric segment of the Fixed Income market not normally followed by the broad investment community is the Repo market (Repo is short for Repurchase Agreement). Repurchase agreements are the mechanism in which U.S. Treasury note and bond positions are borrowed or lent; the so called “grease” of bond market leverage. During the […]
August 2019 Since the interest rate cut at the end of last month, economic data has continued to suggest that the economy is growing moderately despite some trepidation in the manufacturing sector over trade tensions. Despite that fear, services and consumption continue to drive the economy. Moreover, with the workforce at full employment and wages […]
July 2019 The Federal Reserve lowered the overnight Fed Fund rate by 25 basis points as expected, at the conclusion of last month’s FOMC meeting. As is the case following every FOMC meeting, the Fed Chairman gave a press conference with the goal of ensuring market participants understand the thinking of the committee. Typically, the […]
June 2019
Last month we discussed the sudden and dramatic shift in interest rate expectations given the weakness of the May jobs report. We wrote about how that was not the first undershoot this year and that previous misses have been reversed in subsequent releases. It turns out that our guess was right, as the June jobs report, which was expected to show 160,000 net new jobs was actually reported as a gain of 224,000. Anticipating that it would be more than enough to convince the Fed not to raise rates, investors dumped fixed income, causing the yield-to-maturity of the 30-year to jump by nearly 10 basis points by the end of the day, as traders looked forward to Fed Chairman Powell’s testimony before congress the following week. The expectation was that he’d focus on the unexpectedly strong report and walk back the notion that the Open Market Committee would need to reduce rates at the end of July. In doing so he would be able to regain some of the confidence lost this year and avoid exacerbating imbalances already evident in the capital markets. Instead he went full-on “dovish,” denying that the current job market could be described as “hot,” and emphasized the global slowdown occurring outside of the United States. On the day of his testimony to the Senate, the Bureau of Labor Statistics released the Consumer Price Index with the measure exceeding expectations. The Core Index, which excludes food and energy, rose 2.1% year-over-year, above the Fed’s supposed target of 2.0%. Equity investors were euphoric to have better than expected economic data and the Fed preparing to cut interest rates.
We’ve noted on numerous occasions that the average American, when asked what they think their personal annual rate of inflation is, responds that it’s 3%, give or take a few basis points, followed by griping about the runaway cost of healthcare, insurance, and tuition. And yet month after month the BLS reports inflation that is well below that anecdotal rate. Of course the BLS “adjusts” the index in various ways to smooth out the variation and take into consideration the changing basket of goods and product substitution. We’ve always been skeptical of the BLS number and for good reason. Entitlement increases are based on the CPI numbers and the lower they are, the smaller the annual increase. In an effort to square the circle between the official inflation measure and the anecdotal rate of inflation that consumers so often quote we looked to The Conference Board, a private entity not affiliated with the U.S. government. The Conference Board, among other things, conducts a number of surveys of consumer behavior and attitudes which investors study in an effort to understand the health of the economy. Consumer confidence is the report that gains the most attention, but we looked to one of the secondary reports and were surprised by the tale it told. The report, Consumer Inflation Rate Expectation 12-months Hence, showed that since 2001, consumers have not once expected their cost of living in the coming 12 months to rise less than 4.0%. Not once in 216 measurement periods; we’d call that statistically significant! The respondents are the average Americans who base their cost of living projection on the cost of items they buy and not a basket of goods that the statisticians at the BLS massage to make it seem as inflation is not eroding the value of our paychecks. By the way, in the most recent survey the expected cost of living increase for the coming 12 months is 5.1%. And yet when we put pen to paper this time next month the Fed Funds rate is likely to be 25 basis points lower than where it stands today. There’s no wonder that Chairman Powell’s credibility has fallen so rapidly.
Copyright 2019, Halyard Asset Management, LLC. All rights reserved.
May 2019
We’re another month into the U.S.-China trade dispute and it appears that select economic data is softening somewhat. Despite that, we’re reluctant to jump to conclude that economic growth is on the verge of a recession. The most recent indicator to disappoint was the May employment report which indicated an increase of 75,000 new jobs for the month; well below the 175,000 expected. However, there are several factors that need to be taken into consideration. First, the Midwestern United States experienced heavy flooding and, as happens during a snowy winter, extreme weather often depresses job creation. Secondly, job creation has been quite erratic this year. January’s report indicated that the U.S. gained 312,000 jobs followed by 56,000 in February and 153,000 in March. Following the February and March reports market watchers started to worry that the Fed had been too aggressive in raising rates, especially with Trump waging a trade battle. Then, out of the blue, the April employment report showed job growth of 224,000, surprising on the high side.
Contrary to the monthly report, the weekly claims for unemployment insurance continue to come in at a very low rate. The most recent release indicated 222,000 new applications for unemployment insurance. To put that into perspective, at the peak of the crisis applications totaled more than 600,000 per week. Similarly, the JOLTS job opening report indicates that there are more than 7.4 million unfilled job openings. That’s just below the all-time peak in job openings reached last month.
Despite what is arguably full employment, fixed income investors have concluded that the Federal Reserve is going to cut the overnight lending rate to offset economic weakness. On the afternoon of the May employment report, Barclay’s bank forecasted that the Fed will cut rates by 50 basis points at the July meeting. That’s a bold prediction and one that would seem uncharacteristic for the Fed. Based on very little evidence and equity indices that rest just below an all-time high, it seems more likely that the FOMC will be reluctant to preemptively cut rates. They have taken great pains to project themselves as patient and deliberate. Also of consideration, the July report is released on the last day of the month. By that time, the June report will have been released as well as the revision to the May report. In terms of economic data, the steadiness of the U.S. economy could look quite different six weeks from now. The last thing the Fed wants to do is to cut rates and then reverse that cut shortly thereafter.
For sure, a big determinate will be the outcome of trade negotiations. As we’ve written before, a negative outcome will likely slow economic growth as consumers slow their purchases of more expensive Chinese-made goods. Tariffs have a tax-like effect on consumer prices, causing the price index to spike initially. It’s impossible to forecast the longer term impact on economic growth but suffice it to say that it wouldn’t be good for either country. It would appear that President Trump is betting that the impact to the Chinese market would be more damaging than it would be on the domestic market and, as such, the Chinese are more motivated to reach a near-term agreement. In the interim, the uncertainty of the outcome has wreaked havoc on the U.S. bond market as investors scramble for Treasury bonds.
On the other hand, should the U.S. and China reach an agreement and tariffs are successfully avoided it could be quite beneficial to our economy. Hopefully by this time next month we’ll have a successful resolution and we can begin worrying about the debt ceiling battle later this summer and a no-deal Brexit shortly thereafter.
Copyright 2019, Halyard Asset Management, LLC. All rights reserved.
April 2019
As we’ve written for the last few years, interest rates across the yield curve are too low given the strong economic backdrop. Testament to its sustainability, the U.S. economy has continued to grow despite the behavior of politicians on both sides of the aisle and the Atlantic Ocean. The sharp drop in interest rates from the fourth quarter of last year through January was due in part to the U.S. government shutdown. That was followed by an even lower yield in March as Great Britain approached their BREXIT deadline. After the U.K. and the E.U. kicked the BREXIT can down the road, U.S. investors returned to complacency and volatility fell out of the stock and bond markets. However, that abatement was not to last as Donald Trump’s attempt to reach a trade and intellectual property agreement with the Chinese fizzled. The market impact has been the same as the previous two episodes; stock prices and interest rates both falling precipitously. Economists and political pundits are forecasting that an outright trade war is unlikely but warn that should such an event come to pass it would be detrimental to the economy.
Earlier this month the Trump administration levied a 25% tariff on an additional $200 Billion of Chinese imports. In response, China will impose a similar tariff on $60 billion U.S. goods shipped to China. The overwhelming majority of those Chinese imports are food and energy. Because the trade balance between the U.S. and China is so lopsided in favor of Chinese exporters, which is the reason for the trade war, a prolonged war is not likely to tip the U.S. economy into recession. But with virtually all Chinese imports being subject to tariff, there’s likely to be an uptick in inflation and some business disruption. A large percentage of goods sold at companies like Walmart and Amazon are imported from China. With their narrow profit margins, neither company will be able to absorb the increased cost of goods sold and will need to pass the cost increase onto consumers. The typical Walmart shopper is a budget-constrained consumer and is in no position pay 25% more for any of their purchases. They will be forced to either buy less of their typical basket of goods or substitute a U.S. made product for the Chinese made good. The latter is, after all, the object of the war. But given the dependence of the American buyers on Chinese made goods, a near term substitution is likely to be problematic. With that, we envision a situation where GDP expands initially due to the heightened cost of goods sold, but GDP ultimately takes a hit because economic activity slows as goods become unaffordable and retailers need to cut costs by firing workers. Trump has been upbeat about the situation and has promised to have a meeting with Premier Xi at the G20 meetings later this month. But that doesn’t ensure that the tariffs don’t start to bite this summer. It’s no wonder the capital markets are in a bit of a panic.
With the risk of failed negotiations rising, speculators have raised the likelihood of a Fed Funds rate cut and now expect a 25 basis point cut by the end of this year and another 25 basis point cut in 2020. In fact, Trump is already calling for the Federal Reserve to cut rates to support the trade war. We are at a loss as to what a rate cut would do for the trade war, but Trump has made it a habit of badgering the Fed to cut rates.
Continuing with the Federal Reserve, the central bank issued a rare warning about the riskiness of the leveraged loan market, warning investors that the credit quality of the broad market has deteriorated and that prices are likely to come under severe pressure in the next downturn. We would take that a step further and spread that warning to the BBB-rated component of the investment grade market. We’ve analyzed more than a few companies that have questionable balance sheets and deem their BBB-rating to be one or two quarters from being downgraded into junk territory. The worry with such a situation is the junk bond buying universe is much smaller than the investment grade universe which is likely to exacerbate an otherwise challenging situation.
Copyright 2019, Halyard Asset Management, LLC. All rights reserved.
March 2019
Investor perception has turned with regard to fundamental economic activity and the pricing of interest rates. The Federal Reserve has targeted the Fed Funds rate at approximately 2.42% while the yield on the 5-year Treasury note is 2.30%. That the 5-year note yields less than the overnight rate is known as an inversion and typically a sign of an unhealthy market. When the yield curve inverts, it indicates that investors expect the average overnight rate for that term will be below that of the current overnight rate. In essence, investors are locking in the rate for 5 years before the Fed cuts rates. We believe that given current economic fundamentals, the thought that the Fed will lower rates is ridiculous. And yet one well-respected professional investor wondered if the Fed would be forced to cut interest rates to meet the expectations of investors. Given the degree of confusion the Fed has created, the question, which would normally be considered absurd, is a valid concern. In addressing that concern, the ultra-dovish Minneapolis Fed President, Neel Kashkari, said that he didn’t believe that an immediate rate cut is justified. Of course it isn’t justified! Rates have fallen because the Fed is buying bonds and plans to cease balance sheet runoff in May, meaning they will be buying even more bonds. It’s foolish to look to the bond market as an economic indicator because the Fed is manipulating the indicator. They could look at the unemployment rate which stand at 3.8%, only 0.1% higher than the low touched this century, or the 7 million jobs that are available but remain unfilled. Similarly, for the week ending March 30, initial claims for unemployment insurance totaled 202,000, the lowest level since 1969. To put that into perspective, the workforce in 1969 according to the Federal Reserve of St. Louis was approximately 81 million workers. As of February the workforce totaled more than 163 million.
But employment has historically been a lagging indicator and perhaps those unfilled jobs will go away with a recession. Counter to that argument is the S&P 500 which has recovered from the hedge fund dump that happened in December and now stands just below its all-time high.
Since the dovish about face in December, the clear beneficiaries are the rate sensitive industries. After nearly a year of disappointing sales, auto sales in March registered an annualized 17.5 million units, well above consensus expectations. Similarly, since the beginning of the year mortgage applications have skyrocketed with purchases climbing nearly 10% and refinancing jumping an eye popping 58% year-over-year, respectively.
Much has been written about how much of a role Donald Trump played in the Fed’s policy reversal with most concluding that Chairman Powell caved to Presidential pressure. The Fed board members have sought to downplay the President’s role, but that has done little to change consensus thinking. What seems obvious is that Trump believes that his cajoling was effective and that the rally in stock prices this year is to his credit. What also seems clear is that he believes cutting interest rates would be even better. The “more is better” mentality seems to now extend beyond browbeating Powell, to stocking the board with Governors sympathetic to Trump’s wishes. For the most part, the Federal Reserve Board has been above politics and the Fed Chairmen have avoided having politics play a role in their decision making. To change that policy risks damaging the economy for years or even decades to come. The reason why the Fed tightens monetary policy when activity is robust and eases policy when activity slows is to attempt to balance employment and inflation with steady growth. At this stage of the economic cycle a 3.00% Fed Funds rate is arguably a sensible neutral rate. Instead, Trump is advocating cutting interest rates and reintroducing bond buying in an attempt to reaccelerate growth. As a mature economy, the U.S. is going to have a natural growth rate of between 2% to 3%. To push growth above that pace is certain to come with consequences.
Copyright 2019, Halyard Asset Management, LLC. All rights reserved.
February 2019
It would appear that economic pundits believe that the U.S. economy is either sustainably robust or faltering and on the verge of recession. Certainly, Central Bankers around the globe are suspiciously reassuring that economic growth is just right and in case things go awry, they stand ready and able to act. Much as Fed Chairman Powell did in his speech last month, European Central Bank President Mario Draghi gave a sobering assessment of the European economy, recognizing that business activity in the region has slowed materially. In response, he vowed to not raise interest rates in 2019 and to reimplement the Targeted Long-Term Refinancing Operation for the third time (TLTRO III). TLTRO is the program in which the ECB issues low cost loans to European Banks with the idea that the banks will turn around and relend the cash to borrowers, thereby stimulating growth. At least that is the stated goal of the program. In reality, the reimplementation is being put in place because the previous TLTRO is rolling off and the ECB needs to head off a funding crisis of their own creation. Despite the dovish turn in policy, we doubt that it will result in anything more than tepid growth in the region. As we’ve discussed on several occasions, we think that the problem with economic growth in Europe is structural. Monetary policy can provide a short term burst to activity but the socialist tendencies and high consumption tax will keep the economy from growing rapidly.
Also during the month, Bank of England Governor Mark Carney reversed his opinion of the consequences to the economy should the United Kingdom leave the European Union without an agreement on trade. In November, Carney opined that should a no-deal BREXIT come to pass, the economy could contract as much as 7% and the exchange rate for the Pound Sterling could fall as much as 25% against the Euro and the U.S. dollar. On Thursday he tempered that forecast saying that the economic impact would only be about half of what he originally forecast. Nonetheless, a contraction of economic activity on the order of 3% in the U.K. is likely to have repercussions for U.K. as well as continental Europe. At the time of this writing, with two weeks until the so called divorce date, no solution for an amicable split from the European Union exists. Ironically, the FTSE 100 is 5% higher, with interest rates and the value of the Pound Sterling marginally unchanged over the first two months of the year. One can only guess at the value of those markets one month from now.
Turning to the U.S., despite the “full court press” of dovish comments by the various members of the FOMC, economic growth continues to impress. On the last day of February, Q4 2018 GDP was released, showing 2.6% quarter-over-quarter growth, annualized. That outcome was surprising given that consensus was expecting at 2.2%. Even more impressive, when compared to the Q4 2017, growth for the period registered 3.1%. Moreover, that growth was achieved despite an abysmal month for stock prices and concern the economy was on the verge of recession. Despite that gloomy end to year, stocks have demonstrated impressive resilience, rallying 11% in the first two months of this year. That comes on the back of solid growth in fourth quarter earnings. Equity investors are again “climbing the wall of worry” investing in stocks despite the government closure that started the year and the on-again off-again trade negotiations between the U.S. and China. The big question is how investors will react when the U.K. and the Europe Union finally split.
Copyright 2019, Halyard Asset Management, LLC. All rights reserved.
January 2019
The January Federal Open Market Committee (FOMC) meeting yielded no rate hike and a dovish outlook for interest rates, as expected. Chairman Powell concluded this meeting with a press conference as will be the convention following every FOMC meeting going forward. The standard to date had been to have a press conference every other meeting. Our guess is that he would have preferred to skip this one given his marked about-face on interest rates. Typically, the Chairman is lobbed “softball” questions in a tacit understanding that the media doesn’t want to embarrass him. Such was especially the case with the thin-skinned previous Chairs Bernanke and Yellen. However, in a break from that understanding, Chairman Powell was bluntly asked pointed questions such as, “is the Fed at the end of rate hike cycle, what would it take for interest rates to rise, has the risk of recession increased, and is trade policy influencing the FOMC decision making.” Those are all questions the Chairman would prefer not to answer since they directly affect the capital markets and pose the risk of him being wrong again. He is now clearly perceived as having been wrong back in September when he said the Fed Funds rate was nowhere near the neutral rate. What’s worse, one questioner asked if there was now a Powell equity put in place. The insinuation, of course, is that’s now the conventional wisdom. The idea of a FOMC put originally came into play when Alan Greenspan cut rates sharply in the wake of the 1987 stock market crash. With each subsequent large market correction, the Fed would ease monetary policy conditions. The more severe the correction, the more severe the easing of monetary policy. Until it reached the absurdity that we’ve witnessed in the wake of the 2008 financial panic with 0% interest rates and the Fed buying more than $4 Trillion in government debt.
Chairman Powell’s hawkish tone and December rate hike panicked investors and resulted in the sharp fall in stock prices. He reacted by reversing his hawkish rhetoric and assessment of interest rates. We think there’s a very good chance that reversal will come back to haunt him later this year. The economy continues to demonstrate robust strength. The January employment report showed that 304,000 new jobs were created in the month; a shocking amount of job creation given this stage of the cycle. In addition, average hourly earnings rose 3.2% over last year’s reading, down 0.1% from last month but the highest rate of change since 2009. It wasn’t that long ago that economists were bemoaning that wage grow couldn’t break above 2%. To be fair, consumer confidence and softer measures of economic activity such as manufacturer surveys are portraying a slowing in economic activity, but we argue that it’s self-inflicted damage from the White House and Congress. Despite the stories about government workers who were unable to pay the mortgage, put food on the table and purchase necessities for the family, the shutdown effected a very small subset of the population. However, it had the collateral effect of depressing the general confidence of the country as a whole. Whether in agreement with the strategy or against, it’s hard to argue that it didn’t have a negative impact on consumer sentiment.
Similarly, the trade battle with China has gone back and forth from being close to resolution to seeming likely to drag on for a very long time. The effect on the U.S. economy so far has been muted, at best, but a number of companies that operate on a global scale have reported that tariffs are impacting their business. If the two countries are able to arrive on a solution in the near-term, either real or perceived, that would bode very well for market sentiment and consumer confidence. If unable to reach a compromise, the earnings of global companies will come under pressure. The worry is that the contraction in those companies could have a contagion effect to domestic business and the consumer as a whole. In that instance, economic growth would be at risk.
Copyright 2019, Halyard Asset Management, LLC. All rights reserved.