Happy Holidays
2011 Outlook
The Holidays are here and 2011 will soon be upon us. With liquidity scare from now through year-end 2011 should be the focus of all fixed income investors. 2011 is going to tell us much. It will tell us if the EU will hold together. It will tell us if the euro can survive as a currency. It will tell us if centralized monetary policy and localized fiscal policies is a feasible model in the long-term. 2011 will also tell us what a non-bubble U.S. expansion looks like.
Europe is going to be interesting. Its problems are not going to be solved with bailout funds and strong language. Troubled countries are either going to cut benefits to its citizens, adopt pro-growth policies or leave the euro and try to devalue their way out of their problems. The list of troubled countries may be expanding. Belgium may join the PIIGS among troubled European countries. I still haven’t come with a new acronym. The bottom line is that Europeans have some difficult choices to make.
One choice which will probably not be available is to continue with their market / welfare state hybrid while being part of a common currency. The ECB can do little to help distressed countries because it can’t ease or engage in QE to help a country like Greece without damaging the economies of countries like Germany. One way to solve this dilemma would be to give the EU the authority to dictate both fiscal and monetary policy for the entire bloc, a United Stated of Europe if you will. However, that would require member countries to give up their sovereignty and adhere to rules set by a central governing body. This will not go over well among the European populace. Although its demise is not certain make no mistake, the euro is in trouble.
Closer to home we will soon see what the economic potential of a non-bubble-fueled U.S. economy looks like. Economic data during the first half of 2011 will be positively affected by the extension of the Bush-era tax cuts and the suspension of the worker portion of the payroll tax. However as with all temporary stimulus measures, the benefits are likely to be short-lived and less affective than anticipated. By the end of 2011, the U.S. economy will have to fly on its own power. Not all stimulus will be removed. It is unlikely that the Fed will engage in QE3, but it is unlikely to raise rates in 2011.
Long-term rates may not have far to rise in 2011. The recent rise of long-term rates is mostly a correction following a smaller than anticipated QE2 program and better growth outlook. Current long-term rates probably have GDP between 3.50% and 4.00% mostly built in. We could see a 4.00% 10-year note by the end of 2011, but maybe not much higher. If the economy cannot gain more traction, long-term rates could languish in the mid-3.00% area. In fact, Philadelphia Fed President Charles Plosser, who has been one of the more hawkish and optimistic Fed officials gave his 2011 estimate today. He forecasts that 2011 will be in the 3.00% to 3.50% area.
Fixed income investing in this environment is not that difficult, if one manages expectations. Ladder your portfolio. Resist swapping into “sexy” products or overweighting on the long end of the curve (or the short end of the curve). Invest new money on the belly of the curve (5-10 years) unless that runs counter to your goals, objectives or risk tolerances. TIPS are rich. The break even between 10-year TIPS and the 10-year treasury is 230 basis points. With inflation likely to be tamer than what the alarmists are predicting us TIPS only as hedging vehicle. Watch out for bubbles in very-low-rated bonds (low B and CCC) and a correction in investment grade industrials. Financials, insurance and, to a lesser extent, telecom offer the best values.
Investors should consider callable agency bonds, including step-ups. I also believe that corporate step-ups offer value, more than do LIBOR-based floaters. CPI corporate floaters may be a better option. Not because inflation is going to run, but because even modest increases in inflation will be greater than what occurs in three-month LIBOR (the typical benchmark for floaters) as it is joined at the hip with Fed Funds and the Fed is not budging in 2011. Not unless housing takes off, removing significant headwinds facing the economy, but that probably will not happen.
Until next year.
Wednesday, December 22, 2010
Wednesday, December 15, 2010
Right Said Fed
The November Advance Retail Sales came in better than expected as generous discounts and more optimistic consumers kicked off the holiday shopping season in a big way. Target and Macys were among the retailers reporting strong sales in November, largely due to impressive Thanksgiving sales.
One economist told Bloomberg News:
"Holiday sales are looking pretty good. Consumer spending will steadily improve in coming months. We're seeing a better overall economic outlook."
The street consensus if for improved consumer spending, but considering how poor consumer spending had been, even a big improvement could still leave consumer spending below to what we have become accustomed this far into a recovery. With unemployment expected to remain high and the housing market likely to remain impaired for several more years, consumer spending will likely rise slowly,
A sign that consumer spending is more than holiday driven is the report by Home Depot which indicated that sales of plumbing and electrical supplies rose. Although it is possible that many handy people are going to get what they want for Christmas, Home Depot's results look to be a sign that the pick up in consumer spending is more broadly based. On the down side, electronics retailer Best Buy reported worse-than-expected earnings as discounters such as Amazon and Wal-Mart are providing stiff competition
The headline PPI figure was up .8% versus a prior number of .4% (month-over-month) However, core PPI (MoM) came in at .4%, the smallest increase in five months. Much of the core PPI gain was due to higher energy prices (although egg prices were up a whopping 23%). How much will this influence CPI? Probably not that much. High unemployment, reduced household wealth and a fierce battle for market share are preventing businesses from passing price increases onto consumers. Raising prices is an almost sure way to lose market share in this environment. Instead businesses increase productivity by purchasing more efficient equipment or send jobs to lower-labor regions. This is helping to moderate the employment recovery.
The Fed will announce its rate decision this afternoon, there should be no surprises. The Fed will leave the Fed Funds target rate at between 0.00% and 0.25%. It is likely to reinforce its commitment to QE2, but its statement may very well have a more positive tone as to the strength and pace of the recovery.
The question which is being asked across the industry (across the country, actually), is: Is QE2 working. One could argue is that QE2 has sparked inflation fears in many areas of the economy, but has not helped to boost prices in the sector for which the Fed had hoped to see higher prices, real estate. However, some experts believe that Fed policies are working.
In today's Wall Street Journal, Wharton Professor Jeremy Siegel opines that QE2 is working and the sign that is working is higher treasury yields. Higher yields in among U.S. treasuries have been pointed to as a sign that Fed policy has been a failure based on the belief that QE2 has pushed bond yields and mortgage rates higher due to increased inflation fears because the Fed is causing the government to print money. This is the so-called vigilante theory.
Mr. Siegel argues that the real reason rate have been rising is that the bind market is becoming more optimistic that the economic recovery is strengthening, He states:
"Long-term Treasury rates are influenced positively by economic growth-which encourages consumers to borrow in anticipation of higher incomes and causes firms to seek funds to expand capacity-and by inflationary expectations. Long-term Treasury rates are affected negatively by risk aversion: Seeking a safe haven, investors pile into Treasury bonds, running up their prices and lowering their yields."
Mr. Siegel gets no argument from us, but bond yields are up for a variety of reasons. One reason is certainly due to better growth prospects. However, some of it is due to inflation fears due to the printing of money (we would argue that most of the vigilantism was in response to the tax cut extensions). Seemingly lost in this discussion is that fact that in the months leading up to the launch of QE2, many market participants purchased large amounts of U.S. treasuries on the beliefs that the size of QE2 would be much larger (some thought it would be nearly twice the size of what actually launched) and that the Fed would also target the very long end of the yield curve. Neither scenario played out.
There has been much talk about how the bull market in binds is over. No kidding, When the 10-year treasury note was around 2.50%, did any responsible person really believe it was going much lower (higher in price)? And if so, did any responsible person really believe it would stay there for a long period of time. Look at where long-term U.S. interest rates are, currently. If they rose 50 or even 100 basis points they would still be on the historically low side.
Just because the bull market is over does not mean that the bear market will push rates bank to what were common in the early 1980s. It does not even mean that they will rise to where they were in the early 1990s. All it means is that the probabilities for a double-dip recession of lessened and that the market has readjusted. Of course if one has laddered and diversified one's portfolio, one probably has little angst over where rates are going.
One economist told Bloomberg News:
"Holiday sales are looking pretty good. Consumer spending will steadily improve in coming months. We're seeing a better overall economic outlook."
The street consensus if for improved consumer spending, but considering how poor consumer spending had been, even a big improvement could still leave consumer spending below to what we have become accustomed this far into a recovery. With unemployment expected to remain high and the housing market likely to remain impaired for several more years, consumer spending will likely rise slowly,
A sign that consumer spending is more than holiday driven is the report by Home Depot which indicated that sales of plumbing and electrical supplies rose. Although it is possible that many handy people are going to get what they want for Christmas, Home Depot's results look to be a sign that the pick up in consumer spending is more broadly based. On the down side, electronics retailer Best Buy reported worse-than-expected earnings as discounters such as Amazon and Wal-Mart are providing stiff competition
The headline PPI figure was up .8% versus a prior number of .4% (month-over-month) However, core PPI (MoM) came in at .4%, the smallest increase in five months. Much of the core PPI gain was due to higher energy prices (although egg prices were up a whopping 23%). How much will this influence CPI? Probably not that much. High unemployment, reduced household wealth and a fierce battle for market share are preventing businesses from passing price increases onto consumers. Raising prices is an almost sure way to lose market share in this environment. Instead businesses increase productivity by purchasing more efficient equipment or send jobs to lower-labor regions. This is helping to moderate the employment recovery.
The Fed will announce its rate decision this afternoon, there should be no surprises. The Fed will leave the Fed Funds target rate at between 0.00% and 0.25%. It is likely to reinforce its commitment to QE2, but its statement may very well have a more positive tone as to the strength and pace of the recovery.
The question which is being asked across the industry (across the country, actually), is: Is QE2 working. One could argue is that QE2 has sparked inflation fears in many areas of the economy, but has not helped to boost prices in the sector for which the Fed had hoped to see higher prices, real estate. However, some experts believe that Fed policies are working.
In today's Wall Street Journal, Wharton Professor Jeremy Siegel opines that QE2 is working and the sign that is working is higher treasury yields. Higher yields in among U.S. treasuries have been pointed to as a sign that Fed policy has been a failure based on the belief that QE2 has pushed bond yields and mortgage rates higher due to increased inflation fears because the Fed is causing the government to print money. This is the so-called vigilante theory.
Mr. Siegel argues that the real reason rate have been rising is that the bind market is becoming more optimistic that the economic recovery is strengthening, He states:
"Long-term Treasury rates are influenced positively by economic growth-which encourages consumers to borrow in anticipation of higher incomes and causes firms to seek funds to expand capacity-and by inflationary expectations. Long-term Treasury rates are affected negatively by risk aversion: Seeking a safe haven, investors pile into Treasury bonds, running up their prices and lowering their yields."
Mr. Siegel gets no argument from us, but bond yields are up for a variety of reasons. One reason is certainly due to better growth prospects. However, some of it is due to inflation fears due to the printing of money (we would argue that most of the vigilantism was in response to the tax cut extensions). Seemingly lost in this discussion is that fact that in the months leading up to the launch of QE2, many market participants purchased large amounts of U.S. treasuries on the beliefs that the size of QE2 would be much larger (some thought it would be nearly twice the size of what actually launched) and that the Fed would also target the very long end of the yield curve. Neither scenario played out.
There has been much talk about how the bull market in binds is over. No kidding, When the 10-year treasury note was around 2.50%, did any responsible person really believe it was going much lower (higher in price)? And if so, did any responsible person really believe it would stay there for a long period of time. Look at where long-term U.S. interest rates are, currently. If they rose 50 or even 100 basis points they would still be on the historically low side.
Just because the bull market is over does not mean that the bear market will push rates bank to what were common in the early 1980s. It does not even mean that they will rise to where they were in the early 1990s. All it means is that the probabilities for a double-dip recession of lessened and that the market has readjusted. Of course if one has laddered and diversified one's portfolio, one probably has little angst over where rates are going.
Friday, December 3, 2010
Make Up Your Mind
Just when it you thought it was safe to believe that the economy was gaining some steam, today's data poured water on the fire. Nonfarm payrolls came in with a disappointing 39,000 new jobs in the month of November. Even when one considers the upward revision of 21,000 jobs for the October that only equals a total of 60,000 new jobs. The two-month average of approximately 105,000 new jobs per month, roughly half the number of jobs needed to lower the unemployment rate.
The private payrolls data, considered to be a better measure of unemployment recovery, due to the importance of the private sector in the U.S. economy, was also disappointing reporting only 50,000 new jobs with an upward revision of 1,000 additional jobs to the October data. This is quite a disappointment given last Wednesday’s better-than-expected ADP employment data.
Not surprisingly the markets initially reacted negatively to the data then recovered significantly. The reason for the recovery was said to be the belief that payrolls data for November may be a negative outlier. Supporters of this theory point to the strong ADP number. I cry foul on this. Why do I cry foul? The ADP report (a measure of private payrolls) has undershot the private payrolls component of the establishment survey. Critics have pointed to this and decried the ADP report as being unreliable as it underestimates the employment recovery. Not with the ADP report overshooting today’s private sector data, it is ADP which is being called accurate and the establishment data is now deemed to be unreflective of the job market recovery.
Beware of pundits, market participants and strategists who cherry-pick data for their own needs. Economists put far more value in the Nonfarm Payrolls data and its private sector component for a reason. It is more broad-based and tells a more complete and accurate story. Blind market bulls cannot have it both ways,
As if the Nonfarm Payrolls report wasn’t depressing enough, the Unemployment Rate report offered no comfort. The unemployment rate rose to 9.8% from 9.6%. Often during an economic recovery the unemployment rates will trend higher as discouraged displaced workers become more optimistic and answer the so-called household survey that they are now looking for work. However, that was not the case this time around. The unemployment rate rose due to more Americans being laid off.
I don’t often find much valuable commentary on CNBC. I believe that CNBC really stands for Constantly Naively Bullish Channel. However, today one guest speaker (whose name I did not hear) made a poignant observation. He stated that maybe the impact of technology on productivity is being underestimated and the impetus for large-scale hiring just isn’t there, in spite of the pick up in economic activity. I have heard that before, but I can’t remember where. ;)
Today’s soft jobs data should not come as a complete surprise. Fed Chairman Bernanke has been warning that the economic recovery is sluggish and job growth is impaired. This is why the Fed engaged in QE2 and could very well leave the Fed Funds rate unchanged well into 2012.
Fed policy is causing some inflation concerns. This is not surprising as the Fed as acknowledged it is trying to accomplish just that. However, the benchmark from which to gauge the bond market’s inflation concerns has changed. For almost a decade, the 10-year treasury note was the long-term benchmark for inflation concerns. This was because of the suspension of 30-year government bond issuance in 2001 and because a comparatively small float (amount issued) compared with the 10-year since 30-year auctions resumed a few years ago. Now with Fed making about 1/5th of its purchases in the 10-year area, the 10-year yield, although higher recently, is probably too low to accurately reflect inflation concerns. The long bond has regained its status as the long-term inflation benchmark.
What does the long bond yield tell me? That inflation pressures may increase, but there is no need to buy a wheel barrow to haul grocery money to the store. Sure, we could see 5.00% by 2012, but I doubt we will see inflation strong enough to push long-term rates much higher, not unless we can create another bubble.
There is a debate as to what is and isn’t inflation. There is a stupid YouTube video circulating explaining QE2 and why it makes not sense. The video appears to have been made by an Intellectually-challenged NPR intern using a kiddy V-Tech computer. The video asks why the Fed does not see inflation when food, energy, healthcare and tuition costs are higher.
Obviously this gadfly does not understand demand curves and taxes on consumption from price increases in sectors which have inelastic demand curves. He or she also does not understand that producers cannot pass price increases through to consumers. I don’t know about you, but I am paying less for clothing, vehicles, electronics and various other goods and services.
The area experiencing severe deflation is housing. Not only is the Fed largely responsible for the small amount of inflation pressures we are experiencing, but it is the only thing standing in the way of a collapse in housing prices.
I am not defending the Fed. I am only explaining why it is concerned with deflation and why it has engaged in QE2. If it were up to me I would let home prices reset to levels at which people could afford to purchase them. There are many people who cannot obtain a mortgage for a $500,000 home, but could for a $300,000 home. However, letting prices reset would not only blow up many influential investors in mortgage securities, it could impair the banks, including some large banks. The Fed does not want FC2 (Financial Crisis 2). QE2 is much more palatable. However, it will extend the time needed to turn the economy around, not until the glut of available homes is absorbed by the market will the economy recover.
The private payrolls data, considered to be a better measure of unemployment recovery, due to the importance of the private sector in the U.S. economy, was also disappointing reporting only 50,000 new jobs with an upward revision of 1,000 additional jobs to the October data. This is quite a disappointment given last Wednesday’s better-than-expected ADP employment data.
Not surprisingly the markets initially reacted negatively to the data then recovered significantly. The reason for the recovery was said to be the belief that payrolls data for November may be a negative outlier. Supporters of this theory point to the strong ADP number. I cry foul on this. Why do I cry foul? The ADP report (a measure of private payrolls) has undershot the private payrolls component of the establishment survey. Critics have pointed to this and decried the ADP report as being unreliable as it underestimates the employment recovery. Not with the ADP report overshooting today’s private sector data, it is ADP which is being called accurate and the establishment data is now deemed to be unreflective of the job market recovery.
Beware of pundits, market participants and strategists who cherry-pick data for their own needs. Economists put far more value in the Nonfarm Payrolls data and its private sector component for a reason. It is more broad-based and tells a more complete and accurate story. Blind market bulls cannot have it both ways,
As if the Nonfarm Payrolls report wasn’t depressing enough, the Unemployment Rate report offered no comfort. The unemployment rate rose to 9.8% from 9.6%. Often during an economic recovery the unemployment rates will trend higher as discouraged displaced workers become more optimistic and answer the so-called household survey that they are now looking for work. However, that was not the case this time around. The unemployment rate rose due to more Americans being laid off.
I don’t often find much valuable commentary on CNBC. I believe that CNBC really stands for Constantly Naively Bullish Channel. However, today one guest speaker (whose name I did not hear) made a poignant observation. He stated that maybe the impact of technology on productivity is being underestimated and the impetus for large-scale hiring just isn’t there, in spite of the pick up in economic activity. I have heard that before, but I can’t remember where. ;)
Today’s soft jobs data should not come as a complete surprise. Fed Chairman Bernanke has been warning that the economic recovery is sluggish and job growth is impaired. This is why the Fed engaged in QE2 and could very well leave the Fed Funds rate unchanged well into 2012.
Fed policy is causing some inflation concerns. This is not surprising as the Fed as acknowledged it is trying to accomplish just that. However, the benchmark from which to gauge the bond market’s inflation concerns has changed. For almost a decade, the 10-year treasury note was the long-term benchmark for inflation concerns. This was because of the suspension of 30-year government bond issuance in 2001 and because a comparatively small float (amount issued) compared with the 10-year since 30-year auctions resumed a few years ago. Now with Fed making about 1/5th of its purchases in the 10-year area, the 10-year yield, although higher recently, is probably too low to accurately reflect inflation concerns. The long bond has regained its status as the long-term inflation benchmark.
What does the long bond yield tell me? That inflation pressures may increase, but there is no need to buy a wheel barrow to haul grocery money to the store. Sure, we could see 5.00% by 2012, but I doubt we will see inflation strong enough to push long-term rates much higher, not unless we can create another bubble.
There is a debate as to what is and isn’t inflation. There is a stupid YouTube video circulating explaining QE2 and why it makes not sense. The video appears to have been made by an Intellectually-challenged NPR intern using a kiddy V-Tech computer. The video asks why the Fed does not see inflation when food, energy, healthcare and tuition costs are higher.
Obviously this gadfly does not understand demand curves and taxes on consumption from price increases in sectors which have inelastic demand curves. He or she also does not understand that producers cannot pass price increases through to consumers. I don’t know about you, but I am paying less for clothing, vehicles, electronics and various other goods and services.
The area experiencing severe deflation is housing. Not only is the Fed largely responsible for the small amount of inflation pressures we are experiencing, but it is the only thing standing in the way of a collapse in housing prices.
I am not defending the Fed. I am only explaining why it is concerned with deflation and why it has engaged in QE2. If it were up to me I would let home prices reset to levels at which people could afford to purchase them. There are many people who cannot obtain a mortgage for a $500,000 home, but could for a $300,000 home. However, letting prices reset would not only blow up many influential investors in mortgage securities, it could impair the banks, including some large banks. The Fed does not want FC2 (Financial Crisis 2). QE2 is much more palatable. However, it will extend the time needed to turn the economy around, not until the glut of available homes is absorbed by the market will the economy recover.
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