I interrupt my vacation to bring you an update on the markets. Although I am not in my battle chair the view from my mountain is quite clear.
The yield of the 10-year U.S. treasury has been rising all this week and was 3.12% at my last observation today. Some have been pointing to the end of QE2 and the lack of Fed buying of U.S. treasuries for higher long-term interest rates. Bear scat! The reason for the selloff of U.S. treasuries is the approval of austerity measures by the Greek Parliament and the reduced probabilities of default and contagion.
Speaking of Greece (and bear scat), German banks have agreed to voluntarily exchange their Greek debt with maturities out to 2014 for longer dated Greek debt. It is not yet clear if the ratings agencies will consider it a default. If it walks like a duck and quacks like a duck... you get the picture.
Well that it is all for now. Jusqu’a semaine
Thursday, June 30, 2011
Friday, June 24, 2011
Mid-Year Review
Yes folks, it is that time of the year. It is the time of the year for me to take a holiday. For the following two weeks, Making Sense will be conspicuously absent from you inbox. Fear not, I will be back on July 11th.
But before I go, we would like to recap the first half of 2011. Here goes:
The recovery was sluggish; the natural disasters in Japan, the sovereign debt crisis in Europe, a declining housing market and poor job growth conspired to send long-term interest rates lower. This was especially true following the Fed's decision to end QE2 purchases at the end of June, but to continue to reinvest maturing assets.
The Fed's decisions to end QE2 bond purchases sent the blogosphere into a tizzy with predictions of spiking interest rates due to a lack of demand for U.S. treasuries once the Fed ceased purchasing U.S debt. Surprise! Rates went in the other direction as most of the alarmists (few of whom were actually fixed income market participants) failed to understand that the cessation of QE2 was potentially disinflationary (think quantitative tightening).
What does the second half of the year hold in store? The consensus forecast among Wall Street economists calls for sluggish economic growth. Headline CPI (including food and energy) is forecast to run at an annual rate of 3.00% for 2011 before falling to 2.20% for 2012. If this forecast is anywhere close to reality there should only be modest pressure on long-term interest rates and almost no change to short-term rates, such as Fed Funds and Three-Month LIBOR. In fact, it is not inconceivable that the Fed keeps Fed Funds unchanged throughout all of 2012.
This is not to say that there will be no Fed tightening. Should the Fed cease reinvesting its maturing QE assets or begins to sell them, that would be a form of (quantitative) tightening. The Fed could, in theory, sell its QE assets and effectively raise policy rates approximately 100 basis points without touching the Fed Funds rate (see Taylor Rule).
Don't look for consumers to ride to the rescue. They are deleveraging and will continue to do so. Gone are the days of easy credit and a new SUV every two years. This is a healthy, but painful development.
See ya in two weeks.
But before I go, we would like to recap the first half of 2011. Here goes:
The recovery was sluggish; the natural disasters in Japan, the sovereign debt crisis in Europe, a declining housing market and poor job growth conspired to send long-term interest rates lower. This was especially true following the Fed's decision to end QE2 purchases at the end of June, but to continue to reinvest maturing assets.
The Fed's decisions to end QE2 bond purchases sent the blogosphere into a tizzy with predictions of spiking interest rates due to a lack of demand for U.S. treasuries once the Fed ceased purchasing U.S debt. Surprise! Rates went in the other direction as most of the alarmists (few of whom were actually fixed income market participants) failed to understand that the cessation of QE2 was potentially disinflationary (think quantitative tightening).
What does the second half of the year hold in store? The consensus forecast among Wall Street economists calls for sluggish economic growth. Headline CPI (including food and energy) is forecast to run at an annual rate of 3.00% for 2011 before falling to 2.20% for 2012. If this forecast is anywhere close to reality there should only be modest pressure on long-term interest rates and almost no change to short-term rates, such as Fed Funds and Three-Month LIBOR. In fact, it is not inconceivable that the Fed keeps Fed Funds unchanged throughout all of 2012.
This is not to say that there will be no Fed tightening. Should the Fed cease reinvesting its maturing QE assets or begins to sell them, that would be a form of (quantitative) tightening. The Fed could, in theory, sell its QE assets and effectively raise policy rates approximately 100 basis points without touching the Fed Funds rate (see Taylor Rule).
Don't look for consumers to ride to the rescue. They are deleveraging and will continue to do so. Gone are the days of easy credit and a new SUV every two years. This is a healthy, but painful development.
See ya in two weeks.
Sunday, June 12, 2011
Back By Popular Demand
I have had requests for an updated blog considering all that has been happening in the markets and the economy. While low treasury yields, a measure of disinflation, a double-dip in real estate values and poor job growth may be breaking news to many investors and market participants, they have all been subjects of previous editions of this blog.
Here is the quick and dirty analysis of the fixed income world as we know it. During the first quarter of this year, the economy was finally gaining momentum however, because it was dependent on historically-accommodative Fed policy and U.S. manufacturing, much of which was export related the economy was very susceptible to disruptive events. The disaster in Japan provided such a disruption. Job growth and wage growth are also needed for the economy to march forward. Except for what appears to be a bounce-back from a snowy winter, job growth is disappointing.
Face it folks, the economy will trudge forward. Growth could top 3.5% the second half of 2011, but much more than that will be difficult. Next year, growth will struggle to reach 3.0%, but that is ok as it is approximately the 235-year average growth rate for the U.S.
Tomorrow I will discuss how various areas of the fixed income market might behave during the next six-to-twelve months.
Here is the quick and dirty analysis of the fixed income world as we know it. During the first quarter of this year, the economy was finally gaining momentum however, because it was dependent on historically-accommodative Fed policy and U.S. manufacturing, much of which was export related the economy was very susceptible to disruptive events. The disaster in Japan provided such a disruption. Job growth and wage growth are also needed for the economy to march forward. Except for what appears to be a bounce-back from a snowy winter, job growth is disappointing.
Face it folks, the economy will trudge forward. Growth could top 3.5% the second half of 2011, but much more than that will be difficult. Next year, growth will struggle to reach 3.0%, but that is ok as it is approximately the 235-year average growth rate for the U.S.
Tomorrow I will discuss how various areas of the fixed income market might behave during the next six-to-twelve months.
Friday, June 3, 2011
The Soft Patch Gazette
This week was filled with disappointing economic data. Today’s Nonfarm Payrolls report was just the icing on a very stale cake. Employers added the fewest number of workers in eight months during the month of May. Some of the drop in the pace of hiring is probably due to supply shocks from Japan, but part of the cause of soft job growth may be structural. Without an exploding tech sector and McMansion Happy Meal financing in the real estate sector job creation remains challenging. The print of 54,000 new jobs was below even the post pessimistic estimate of 65,000 within the Bloomberg survey of economists.
Some economists and strategists have opined that May’s poor number may be “transitory.” This is probably true, but some economists, such believe that the Nonfarm Payroll prints of over 200,000 in February, March and April were not reflective of U.s. employment fundamentals, but were the result of hiring playing catch-up from the poor numbers seen in December and, especially, January which were greatly influenced by severe weather experienced in many parts of the U.S.
One Wall Street economist told Bloomberg News:
“These are pretty bleak numbers. Some of the engines of hiring just went away. Combined with the slowdown in consumer spending, it raises concern that the slowing in hiring could be with us for a while.”
Folks we are in another soft patch. Although the disaster in Japan exacerbated the problem, it was not the cause. Poor job growth, an impaired housing market and a debt-laden consumer are conspiring to keep growth sluggish. Slowing of major foreign currencies is adding to the economic headwinds.
Manufacturing expanded at a slower pace in May (the slowest pace in over a year) as higher commodities prices and supply disruptions due to the earthquake and tsunami in Japan. However, a modestly stronger U.S. dollar (which can hurt U.S. exports) and measures taken by policymakers in China and India to slow growth and combat inflation may also be partially to blame.
Businesses are spending less on new equipment after modernizing and increasing efficiency during the past two years. One economist told Bloomberg News:
“We’re seeing some loss of momentum. Unless there’s ample growth in demand, orders will be stagnant. Businesses are hesitant to move heavily in terms of investment. They’ve gone through replacing outdated equipment and now there’s less reason to spend.”
Recent housing, employment and manufacturing data have some pundits predicting doom and gloom for the economy going forward. This view may be as misplaced as the views of those who were predicting a robust v-shaped recovery. Fundamentals appear to be in place for a modest, albeit bumpy, recovery.
As we stated yesterday. The pessimism which appears to be building among some market participants may be due to overly optimistic assumptions going into the recovery. We have stated many times that a robust v-shaped recovery was not likely because it would probably require the kind of leveraged spending and strong real estate market which had been prevalent during the past two decades. Today’s Wall Street Journal editorial page contains a very good description of the current economic recovery and explains why housing cannot and should not be relied upon to rescue the economy. The Journal states:
“The clamor to boost housing as an economic savior is especially odd because we've tried this before with dire or fruitless results. The start of the last decade's mania was Federal Reserve Chairman Alan Greenspan's attempt to boost housing to substitute for the impact of the dot-com crash and 9/11. It worked for a while but created the bubble that led to the panic and meltdown.”
The Journal opines about government programs to boost or halt the fall of home prices:
“Their main result, other than subsidizing some Americans at the expense of others, has been to sustain the housing recession over a longer period of time. The price decline would have been sharper without them, but the recovery would have happened sooner and would probably be well underway by now.”
Their opinion is along the line of our comments made in March 2008 (six months prior to the financial crisis). We suggested that home prices be permitted to retreat to levels at which buyers would be attracted. However, if prices were permitted to fall in March of 2008, while credit was still fairly easy to obtain and the full extent of the mortgage mess not yet known, it is possible that bargain hunters may have entered the market prior to home prices falling to current levels or lower. Worst case probably would have been what the Journal suggests.
The Journal continues:
“Prices are continuing to fall again because we still have too much housing stock. That excess needs to be cleared, and the inevitable foreclosures need to be processed and the homes resold before prices can find a new bottom. After years of forlorn attempts at price levitation, rapidly clearing that stock to find that bottom ought to be the main goal of housing policy. Only then will a recovery begin.”
The Journal ends with:
“Housing is a major part of the U.S. economy but it needs to shrink from its artificial, subsidized share of U.S. wealth to a level that is sustainable based on population, income and productivity growth. A healthier economy must be built on capital investment in plant and equipment, new ideas and new companies. We need an investment boom, not another housing bubble.”
If it were this simple, why haven’t policymakers followed the Journal’s suggested course? It comes down to politics. It is difficult for politicians to say to their constituents that it could be years or even a decade or more before their home values recover.
Why did the Fed and other policymakers use housing as a way to engineer an economic recovery? Probably because it was the easiest way to generate rapid growth. The thinking of the time was that banks would not lend money to those who could not repay and that the resulting consumer spending would bleed over into other sectors of the economy and result in a broad-based, self-sustaining expansion. As we now know, that was not going to happen.
In the absence of leveraged consumer spending, the recovery is likely to be modest, bumpy and lengthy. As another Journal article explains: It is not the absence of credit which is the problem, but the lack of demand for credit.
It is the realization that economic growth and job growth may not be poised to leap forward which has pushed the yield of the 10-year U.S. treasury note lower in recent weeks. The Fed’s decision to end QE2 this month, but continue to reinvest maturing assets, has also strengthened the U.S. treasury prices. Lastly, the fact that the Fed is removing stimulus, albeit modestly, by halting QE2, which is somewhat deflationary, has sent investors back into U.S. treasuries.
The 10-year note is widely considered to be a barometer of fixed income market sentiment regarding growth and inflation. The bond market appears to be telling us that it is not especially concerned with inflation pressures building and it is not looking forward to robust economic growth. Some market participants, such as Pimco’s Bill Gross, warn that once QE2 ceases later this month U.S. treasury prices could fall as there are no buyers to replace the Fed.
This may or may not be true. However, the bond market is much more proactive than reactive. If bond market participants believed that that the price of the 10-year U.S. treasury note would plummet because the Fed would be purchasing fewer bonds, it is unlikely that there would be so much buy-side interest now.
It is not the base case scenario of Citi strategists for long-term yields to trend lower going forward. However, Citi’s Q4 2011 10-year treasury yield forecast was lowered from 3.70% to 3.60%. The street consensus forecast remains at 3.82%. There has been no change to either the Citi forecast or the street consensus estimate both of which call for the first 25 basis point Fed Funds rate hike to occur sometime in the first quarter of 2012. However, such forecasts are always subject to change based on economic conditions.
There have been some rumblings regarding a possible QE3. such talk is probably premature. However, if the economic “soft patch” is more lengthy than many are forecasting, it is possible that the Fed delays policy tightening longer than what is currently expected. Investors should be more fearful of slow growth than higher interest rates during the remainder of 2011.
In the late 1940s and 1950s, 10-year treasury yields were similar to today’s yields. It wasn’t until Cold War spending and infrastructure spending was ramped up that long-term rates began to rise. They really took off during the 1960s and 1970s as increased social spending, Cold War spending, higher taxes, accommodative Fed policy which was focused on employment and not on inflation permitted rates to explode upward. Beginning in the 1980s, then Fed Chairman Paul Volcker’s focus on inflation and his subsequent success resulted in a three decade decline of long-term interest rates. It is possible that we already have reverted to the norm or just below it.
Technical strategists may look at this chart and its various data points and look for trends and events which periodically repeated. It is our view (remember we are trading types and not strategists) that the markets (including the bond market) respond to economic conditions, global events and policies set by human beings. Events do not just occur in patterns. Fate does not exist in the bond market.
Some economists and strategists have opined that May’s poor number may be “transitory.” This is probably true, but some economists, such believe that the Nonfarm Payroll prints of over 200,000 in February, March and April were not reflective of U.s. employment fundamentals, but were the result of hiring playing catch-up from the poor numbers seen in December and, especially, January which were greatly influenced by severe weather experienced in many parts of the U.S.
One Wall Street economist told Bloomberg News:
“These are pretty bleak numbers. Some of the engines of hiring just went away. Combined with the slowdown in consumer spending, it raises concern that the slowing in hiring could be with us for a while.”
Folks we are in another soft patch. Although the disaster in Japan exacerbated the problem, it was not the cause. Poor job growth, an impaired housing market and a debt-laden consumer are conspiring to keep growth sluggish. Slowing of major foreign currencies is adding to the economic headwinds.
Manufacturing expanded at a slower pace in May (the slowest pace in over a year) as higher commodities prices and supply disruptions due to the earthquake and tsunami in Japan. However, a modestly stronger U.S. dollar (which can hurt U.S. exports) and measures taken by policymakers in China and India to slow growth and combat inflation may also be partially to blame.
Businesses are spending less on new equipment after modernizing and increasing efficiency during the past two years. One economist told Bloomberg News:
“We’re seeing some loss of momentum. Unless there’s ample growth in demand, orders will be stagnant. Businesses are hesitant to move heavily in terms of investment. They’ve gone through replacing outdated equipment and now there’s less reason to spend.”
Recent housing, employment and manufacturing data have some pundits predicting doom and gloom for the economy going forward. This view may be as misplaced as the views of those who were predicting a robust v-shaped recovery. Fundamentals appear to be in place for a modest, albeit bumpy, recovery.
As we stated yesterday. The pessimism which appears to be building among some market participants may be due to overly optimistic assumptions going into the recovery. We have stated many times that a robust v-shaped recovery was not likely because it would probably require the kind of leveraged spending and strong real estate market which had been prevalent during the past two decades. Today’s Wall Street Journal editorial page contains a very good description of the current economic recovery and explains why housing cannot and should not be relied upon to rescue the economy. The Journal states:
“The clamor to boost housing as an economic savior is especially odd because we've tried this before with dire or fruitless results. The start of the last decade's mania was Federal Reserve Chairman Alan Greenspan's attempt to boost housing to substitute for the impact of the dot-com crash and 9/11. It worked for a while but created the bubble that led to the panic and meltdown.”
The Journal opines about government programs to boost or halt the fall of home prices:
“Their main result, other than subsidizing some Americans at the expense of others, has been to sustain the housing recession over a longer period of time. The price decline would have been sharper without them, but the recovery would have happened sooner and would probably be well underway by now.”
Their opinion is along the line of our comments made in March 2008 (six months prior to the financial crisis). We suggested that home prices be permitted to retreat to levels at which buyers would be attracted. However, if prices were permitted to fall in March of 2008, while credit was still fairly easy to obtain and the full extent of the mortgage mess not yet known, it is possible that bargain hunters may have entered the market prior to home prices falling to current levels or lower. Worst case probably would have been what the Journal suggests.
The Journal continues:
“Prices are continuing to fall again because we still have too much housing stock. That excess needs to be cleared, and the inevitable foreclosures need to be processed and the homes resold before prices can find a new bottom. After years of forlorn attempts at price levitation, rapidly clearing that stock to find that bottom ought to be the main goal of housing policy. Only then will a recovery begin.”
The Journal ends with:
“Housing is a major part of the U.S. economy but it needs to shrink from its artificial, subsidized share of U.S. wealth to a level that is sustainable based on population, income and productivity growth. A healthier economy must be built on capital investment in plant and equipment, new ideas and new companies. We need an investment boom, not another housing bubble.”
If it were this simple, why haven’t policymakers followed the Journal’s suggested course? It comes down to politics. It is difficult for politicians to say to their constituents that it could be years or even a decade or more before their home values recover.
Why did the Fed and other policymakers use housing as a way to engineer an economic recovery? Probably because it was the easiest way to generate rapid growth. The thinking of the time was that banks would not lend money to those who could not repay and that the resulting consumer spending would bleed over into other sectors of the economy and result in a broad-based, self-sustaining expansion. As we now know, that was not going to happen.
In the absence of leveraged consumer spending, the recovery is likely to be modest, bumpy and lengthy. As another Journal article explains: It is not the absence of credit which is the problem, but the lack of demand for credit.
It is the realization that economic growth and job growth may not be poised to leap forward which has pushed the yield of the 10-year U.S. treasury note lower in recent weeks. The Fed’s decision to end QE2 this month, but continue to reinvest maturing assets, has also strengthened the U.S. treasury prices. Lastly, the fact that the Fed is removing stimulus, albeit modestly, by halting QE2, which is somewhat deflationary, has sent investors back into U.S. treasuries.
The 10-year note is widely considered to be a barometer of fixed income market sentiment regarding growth and inflation. The bond market appears to be telling us that it is not especially concerned with inflation pressures building and it is not looking forward to robust economic growth. Some market participants, such as Pimco’s Bill Gross, warn that once QE2 ceases later this month U.S. treasury prices could fall as there are no buyers to replace the Fed.
This may or may not be true. However, the bond market is much more proactive than reactive. If bond market participants believed that that the price of the 10-year U.S. treasury note would plummet because the Fed would be purchasing fewer bonds, it is unlikely that there would be so much buy-side interest now.
It is not the base case scenario of Citi strategists for long-term yields to trend lower going forward. However, Citi’s Q4 2011 10-year treasury yield forecast was lowered from 3.70% to 3.60%. The street consensus forecast remains at 3.82%. There has been no change to either the Citi forecast or the street consensus estimate both of which call for the first 25 basis point Fed Funds rate hike to occur sometime in the first quarter of 2012. However, such forecasts are always subject to change based on economic conditions.
There have been some rumblings regarding a possible QE3. such talk is probably premature. However, if the economic “soft patch” is more lengthy than many are forecasting, it is possible that the Fed delays policy tightening longer than what is currently expected. Investors should be more fearful of slow growth than higher interest rates during the remainder of 2011.
In the late 1940s and 1950s, 10-year treasury yields were similar to today’s yields. It wasn’t until Cold War spending and infrastructure spending was ramped up that long-term rates began to rise. They really took off during the 1960s and 1970s as increased social spending, Cold War spending, higher taxes, accommodative Fed policy which was focused on employment and not on inflation permitted rates to explode upward. Beginning in the 1980s, then Fed Chairman Paul Volcker’s focus on inflation and his subsequent success resulted in a three decade decline of long-term interest rates. It is possible that we already have reverted to the norm or just below it.
Technical strategists may look at this chart and its various data points and look for trends and events which periodically repeated. It is our view (remember we are trading types and not strategists) that the markets (including the bond market) respond to economic conditions, global events and policies set by human beings. Events do not just occur in patterns. Fate does not exist in the bond market.
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