This weekend the Fed will conduct its annual conference in Jackson Hole, Wyoming. With the exception that CPI Core inflation is running at 1.8% this year versus 0.9% last August, the agenda at this year’s conference will be remarkably similar.
As with last year’s meeting, the U.S economy has hit a soft patch. As with last year, the Fed his being looked to for answers. However unlike last year, the Fed is almost out of ammo. All it can really do is move its bond holdings farther out on the yield curve. This would permit the Fed to keep policy accommodation in place and keep long-term rates low. QE, like traditional easing, can be and should be inflationary. This is why long-term rates rose IN SPITE of increased Fed purchases of debt during QE2.
Some believe (equity market participants) that the Fed is poised to announce or at least hint at QE3. Good luck with that. The benefits of QE are so diminished at this point that even if new bond purchases would be on the long end of the curve, long-term rates would probably rise somewhat as market participants hit the Fed’s bid until the economy slows again when they resume buying long-dated treasuries.
The problems with the U.S. economy are of a structural nature. All the cyclical tools in the world are not going to fix these problems. Making the U.S. more business friendly on the tax, regulation and labor cost front are what is needed. When housing finally clears in another five years or so the healing will pick up speed. This is providing that the structural problems are rectified. Until then, the words slow and arduous will be used to describe U.S. economic growth.
Tuesday, August 23, 2011
Tuesday, August 9, 2011
Target Sighted
The Fed stated that it plans on keeping the Fed Funds rate between 0.00% and 0.25% until at least mid-2013. Although it is not surprising that the Fed would remain extraordinarily accommodative for that long, it is surprising that the Fed would set a target. The Fed has not traditionally set targets. However, Fed Chairman Bernanke has in his academic past spoken positively about targeting.
By setting this target time frame, the Fed takes the mystery out of policy for the next two years. This makes it easier for lenders, borrowers, and businesses to make strategic decisions. It also provides clarity for investors. The Fed is sending a message. That message is: Get out of cash and floating-rate securities based on short-term benchmarks and into high-dividend paying stocks, high grade bonds seven to ten years out (especially banks, finance companies and insurance) and BB-rated high yield bonds 5 years and in.
Preferreds had cheapened up recently, but they rebounded late in today’s trading session. There maybe some value left it that asset class. Step-up notes offer some value here as many have attractive yields-to-call if rates do remain low and they are called away, but provide cushion should rates rise.
Play defense, but vigilance is a very good defense.
P.S. Indirect bidders (which include foreign central banks) purchased almost 47% of today’s 3-year treasury note auction versus a 36% average for the past 10 auctions. So much for the exodus from the AA+ U.S. treasury.
Sunday, August 7, 2011
The Bond Market Explained
What a week in the bond market. Prices of U.S. treasuries rallied following an agreement between both parties in congress and the president to raise the debt ceiling and cut spending by $2.5 trillion. This follows a week when investors purchased large quantities of treasuries in a flight to safety in the event that the U.S. failed to raise the debt ceiling. Confused yet? Let me explain.
Investors purchased treasuries the week before a debt ceiling an agreement was reached because if the U.S. did not raise the debt ceiling the global financial system and capital markets around the globe could have been thrown into turmoil. Meanwhile the U.S. would most likely have serviced its dent, uninterrupted, instead choosing to withhold payments to government spending programs, pensions and salaries. So if turmoil was avoided, why did prices of U.S. treasuries continue to rally?
The rise in U.S. treasury prices was due in part to the budget cuts and the fear that the U.S. would not be able to inject further stimulus if economic data indicated it was needed. The market fears a near stagnant U.S. economy or, worse a recession. Recent data suggests that growth may indeed be slowing. Some of the slowdown can be blamed on supply disruptions in Japan and a consumer squeezed by higher food and energy prices. Although those headwinds appear to be temporary, new, possibly stronger and longer-lasting headwinds appear to be on the horizon, headwinds which should keep growth and interest rates low. Let’s discuss:
1) Spending cuts / higher taxes: Spending cuts and higher taxes are part of the plan to address America’s budgets crisis. These will create headwinds by removing money from the pockets of many consumers. Taxes are straightforward. The more taxes one pays, the fewer dollars one has left to spend. Budget cuts are less intuitive, but when you think about it makes sense. Budgets cuts mean the firing of government workers and fewer purchases of goods and services by government agencies. Although one can argue that such measures are good over the long haul, headwinds are created by such measures in the near term. The U.S. is undertaking austerity measures similar to those European periphery countries should undertake, but refuse to do.
2) Europe: Europe is a mess. European leaders are choosing to throw cash at the problems whenever the bond market votes with its feet and shows its reluctance to finance periphery nations, at least not at affordable rates. The markets are losing their patience. The recent rally in U.S. treasuries is due in part to a no vote on the way European officials are handling their ever-growing crisis.
3) Global Slowdown: The Global economy is slowing. China is fighting its own real estate bubble and is trying to slow inflation with less accommodative polices. This does not mean that China will stop growing. The country is so far behind developed nations in the west it cannot help but growing. It can grow at a robust pace almost by accident. However, if this is all the growth we can get in our economy based on exports (the exportation of manufactured goods has been one of the few bright spots in the U.S. recovery) with China in an economic bubble, what happens when overseas demand slackens?
4) A strapped U.S. consumer: The U.S. consumer is overleveraged and is sitting on depressed real estate. Add to this plight, no wage growth and more layoffs and the consumer is in no position to lead the economy back from the depths of despair. It could be many years before the consumer can lead the way and even then he might read more cautiously.
Consumers will spend again, but they are in the midst of an economic hangover. Just as in an alcohol-induced hangover, one must take some time to recover from one’s drunken binge. But fear not, they will drink again, but it is possible they will be a bit more responsible the next time around. Surveys of the under-30 set indicate that they eschew the 4,000 square foot McMansions and $50,000 SUVs. Older consumers are also learning to spend more judiciously. Consumer spending may peak at levels seen in the 1980s or before when the consumer is back in the game.
5) Banks: Banks are not going to lend to anyone but the most qualified borrowers. This is for several reasons. First: It is not easy to securitize loans to lower or even mid-quality borrowers, at least not at rates which would entice borrowers. Investors are demanding higher rates of return for investing in such loans and there are fewer of these investors.
Secondly: Banks will not hold them on their balance sheets. For one thing, they could be criticized by regulators for having too much risk on their balance sheets. Another factor keeping banks from lending to higher-risk borrowers is that politicians will accuse banks of predatory lending if they lend to those whose ability to service their debt is in question.
Instead, banks will continue to engage in a carry trade in which they borrow at near-zero-percent rates on the short end and purchase 10-year treasury notes. Even with a rate of 2.50% on the 10-year U.S. treasury note, banks can earn over 200 basis points without incurring much, if any, risk.
Some may criticize my thesis and point out that the S&P’s recent downgrading of the U.S. sovereign credit rating to AA+ will cause a selloff of U.S. treasuries. Any such selloff will be short-lived (and a bit stupid). Most investors who buy large quantities of U.S. treasuries can still own them even if they are not AAA-rated. They have an exemption for U.S. government debt.
What could push long-term U.S. rates higher is if the Fed engages in QE3 or similar stimulus. When the Fed instituted QE1 and, especially, QE2 long-term rates trended higher. This confounded investors and Fed officials alike. I have explained this earlier (the Wall Street Journal finally explained this weekend) that quantitative easing, like traditional easing, is inflationary in nature. It tends to weaken the dollar and pushes prices and long-term rates higher. This is exactly what happened with the first two rounds of QE. The positive effects on growth diminished with each round of QE, but the negative effects on inflation (pushing it higher) increased. A QE3 would likely cause this trend to continue.
An idea of the Fed eliminating the 0.25% rate paid to institutions for deposits held at the Fed has been floated. The thinking is that if banks are no longer earning this 0.25% they might be more inclined to lend that capital. More likely results would be the purchasing of U.S. treasuries or expense cuts (layoffs and the canceling of expenditures). This would put a heavier lid on long-term interest rates.
Weighing the data, recent economic data, large layoffs announced by businesses, government policy decisions (necessary though they were) and the lack of arrows in the Fed’s quiver, poor economic growth and relatively low interest rates appear to be what is in store for at least the next year. I would not be surprised if the Fed funds rate was left unchanged throughout 2012 and beyond. If someone approaches you with the idea of buying floating-rate securities pegged off of short-term reference rates don’t walk, run!
Hang in their folks. We will all get through this, but it will take time, patience and belt-tightening.
Investors purchased treasuries the week before a debt ceiling an agreement was reached because if the U.S. did not raise the debt ceiling the global financial system and capital markets around the globe could have been thrown into turmoil. Meanwhile the U.S. would most likely have serviced its dent, uninterrupted, instead choosing to withhold payments to government spending programs, pensions and salaries. So if turmoil was avoided, why did prices of U.S. treasuries continue to rally?
The rise in U.S. treasury prices was due in part to the budget cuts and the fear that the U.S. would not be able to inject further stimulus if economic data indicated it was needed. The market fears a near stagnant U.S. economy or, worse a recession. Recent data suggests that growth may indeed be slowing. Some of the slowdown can be blamed on supply disruptions in Japan and a consumer squeezed by higher food and energy prices. Although those headwinds appear to be temporary, new, possibly stronger and longer-lasting headwinds appear to be on the horizon, headwinds which should keep growth and interest rates low. Let’s discuss:
1) Spending cuts / higher taxes: Spending cuts and higher taxes are part of the plan to address America’s budgets crisis. These will create headwinds by removing money from the pockets of many consumers. Taxes are straightforward. The more taxes one pays, the fewer dollars one has left to spend. Budget cuts are less intuitive, but when you think about it makes sense. Budgets cuts mean the firing of government workers and fewer purchases of goods and services by government agencies. Although one can argue that such measures are good over the long haul, headwinds are created by such measures in the near term. The U.S. is undertaking austerity measures similar to those European periphery countries should undertake, but refuse to do.
2) Europe: Europe is a mess. European leaders are choosing to throw cash at the problems whenever the bond market votes with its feet and shows its reluctance to finance periphery nations, at least not at affordable rates. The markets are losing their patience. The recent rally in U.S. treasuries is due in part to a no vote on the way European officials are handling their ever-growing crisis.
3) Global Slowdown: The Global economy is slowing. China is fighting its own real estate bubble and is trying to slow inflation with less accommodative polices. This does not mean that China will stop growing. The country is so far behind developed nations in the west it cannot help but growing. It can grow at a robust pace almost by accident. However, if this is all the growth we can get in our economy based on exports (the exportation of manufactured goods has been one of the few bright spots in the U.S. recovery) with China in an economic bubble, what happens when overseas demand slackens?
4) A strapped U.S. consumer: The U.S. consumer is overleveraged and is sitting on depressed real estate. Add to this plight, no wage growth and more layoffs and the consumer is in no position to lead the economy back from the depths of despair. It could be many years before the consumer can lead the way and even then he might read more cautiously.
Consumers will spend again, but they are in the midst of an economic hangover. Just as in an alcohol-induced hangover, one must take some time to recover from one’s drunken binge. But fear not, they will drink again, but it is possible they will be a bit more responsible the next time around. Surveys of the under-30 set indicate that they eschew the 4,000 square foot McMansions and $50,000 SUVs. Older consumers are also learning to spend more judiciously. Consumer spending may peak at levels seen in the 1980s or before when the consumer is back in the game.
5) Banks: Banks are not going to lend to anyone but the most qualified borrowers. This is for several reasons. First: It is not easy to securitize loans to lower or even mid-quality borrowers, at least not at rates which would entice borrowers. Investors are demanding higher rates of return for investing in such loans and there are fewer of these investors.
Secondly: Banks will not hold them on their balance sheets. For one thing, they could be criticized by regulators for having too much risk on their balance sheets. Another factor keeping banks from lending to higher-risk borrowers is that politicians will accuse banks of predatory lending if they lend to those whose ability to service their debt is in question.
Instead, banks will continue to engage in a carry trade in which they borrow at near-zero-percent rates on the short end and purchase 10-year treasury notes. Even with a rate of 2.50% on the 10-year U.S. treasury note, banks can earn over 200 basis points without incurring much, if any, risk.
Some may criticize my thesis and point out that the S&P’s recent downgrading of the U.S. sovereign credit rating to AA+ will cause a selloff of U.S. treasuries. Any such selloff will be short-lived (and a bit stupid). Most investors who buy large quantities of U.S. treasuries can still own them even if they are not AAA-rated. They have an exemption for U.S. government debt.
What could push long-term U.S. rates higher is if the Fed engages in QE3 or similar stimulus. When the Fed instituted QE1 and, especially, QE2 long-term rates trended higher. This confounded investors and Fed officials alike. I have explained this earlier (the Wall Street Journal finally explained this weekend) that quantitative easing, like traditional easing, is inflationary in nature. It tends to weaken the dollar and pushes prices and long-term rates higher. This is exactly what happened with the first two rounds of QE. The positive effects on growth diminished with each round of QE, but the negative effects on inflation (pushing it higher) increased. A QE3 would likely cause this trend to continue.
An idea of the Fed eliminating the 0.25% rate paid to institutions for deposits held at the Fed has been floated. The thinking is that if banks are no longer earning this 0.25% they might be more inclined to lend that capital. More likely results would be the purchasing of U.S. treasuries or expense cuts (layoffs and the canceling of expenditures). This would put a heavier lid on long-term interest rates.
Weighing the data, recent economic data, large layoffs announced by businesses, government policy decisions (necessary though they were) and the lack of arrows in the Fed’s quiver, poor economic growth and relatively low interest rates appear to be what is in store for at least the next year. I would not be surprised if the Fed funds rate was left unchanged throughout 2012 and beyond. If someone approaches you with the idea of buying floating-rate securities pegged off of short-term reference rates don’t walk, run!
Hang in their folks. We will all get through this, but it will take time, patience and belt-tightening.
Wednesday, August 3, 2011
The Dismal Science
One day it looks as though the U.S. could default on its debt and the price of the 10-year U.S. treasury rallies. The next day it looks as though the U.S. will raise its debt ceiling, the price of the 10-year note rallies. The U.S. could get downgraded by S&P, the 10-year note rallies. Moody’s affirms the U.S. AAA credit rating, the price of the 10-year U.S. treasury rallies. Concerns abound that the new budget legislation could put a modest drag on U.S. economic growth, the price of the 10-year note rallies. The slowing economy could cause the Fed to maintain or increase economic stimulus, the price of the 10-year note rises. One could be forgiven for believing that there is a bubble on the long end of the treasury curve. Whether or not that is true depends on how one defines a bubble.
Can the yield of the 10-year treasury note remain in the neighborhood of 2.60%? Over the long term, probably not, but it could remain range traded in the high 2.00% to low 3.00% area for an extended period of time. Note the words “extended period.” These are the same words the Fed has used to communicate how long it plans on keeping monetary policy exceptionally accommodative. When the FOMC meets next week, it is very likely that the Fed once again uses the phrase “extended period.”
The Fed is likely to remain exceptionally accommodative because recent data indicate that the economy is slowing. It was bad enough that consumer spending never ramped up as hoped, but now there are signs that the Global economy might be slowing. Although it is true that if countries like China slowed somewhat, their growth would still be robust, but put this into perspective: It has taken booming developing economies and the largest and longest-lasting infusion of economic stimulus since the Great Depression just to get us this far.
Possible future Fed actions are limited. QE3 is almost certainly out of the question, but the Fed could continue to reinvest maturing QE assets and hold off on asset sales and policy rate increases. This will keep short-term rates punitively low and push investors farther out on the yield curve. There have been suggestions that the Fed should eliminate the 0.25% rate it pays on deposits at the Fed to force banks to use that capital for lending. The counterargument is by doing so foreign banks (which have very large deposits at the Fed) and money market funds (which deposit a significant portion of their capital with the Fed) would be harmed.
I make the argument that as long as the curve is steep, banks would prefer to borrow on the short end of the curve and invest in 10-year notes to pick up almost 250 basis points. This so called carry trade may earn banks less than what they would earn by engaging in mortgage lending, but by purchasing the 10-year treasury note (effectively lending to Uncle Sam) banks do not have to be concerned about securitizing loans, dealing with delinquencies and foreclosures or running afoul of regulators by lending to those who cannot afford to pay or by carrying too much risk on their own books if the loans cannot be securitized. What incentives do banks have to lend to all but the most pristine borrowers? Not much from what we can see. Of course, what other borrowers than those who are very creditworthy and who are not over leveraged desire financing at this time?
Most other Americans are trying to climb out from under a mountain of debt accumulated during the most recent economic bubble. Several years were required accumulate such debt; many years are likely to be required to dispose of it. With unemployment expected to remain stubbornly high for years to come, the ability of consumers to repay their debts will probably be impaired. Consumer spending is also likely to be less than that to which we have become accustomed. As consumer spending makes up more than two-thirds of U.S. economic activity, economic growth could be below historical trends.
Readers know that I was never in the V-shaped recovery / spiking interest rate camp. I was of the opinion that the Fed would be very slow to tighten policy (I even correctly predicted how the Fed would remove accommodation). However, I also believed that long-term yields would rise gradually to the mid / high 3.00% area (further steepening the yield curve) as the economy grew at a below-trend pace (2.0% to 2.5%). However, recent and troubling economic data are pointing to “soft-patch 2011” or worse. This has sent the yield of the 10-year treasury note below 2.60%.
The bond market is pricing in a slowdown. Troubles in Europe and slower growth in emerging nations are causing the flight to safety. Even moves my central banks to increase gold holdings hasn’t stopped the rally on the long end of the curve. If economic data continues to disappoint (and I find it hard to believe that it will not), the Fed could remain on the sidelines throughout 2012 and the yield of the 10-year treasury note could become range traded between 2.50% and 3.00%. I would keep my exposure to LIBOR floaters very light. I will be back following Friday’s employment data.
Can the yield of the 10-year treasury note remain in the neighborhood of 2.60%? Over the long term, probably not, but it could remain range traded in the high 2.00% to low 3.00% area for an extended period of time. Note the words “extended period.” These are the same words the Fed has used to communicate how long it plans on keeping monetary policy exceptionally accommodative. When the FOMC meets next week, it is very likely that the Fed once again uses the phrase “extended period.”
The Fed is likely to remain exceptionally accommodative because recent data indicate that the economy is slowing. It was bad enough that consumer spending never ramped up as hoped, but now there are signs that the Global economy might be slowing. Although it is true that if countries like China slowed somewhat, their growth would still be robust, but put this into perspective: It has taken booming developing economies and the largest and longest-lasting infusion of economic stimulus since the Great Depression just to get us this far.
Possible future Fed actions are limited. QE3 is almost certainly out of the question, but the Fed could continue to reinvest maturing QE assets and hold off on asset sales and policy rate increases. This will keep short-term rates punitively low and push investors farther out on the yield curve. There have been suggestions that the Fed should eliminate the 0.25% rate it pays on deposits at the Fed to force banks to use that capital for lending. The counterargument is by doing so foreign banks (which have very large deposits at the Fed) and money market funds (which deposit a significant portion of their capital with the Fed) would be harmed.
I make the argument that as long as the curve is steep, banks would prefer to borrow on the short end of the curve and invest in 10-year notes to pick up almost 250 basis points. This so called carry trade may earn banks less than what they would earn by engaging in mortgage lending, but by purchasing the 10-year treasury note (effectively lending to Uncle Sam) banks do not have to be concerned about securitizing loans, dealing with delinquencies and foreclosures or running afoul of regulators by lending to those who cannot afford to pay or by carrying too much risk on their own books if the loans cannot be securitized. What incentives do banks have to lend to all but the most pristine borrowers? Not much from what we can see. Of course, what other borrowers than those who are very creditworthy and who are not over leveraged desire financing at this time?
Most other Americans are trying to climb out from under a mountain of debt accumulated during the most recent economic bubble. Several years were required accumulate such debt; many years are likely to be required to dispose of it. With unemployment expected to remain stubbornly high for years to come, the ability of consumers to repay their debts will probably be impaired. Consumer spending is also likely to be less than that to which we have become accustomed. As consumer spending makes up more than two-thirds of U.S. economic activity, economic growth could be below historical trends.
Readers know that I was never in the V-shaped recovery / spiking interest rate camp. I was of the opinion that the Fed would be very slow to tighten policy (I even correctly predicted how the Fed would remove accommodation). However, I also believed that long-term yields would rise gradually to the mid / high 3.00% area (further steepening the yield curve) as the economy grew at a below-trend pace (2.0% to 2.5%). However, recent and troubling economic data are pointing to “soft-patch 2011” or worse. This has sent the yield of the 10-year treasury note below 2.60%.
The bond market is pricing in a slowdown. Troubles in Europe and slower growth in emerging nations are causing the flight to safety. Even moves my central banks to increase gold holdings hasn’t stopped the rally on the long end of the curve. If economic data continues to disappoint (and I find it hard to believe that it will not), the Fed could remain on the sidelines throughout 2012 and the yield of the 10-year treasury note could become range traded between 2.50% and 3.00%. I would keep my exposure to LIBOR floaters very light. I will be back following Friday’s employment data.
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