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 They’ve gone through replacing outdated equipment and now there’s less reason to spend.”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.
Friday, June 3, 2011
Wednesday, May 18, 2011
Welcome To The Camp
Since the Dodd financial regulation bill (and specifically the Collins amendment) was signed into law questions arose about when and if banks would call in their trust preferreds. One camp believed that banks would call in all of their trust preferreds as soon as possible as that form of capital made little sense for banks now that they would lose their Tier-1 capital treatment beginning 2013. Another camp believed that banks would not begin to call in trust preferreds until they actually began to lose their Tier-1 eligibility.
Then there was my camp. I thought that banks would call in trust preferreds whenever it was most economically advantageous to do so. Besides the Tier-1 aspect of trust preferreds, there is the cost of finance aspect. I was of the opinion that banks would choose to call in their highest coupon issues first and that banks are free to determine when the capital event, which is required to trigger an early call occurred. I warned readers that a bank could decide to call in a high-coupon trust preferred, not only before 2013, but at anytime.
Today, Fifth Third back called in their 8.875% FTBprC. It will be called on 6/17/11 at a price of 25. This was bad news for investors who purchased shared recently (up to this morning) at over $26.00 per share. I will warn readers once again; don’t buy high-coupon, high-premium trust preferreds thinking that the will be around until their first call dates and don’t buy low-coupon preferreds at deep discounts thinking that they will be called in the near future at par. Neither scenario is economically advantageous for issuers. Calls are always executed when it is the best interest of the issuer, not investors.
Then there was my camp. I thought that banks would call in trust preferreds whenever it was most economically advantageous to do so. Besides the Tier-1 aspect of trust preferreds, there is the cost of finance aspect. I was of the opinion that banks would choose to call in their highest coupon issues first and that banks are free to determine when the capital event, which is required to trigger an early call occurred. I warned readers that a bank could decide to call in a high-coupon trust preferred, not only before 2013, but at anytime.
Today, Fifth Third back called in their 8.875% FTBprC. It will be called on 6/17/11 at a price of 25. This was bad news for investors who purchased shared recently (up to this morning) at over $26.00 per share. I will warn readers once again; don’t buy high-coupon, high-premium trust preferreds thinking that the will be around until their first call dates and don’t buy low-coupon preferreds at deep discounts thinking that they will be called in the near future at par. Neither scenario is economically advantageous for issuers. Calls are always executed when it is the best interest of the issuer, not investors.
Sunday, May 15, 2011
On the QT
Whatever happened to rising interest rates? The newswires were hot with stories of hyper inflation and soaring interest rates. The stories stoked fear from two angles. One school of thought said that if the Fed kept QE2 rolling it would foster inflation, and therefore, higher interest rates. The second school of thought believed that if the Fed ends QE2, there would be little support for treasury price and long-term interest rates would rise. In other words, no matter what actions the Fed took, long-term interest rates were heading higher. Not so fast Sparky. There appears to be much misunderstanding regarding how QE2 (and QE1 for that matter) affected the bond market.
When the Fed ended QE1 last year, long-term interest rates declined (helped by Euro troubles). When the Fed announced the possibility of QE2, long-term rates began to climb. Long-term rates hit their highest levels since early 2010 last December following the launch of QE2. Now, with the Fed’s announcement that QE2 will end on schedule in June, but that the Fed will reinvest maturing assets, long-term U.S. treasury yields have fallen. The yield of the benchmark 10-year not dropped to 3.16% the other day.
The recent fall of long-term interest rates is not as counterintuitive as it may appear at first glance. When the Fed halted QE1 it was considered to be disinflationary. Many market participants took off their risk trades and headed into U.S. treasuries. When the Fed moved toward QE2, risk trades went back on and really took off when QE2 was launched. Risk trades include speculating in equities, commodities and junk bonds. Now with QE2 likely coming to an end, but with the economy showing a bit more life than last year, long-term rates have fallen, but have not plummeted as in 2010.
This does not mean that long-term rates will not trend higher. However, they are more likely to creep higher rather than experience a spike. The street consensus as per a Bloomberg Survey indicates a consensus opinion of below 4.00% for the yield of the 10-year U.S. treasury note for year-end 2011.
The street consensus forecast for Fed Funds indicates no change to the Fed Funds rate this year with the first Fed action coming in Q1 2012. Three-month LIBOR, which is greatly influenced by the Fed Funds rate, has fallen from .33% to .26% during the past month. The one year forecast for three-month LIBOR is in the .75% to 1.00% area. Investors buying floating rate paper may be very disappointed with their investment choice.
Why may the rise of short-term rate be modest? This is because growth is not expected to be strong enough to move above the U.S. historical trend rate of 3.1%. Also, it must be remembered that QE is a form of easing (lowering rates in alternative fashion). Therefore, the removal of QE stimulus must be regarded as QT or Quantitative Tightening. When QT and rate increases are factored in together, it appears unlikely that the Fed will have to raise the Fed Funds rate very high during the coming interest rate / economic cycle, possibly not higher than 2.00%. I think we may be in for a few boring years as the economy adapts to new realities and housing prices languish until population growth provides the market with QUALIFIED buyers.
When the Fed ended QE1 last year, long-term interest rates declined (helped by Euro troubles). When the Fed announced the possibility of QE2, long-term rates began to climb. Long-term rates hit their highest levels since early 2010 last December following the launch of QE2. Now, with the Fed’s announcement that QE2 will end on schedule in June, but that the Fed will reinvest maturing assets, long-term U.S. treasury yields have fallen. The yield of the benchmark 10-year not dropped to 3.16% the other day.
The recent fall of long-term interest rates is not as counterintuitive as it may appear at first glance. When the Fed halted QE1 it was considered to be disinflationary. Many market participants took off their risk trades and headed into U.S. treasuries. When the Fed moved toward QE2, risk trades went back on and really took off when QE2 was launched. Risk trades include speculating in equities, commodities and junk bonds. Now with QE2 likely coming to an end, but with the economy showing a bit more life than last year, long-term rates have fallen, but have not plummeted as in 2010.
This does not mean that long-term rates will not trend higher. However, they are more likely to creep higher rather than experience a spike. The street consensus as per a Bloomberg Survey indicates a consensus opinion of below 4.00% for the yield of the 10-year U.S. treasury note for year-end 2011.
The street consensus forecast for Fed Funds indicates no change to the Fed Funds rate this year with the first Fed action coming in Q1 2012. Three-month LIBOR, which is greatly influenced by the Fed Funds rate, has fallen from .33% to .26% during the past month. The one year forecast for three-month LIBOR is in the .75% to 1.00% area. Investors buying floating rate paper may be very disappointed with their investment choice.
Why may the rise of short-term rate be modest? This is because growth is not expected to be strong enough to move above the U.S. historical trend rate of 3.1%. Also, it must be remembered that QE is a form of easing (lowering rates in alternative fashion). Therefore, the removal of QE stimulus must be regarded as QT or Quantitative Tightening. When QT and rate increases are factored in together, it appears unlikely that the Fed will have to raise the Fed Funds rate very high during the coming interest rate / economic cycle, possibly not higher than 2.00%. I think we may be in for a few boring years as the economy adapts to new realities and housing prices languish until population growth provides the market with QUALIFIED buyers.
Saturday, May 7, 2011
Grow Job
Yesterday’s employment data was reasonably strong with the economy adding 244,000 jobs. Although this is only 44,000 more jobs necessary to keep pace with population growth, it far exceeded the street consensus estimate of 185,000. Does this mean that job growth is set rocket higher? Probably not, as there are too many headwinds facing the U.S. / global economy.
Hiring at this pace will barely make a dent in the bloated number of people on the unemployment roles. Budgets cuts necessary to pass an agreement on raising the debt ceiling (or to keep the U.S. solvent without raising the debt ceiling), a persistently weak housing market and signs of slowing in emerging market economies promise to keep job growth, and the U.S. economic growth, modest. The fact that there are over 7 million people receiving unemployment benefits means that at anything close to the current pace, it could be several years or more to bring the unemployment rate down below 7.00%. If course by then the economic cycle could start a normal downward trend and nip the job recovery in the bud.
Speaking of the unemployment rate, many investors were confused about how the unemployment rated could tick higher from 8.8% to 9.0% in the face of better-than-expected job growth. This was due to how the so-called household survey is conducted. If a respondent answers that they are not working, but not actively seeking employment they are not considered to be unemployed. However, if a non-working respondent answers that they are seeking employment they are considered to be unemployed. Typically, as job prospects improve, non-working respondents become more confident and answer that they are seeking employment. Because of this, a rising unemployment rate in conjunction with a stronger Nonfarm Payrolls report is considered a positive phenomenon.
All signs continue to point toward a sustainable, but modest recovery. However, the fun may be over for commodities and the equity markets. Make no mistake, the spike in commodities prices during the past year was due in large part to Fed policy which weakened the dollar and had the potential (at least in theory) to cause a robust “v-shaped” recovery. Now we are seeing speculators take their profits and are going home. With their support out of the commodities prices have plummeted.
The equity markets have also benefited from Fed policy as low corporate financing rates and a weaker dollar making U.S.-made goods price-competitive in overseas markets. The result has been a sharp and stout balance sheet recovery. As the Fed removes stimulus, the equity markets could experience a correction. Sell in May and go away could be a good strategy this year. Autumn could be a better time to re-enter the equity markets.
I would wager many investors have interpreted the drop in commodities prices, especially oil prices, as being anti-inflationary. Au contraire, a drop in oil prices should make more consumer cash available to be spent in other, more productive, areas of the economy. Lower oil prices could in fact cause the Fed to act somewhat more aggressively to tighten monetary policy. To those who believed the Fed should have raised rates to combat higher oil prices my thinking may be confusing, but this speaks to the lack of knowledge of what inflation is measured and occurs within the investor community,
If the trend of weakening commodities continues the Fed may be better able to remove stimulus. The first action y the Fed will be to end QE2 purchases. Next, the Fed could cease re-investing maturing QE2 assets and increase the interest rate paid in reserved kept at the Fed. . Then the Fed is likely to engage in a combination of Fed Funds rate hikes and the selling of QE (1 and 2) assets,
Fed Funds rate hikes will likely be modest, few and, possibly, far between. Remember quantitative easing? Well the ending and removal of quantitative easing is quantitative tightening, Investors waiting for high Fed Funds rates are likely to be disappointed during the forthcoming economic cycle. Since U.S. dollar LIBOR is very much linked to the Fed Funds rate, Libor-based floating rates and preferreds are likely to disappoint investors.
Does this mean we will be faced with a stagnant economy in the near future? Probably not, but we could experience trend growth of approximately 3.00% during the next three to five years. What about unemployment? Without a bubble such as what we experience in tech during the 90s and housing during the first decade of the 2000s, the unemployment rate could remain above 7.00%.
Investors must understand that the growth experiences from the mid 80s to 2006 was not fundamentally sustainable, but was rather a Fed-induced and supported recovery from the poor policies of the mid-60s to the late 70s. As with every policy, the Fed’s overshot its mark with two bubbles (tech and housing) near the end of its run.
The low rate, high growth of the middle first decade of the 2000s was called the “Great Moderation.” I think “the “Great Moderation” will occur over the next five years or so. Growth, inflation and employment will all me moderate. After that, your guess is as good as mine.
Hiring at this pace will barely make a dent in the bloated number of people on the unemployment roles. Budgets cuts necessary to pass an agreement on raising the debt ceiling (or to keep the U.S. solvent without raising the debt ceiling), a persistently weak housing market and signs of slowing in emerging market economies promise to keep job growth, and the U.S. economic growth, modest. The fact that there are over 7 million people receiving unemployment benefits means that at anything close to the current pace, it could be several years or more to bring the unemployment rate down below 7.00%. If course by then the economic cycle could start a normal downward trend and nip the job recovery in the bud.
Speaking of the unemployment rate, many investors were confused about how the unemployment rated could tick higher from 8.8% to 9.0% in the face of better-than-expected job growth. This was due to how the so-called household survey is conducted. If a respondent answers that they are not working, but not actively seeking employment they are not considered to be unemployed. However, if a non-working respondent answers that they are seeking employment they are considered to be unemployed. Typically, as job prospects improve, non-working respondents become more confident and answer that they are seeking employment. Because of this, a rising unemployment rate in conjunction with a stronger Nonfarm Payrolls report is considered a positive phenomenon.
All signs continue to point toward a sustainable, but modest recovery. However, the fun may be over for commodities and the equity markets. Make no mistake, the spike in commodities prices during the past year was due in large part to Fed policy which weakened the dollar and had the potential (at least in theory) to cause a robust “v-shaped” recovery. Now we are seeing speculators take their profits and are going home. With their support out of the commodities prices have plummeted.
The equity markets have also benefited from Fed policy as low corporate financing rates and a weaker dollar making U.S.-made goods price-competitive in overseas markets. The result has been a sharp and stout balance sheet recovery. As the Fed removes stimulus, the equity markets could experience a correction. Sell in May and go away could be a good strategy this year. Autumn could be a better time to re-enter the equity markets.
I would wager many investors have interpreted the drop in commodities prices, especially oil prices, as being anti-inflationary. Au contraire, a drop in oil prices should make more consumer cash available to be spent in other, more productive, areas of the economy. Lower oil prices could in fact cause the Fed to act somewhat more aggressively to tighten monetary policy. To those who believed the Fed should have raised rates to combat higher oil prices my thinking may be confusing, but this speaks to the lack of knowledge of what inflation is measured and occurs within the investor community,
If the trend of weakening commodities continues the Fed may be better able to remove stimulus. The first action y the Fed will be to end QE2 purchases. Next, the Fed could cease re-investing maturing QE2 assets and increase the interest rate paid in reserved kept at the Fed. . Then the Fed is likely to engage in a combination of Fed Funds rate hikes and the selling of QE (1 and 2) assets,
Fed Funds rate hikes will likely be modest, few and, possibly, far between. Remember quantitative easing? Well the ending and removal of quantitative easing is quantitative tightening, Investors waiting for high Fed Funds rates are likely to be disappointed during the forthcoming economic cycle. Since U.S. dollar LIBOR is very much linked to the Fed Funds rate, Libor-based floating rates and preferreds are likely to disappoint investors.
Does this mean we will be faced with a stagnant economy in the near future? Probably not, but we could experience trend growth of approximately 3.00% during the next three to five years. What about unemployment? Without a bubble such as what we experience in tech during the 90s and housing during the first decade of the 2000s, the unemployment rate could remain above 7.00%.
Investors must understand that the growth experiences from the mid 80s to 2006 was not fundamentally sustainable, but was rather a Fed-induced and supported recovery from the poor policies of the mid-60s to the late 70s. As with every policy, the Fed’s overshot its mark with two bubbles (tech and housing) near the end of its run.
The low rate, high growth of the middle first decade of the 2000s was called the “Great Moderation.” I think “the “Great Moderation” will occur over the next five years or so. Growth, inflation and employment will all me moderate. After that, your guess is as good as mine.
Wednesday, April 27, 2011
No Surprises From the Fed
The FOMC concluded its meeting and released its statement. Later in the afternoon, Fed chairman Bernanke held the first ever post-meeting press conference. Nothing stated by the FOMC or by Mr. Bernanke himself was surprising, at least not to me.
This was not necessarily the case to many market participants, the airwaves were filled with comments made by pundits predicting language leaving open the possibility of an early end to QE2. Others predicted that the Fed would announce that it would consider not reinvesting the proceeds of maturing assets. Others still were predicting that the Fed would drop “extended period” from its statement regarding the Fed Finds rate. Alas, none of these were to be,
The Fed decided to permit QE2 to run its course, announced that it plans to reinvest proceeds from maturing QE2 assets and that policy will remain accommodative for an extended period of time. The decision to leave the course of policy unchanged was unanimous. Even Philadelphia Fed president Plosser and Dallas Fed president Fischer, two outspoken inflation hawks and QE2 critics voted for staying the course.
In his statement read at the press conference, Fed chairman Bernanke stated his case for staying the course, expressed concern that the growth may be moderating and called inflation pressures transitory. What Mr. Bernanke my mean is that food and energy prices are self-limiting and, in the case of oil prices, at least partially driven by speculation. The Fed has traditionally resisted being held hostage by speculators.
Arguments that the Fed could help the economy by raising rates, strengthening the dollar and putting more money back into the hands of the consumer. Although this idea has its merits, it must be acknowledged that the recovery we have seen thus far is a balance sheet recovery due to cheap corporate financing and favorable exchange rates for export business. Raising the Fed funds rate before employment and housing recovers could send corporate profits and the equity markets plummeting, the results could include a new round layoffs and further depression in the housing sector (Mr. Bernanke’s description of housing was “depressed”).
So what does this mean for interest rates? It obviously means that short-term rates, such as Fed Funds and three-month LIBOR will remain low. It could mean that long-term rates remain somewhat low. However, long-term rates could rise modestly as Fed policy will remain accommodative and foster some inflationary pressures. The opposite could occur when the Fed begins to tighten as disinflationary policies could result a halt to rising long-term rates before they gain much traction, but that is probably a year away.
Many readers will respond that they do not agree with Fed policy and therefore will choose investment strategies which run counter to Fed policy. One bets against the Fed at one’s own risk, The Fed sets policy, not me and not you. My personal view is that the economy needs a cleansing from borrowing and we as a nation must learn to live with in its means, However, that is not only impractical at this time because it would likely result in a recession which could be crippling, but also is not consistent with the Fed’s dual mandates of price stability and job growth. My views of what should be done are irrelevant. We only need to understand what the Fed will do and why and invest accordingly.
Make no mistake; the Fed cannot fix the economy. Mr. Bernanke knows that as well as anyone. He is just trying to keep things chugging along until the boys and girls on Capitol Hill make the necessary tough choices to make the economy fundamentally sound. What those choices are is a discussion for another day.
FYI: May begins my final year at my place of employment.
This was not necessarily the case to many market participants, the airwaves were filled with comments made by pundits predicting language leaving open the possibility of an early end to QE2. Others predicted that the Fed would announce that it would consider not reinvesting the proceeds of maturing assets. Others still were predicting that the Fed would drop “extended period” from its statement regarding the Fed Finds rate. Alas, none of these were to be,
The Fed decided to permit QE2 to run its course, announced that it plans to reinvest proceeds from maturing QE2 assets and that policy will remain accommodative for an extended period of time. The decision to leave the course of policy unchanged was unanimous. Even Philadelphia Fed president Plosser and Dallas Fed president Fischer, two outspoken inflation hawks and QE2 critics voted for staying the course.
In his statement read at the press conference, Fed chairman Bernanke stated his case for staying the course, expressed concern that the growth may be moderating and called inflation pressures transitory. What Mr. Bernanke my mean is that food and energy prices are self-limiting and, in the case of oil prices, at least partially driven by speculation. The Fed has traditionally resisted being held hostage by speculators.
Arguments that the Fed could help the economy by raising rates, strengthening the dollar and putting more money back into the hands of the consumer. Although this idea has its merits, it must be acknowledged that the recovery we have seen thus far is a balance sheet recovery due to cheap corporate financing and favorable exchange rates for export business. Raising the Fed funds rate before employment and housing recovers could send corporate profits and the equity markets plummeting, the results could include a new round layoffs and further depression in the housing sector (Mr. Bernanke’s description of housing was “depressed”).
So what does this mean for interest rates? It obviously means that short-term rates, such as Fed Funds and three-month LIBOR will remain low. It could mean that long-term rates remain somewhat low. However, long-term rates could rise modestly as Fed policy will remain accommodative and foster some inflationary pressures. The opposite could occur when the Fed begins to tighten as disinflationary policies could result a halt to rising long-term rates before they gain much traction, but that is probably a year away.
Many readers will respond that they do not agree with Fed policy and therefore will choose investment strategies which run counter to Fed policy. One bets against the Fed at one’s own risk, The Fed sets policy, not me and not you. My personal view is that the economy needs a cleansing from borrowing and we as a nation must learn to live with in its means, However, that is not only impractical at this time because it would likely result in a recession which could be crippling, but also is not consistent with the Fed’s dual mandates of price stability and job growth. My views of what should be done are irrelevant. We only need to understand what the Fed will do and why and invest accordingly.
Make no mistake; the Fed cannot fix the economy. Mr. Bernanke knows that as well as anyone. He is just trying to keep things chugging along until the boys and girls on Capitol Hill make the necessary tough choices to make the economy fundamentally sound. What those choices are is a discussion for another day.
FYI: May begins my final year at my place of employment.
Monday, April 18, 2011
It's Been a Long Time
It has been a while since I posted commentary. Let's discuss recent events.
Retail sales rose for the ninth consecutive month, albeit at a slower pace, as consumers continue to spend in the face of higher food and energy prices. The increase of retail sales indicates that prices might not havee risen high enough to snuff out consumer spending, but may have risen high enough to slow it down. This could be an example of the economic headwinds which he have discusses previously. The economic headwinds may not be stiff enough to stop the U.S. recovery, but could be enough to slow it down.
It should also be mentioned that a recent pick up in hiring is probably helping consumers to keep pace with higher food and energy costs, but consumers are also being helped by the one-year suspension of payroll taxes. Temporary tax cuts usually carry temporary benefits for consumption. The benefits tend to wane months before the temporary tax cuts end. It is not inconceivable that the benefits of the temporary tax cuts begin to provide diminishing returns with regard to consumer spending in the coming months.
Many economists were encouraged by the increased consumer spending across a broad spectrum of the economy. However, retailers such as Wal-Mart are concerned that higher commodities prices will continue to squeeze consumers. Yesterday Rosalind Brewer, the president of Wal-Mart’s “Wal-Mart East” division said the following during an investor presentation:
“We still see our customer financially strapped. We see the shopper’s wallet being stretched a lot more.”
Wal-Mart’s experiences are worth watching as many of its customers are of the lower-income and middle-income variety. Higher food and energy prices tend to act like a regressive tax on consumption. This means that lower-income consumers are usually impacted the hardest. It is encouraging see that consumer spending continues to increase, but the deceleration is concerning. As physics teaches us, deceleration is actually acceleration in the other direction.
Worries about higher food and energy prices squeezing consumers are beginning to appear among market participants. An article in today’s Wall Street Journal discusses the recent drop in commodities prices and how concerns about a squeezed consumer and slower economic growth could be behind the decline.
Yesterday’s decline in stocks, oil and basic goods has raised concerns that commodities prices have become too expensive for consumers who continue to deal with high unemployment and stagnant wages. Government data released yesterday reported a decline of U.S. exports in February, the first decline since August 2010. Many industry economists continue to lower growth estimates for 2011.
One market participant told Bloomberg News:
"The potential for a slowdown in the global growth story has finally come to fruition. I'm not saying we're going to get a recession, but if you look at the range of growth estimates for the year, people are coming in more toward the bottom of the range. It looks like expectations are on the muted side."
Many pundits and most consumers point to soaring gasoline prices as evidence of inflation. To anyone who must drive to work or to shuttle one’s family from place to place, higher fuel prices are inflationary. However, to the bond market and to many Fed officials inflation is not yet a problem.
We would caution investors against making fixed investment decisions based whether they or some pundit believes the Fed is wrong. It matters not what they believe the Fed should do about higher food and energy prices. It does not matter what we believe the Fed should do about higher food and energy prices. It only matters what the FOMC (specifically Ben Bernanke) believes the Fed should do about higher food and energy prices (or prices and growth as a whole for that matter). Bet against the Fed at your own risk.
Thus far the Fed has given us hints of what it may do going forward. It is probable that the Fed continues QE2 through June as planned, but then ceases bond purchases for the purpose of quantitative easing. That in itself could be considered policy tightening because it potentially removes price support (yield suppression) for the bond market. Higher yields in the open markets could curb inflation (and growth).
However, the cessation of QE2 may not have the effect on interest rates that most people expect. We would like to bring you back to last year when the Fed halted bond purchases as it let QE1 wind down. Following the cessation of QE1 (and other government stimulus measures), the yield of the 10-year treasury note fell.
Why did the yield of the 10-year U.S. treasury note fall when the Fed ended QE1 purchases and rise when the Fed announced it would purchase bonds to keep real interest rates at accommodative levels? The markets viewed the cessation of QE1 as disinflationary (the soft patch into which the U.S. economy fell was largely blamed on the removal of government stimulus). The markets viewed the possibility followed by the implementation of QE2 as being potentially inflationary.
When one stops to think, these were logical reactions. Why else would the Fed engage in quantitative easing except to stimulate consumption and economic growth which are usually inflationary in their effect? The drop in rates following the cessation of QE1 likely reflected market sentiment that a double-dip recession was possible. The response to QE2 was a kind of relief price selloff / yield rally. So what do fixed income market participants believe is coming down the pike? For that we turn to the Bloomberg survey
Retail sales rose for the ninth consecutive month, albeit at a slower pace, as consumers continue to spend in the face of higher food and energy prices. The increase of retail sales indicates that prices might not havee risen high enough to snuff out consumer spending, but may have risen high enough to slow it down. This could be an example of the economic headwinds which he have discusses previously. The economic headwinds may not be stiff enough to stop the U.S. recovery, but could be enough to slow it down.
It should also be mentioned that a recent pick up in hiring is probably helping consumers to keep pace with higher food and energy costs, but consumers are also being helped by the one-year suspension of payroll taxes. Temporary tax cuts usually carry temporary benefits for consumption. The benefits tend to wane months before the temporary tax cuts end. It is not inconceivable that the benefits of the temporary tax cuts begin to provide diminishing returns with regard to consumer spending in the coming months.
Many economists were encouraged by the increased consumer spending across a broad spectrum of the economy. However, retailers such as Wal-Mart are concerned that higher commodities prices will continue to squeeze consumers. Yesterday Rosalind Brewer, the president of Wal-Mart’s “Wal-Mart East” division said the following during an investor presentation:
“We still see our customer financially strapped. We see the shopper’s wallet being stretched a lot more.”
Wal-Mart’s experiences are worth watching as many of its customers are of the lower-income and middle-income variety. Higher food and energy prices tend to act like a regressive tax on consumption. This means that lower-income consumers are usually impacted the hardest. It is encouraging see that consumer spending continues to increase, but the deceleration is concerning. As physics teaches us, deceleration is actually acceleration in the other direction.
Worries about higher food and energy prices squeezing consumers are beginning to appear among market participants. An article in today’s Wall Street Journal discusses the recent drop in commodities prices and how concerns about a squeezed consumer and slower economic growth could be behind the decline.
Yesterday’s decline in stocks, oil and basic goods has raised concerns that commodities prices have become too expensive for consumers who continue to deal with high unemployment and stagnant wages. Government data released yesterday reported a decline of U.S. exports in February, the first decline since August 2010. Many industry economists continue to lower growth estimates for 2011.
One market participant told Bloomberg News:
"The potential for a slowdown in the global growth story has finally come to fruition. I'm not saying we're going to get a recession, but if you look at the range of growth estimates for the year, people are coming in more toward the bottom of the range. It looks like expectations are on the muted side."
Many pundits and most consumers point to soaring gasoline prices as evidence of inflation. To anyone who must drive to work or to shuttle one’s family from place to place, higher fuel prices are inflationary. However, to the bond market and to many Fed officials inflation is not yet a problem.
We would caution investors against making fixed investment decisions based whether they or some pundit believes the Fed is wrong. It matters not what they believe the Fed should do about higher food and energy prices. It does not matter what we believe the Fed should do about higher food and energy prices. It only matters what the FOMC (specifically Ben Bernanke) believes the Fed should do about higher food and energy prices (or prices and growth as a whole for that matter). Bet against the Fed at your own risk.
Thus far the Fed has given us hints of what it may do going forward. It is probable that the Fed continues QE2 through June as planned, but then ceases bond purchases for the purpose of quantitative easing. That in itself could be considered policy tightening because it potentially removes price support (yield suppression) for the bond market. Higher yields in the open markets could curb inflation (and growth).
However, the cessation of QE2 may not have the effect on interest rates that most people expect. We would like to bring you back to last year when the Fed halted bond purchases as it let QE1 wind down. Following the cessation of QE1 (and other government stimulus measures), the yield of the 10-year treasury note fell.
Why did the yield of the 10-year U.S. treasury note fall when the Fed ended QE1 purchases and rise when the Fed announced it would purchase bonds to keep real interest rates at accommodative levels? The markets viewed the cessation of QE1 as disinflationary (the soft patch into which the U.S. economy fell was largely blamed on the removal of government stimulus). The markets viewed the possibility followed by the implementation of QE2 as being potentially inflationary.
When one stops to think, these were logical reactions. Why else would the Fed engage in quantitative easing except to stimulate consumption and economic growth which are usually inflationary in their effect? The drop in rates following the cessation of QE1 likely reflected market sentiment that a double-dip recession was possible. The response to QE2 was a kind of relief price selloff / yield rally. So what do fixed income market participants believe is coming down the pike? For that we turn to the Bloomberg survey
Sunday, April 3, 2011
Truth About Jobs
Friday’s employment data were considered, by some estimates, to be the first true sign that employment is beginning to gain some traction. You may recall that the January data was believed to have been negatively impacted by inclement weather throughout much of the country. This was followed by a strong report in February, but much of the improvement was credited to a snap back in hiring (a make up effect) from the weather-influenced January data.
We believe that one economist summed it up well when he said:
“It’s not a blow-out number but all in all, it’s a good report.”
Most data components indicated improvements. Even government job cuts slowed from a prior -46,000 to -14,000. Professional and Business services (+78,000), Education and Health (45,000), Health and Social Assistance (45,000) and Leisure and Hospitality (37,000) led the sectors reporting gains. The Information sector came in at -4,000 and Transportation and Warehouse did not add any jobs. Manufacturing added 17,000 jobs. The forecast called for a gain of 30,000 new manufacturing jobs.
The so-called household survey reported a drop in the unemployment rate from 8.9% to 8.8%, even as the labor force increased by 160,000. However, the labor force participation rate remained unchanged at 64.2%. This is still below participation rate of 64.9% from years ago.
How can the labor force expand, but the participation rate increase? This is the result of an expanding U.S. population. It is generally agreed that the U.S. economy needs to add approximately 200,000 new jobs each month just to keep pace with the expanding population.
Not all of the numbers were good. Average Hourly Earnings were unchanged on a month-over-month basis and remained unchanged at a pace of +1.7% on a year-over-year basis. Therein lies the problem. Wages are not keeping pace with commodities prices. Consumers, especially middle-income and lower-income consumers, are being squeezed and must make difficult decisions between discretionary spending and heating their homes, fueling their car, putting enough food on the table or taking vacations, buying new appliances, or improving their homes.
Many businesses are also being squeezed. The Average Hourly Earnings data and the Average Weekly Hours data indicate that business spending on labor has not kept pace with corporate profits. Many businesses continue to find it difficult to pass along price increases to consumers as consumers may put off purchases rather than pay higher prices. To compensate for a lack of pricing power, companies continue to squeeze workers by trying to get more production from them and not offering much in the way of pay increases. Unless wage growth takes hold, higher commodities prices could be a drag on consumption. Even the Fed (and individual Fed officials) have lowered their growth forecasts.
Speaking of Fed officials, Minneapolis Fed president Narayana Kocherlakota stated in an interview that the Fed may need to raise short-term interest rates by year-end if underlying inflation rises. Inflation hawks and bond bears (who are usually equity bulls) ran with this story and began predicting an interest rate blow-out to anyone who would listen.
Mr. Kocherlakota believes that higher commodities prices may bleed into core inflation and require the Fed to raise rates. He uses the oft-cited Taylor Rule (which we have mentioned previously) to support his case for higher policy rates. Mr. Kocherlakota believes that inflationary pressures could result in a 75 basis point Fed Funds rate increase according to the Taylor Rule. He makes no mention of whether or not the 75 basis point increase would follow, precede or accompany a selling of U.S. treasury securities holdings accumulated between two rounds of quantitative easing.
According the Taylor Rule, an effectively negative Fed Funds rate was required to boost price pressures (and economic growth) prior to the Feds launch of two rounds of quantitative easing. A 75 basis point increase of the Fed Funs rate may only get the effective Fed Funds rate back to 0.00% or so if QE holdings remain on the Fed’s balance sheet.
We do not dispute that the Fed will change its bias to one of less accommodative Fed policies, but how it may begin to tighten remains unclear. The Fed could remove much stimulus by selling its U.S. treasury holdings without raising the Fed Funds rate. Simply not purchasing additional U.S. treasuries would result in effective tightening of monetary policy. Whether the Fed chooses to first raise rates or reduce the size of its balance sheet remains a question, but it is likely that the first move the Fed will make is to cease QE2 purchases in June.
Although they do not get the media attention given to the inflation hawks, there are a number of Fed officials who do not believe that QE2 purchases will be curtailed. Cleveland Fed president Sandra Pianalto said yesterday that “several important factors will keep inflation in check" and that among them, are "the continuing slow growth in wages, which helps determine the cost of producing goods and services and, in turn, the prices set by firms" and "retailers' reluctance to raise prices in the face of strong competition and soft business conditions."
This morning, New York Fed president William Dudley said in a speech in San Juan, Puerto Rico that he currently does not see a reason for reversing Fed policy in what remains a “still tenuous” recovery. He also termed the recovery as being “far from the mark” of the Fed’s goals of full employment and price stability. It is believed that Mr. Dudley’s view of the economy and Fed policy is similar to that of Fed Chairman Ben Bernanke. Also, the New York Fed president is usually the most influential of the presidents of the regional Fed banks.
Mr. Dudley went on to state:
“We must not be overly optimistic about the growth outlook. A stronger recovery with more rapid progress toward our dual mandate objectives is what we have been seeking. This is welcome and not a reason to reverse course.”
We would like to be clear that there is little contention on the street that the Fed will begin removing stimulus. However, how, when and to what degree the Fed removes stimulus is the subject of much disagreement. Based on recent comments from Fed chairman Bernanke and New York Fed president Dudley, the first step in removing Fed stimulus is likely to be the follow through on QE2 in June. Following that, it is likely the Fed will analyze economic data and gauge the markets’ reaction to both the economic data and the ending of QE2. If the recovery looks like it is gaining more traction and / or core inflation begins to spike, the Fed could raise the Fed Funds rate, begin reducing the size of its balance sheet or a combination of both.
Judging by the pace of the recovery, the population-replacement-like pace of job growth, a lack of wage growth and the lack of business pricing power that has been observed thus far, it is probably unlikely that we will see a spike in shot-term interest rates. Using Mr. Kocherlakota's favored Taylor rule as a guide and considering the unprecedented stimulus it has required just to get the economy to the current pace of recovery, it might turn out that not much tightening will be necessary to reign in inflation end keep growth under control. We doubt that many Fed officials are fearful of an overheating economy.
Following this morning’s economic data prices of long-dated treasuries are little changed. The price of the benchmark 10-year U.S. treasury note is up 3/32s to yield 3.46%. The price of the 30-year U.S. government bond is up 4/32s to yield 4.50%.
There is a possible phenomenon which some investors may have failed to consider, that being the possibility that the removal of Fed stimulus is considered by market participants to be anti-inflationary resulting moderating the rise of long-term interest rates. You might recall that following the launch of QE2 last November, long-term treasury yields began to rise due to fears that the latest round of Fed stimulus would prove to be inflationary. The reverse may be true when QE is halted and, eventually, removed.
When the Fed raises the Fed Funds rate, the response from fixed income market participants (at some point during the tightening cycle) is that the Fed has tightened more than enough to combat inflation and begins to move capital farther out on the yield curve. Since QE is akin to lowering the Fed Funds rate, the removal of QE2 could have the same effect as raising the Fed fund rate.
Bloomberg has posted a revised interest rate forecast as per their survey of fixed income market participants. The current year-end 2011 forecasts are as follows:
Interest Rate Forecasts Q4 2011 Q1 2012 Q2 2012
30-year: 4.95% 5.14% 5.23%
10-year: 3.89% 4.10% 4.21%
2-year: 1.33% 1.68% 1.95%
3-month USD LIBOR 0.62% 0.89% 1.27%
Fed Funds Target Rate .25% 0.50% 1.00%
As you can see, the street does not believe that interest rates are poised to take off, but rather rise gradually. If these forecasts come close to fruition, a laddered portfolio with a duration on the belly of the curve 5 to 7 years out (with maturities out top 10 years) may prove to be advantageous. Step-ups could provide some cushion against modestly higher long-term rates, but floaters adjusting off of short-term benchmarks, such as LIBOR, may disappoint investors.
The truth of the matter is that the recovery sucks. This is due to two factors.
1) The economy is not fundamentally capable of growth rates seen during recoveries of the past two decades. A perfect storm of evermore accommodative Fed policies and ever easier lending standards combined to fuel economic growth by promoting borrowing.
2) Consumers will have to continue to deleverage.
The economy will recover slowly and peak at what will be a disappointing level for many Americans spoiled by getting what they want when the want it.
We believe that one economist summed it up well when he said:
“It’s not a blow-out number but all in all, it’s a good report.”
Most data components indicated improvements. Even government job cuts slowed from a prior -46,000 to -14,000. Professional and Business services (+78,000), Education and Health (45,000), Health and Social Assistance (45,000) and Leisure and Hospitality (37,000) led the sectors reporting gains. The Information sector came in at -4,000 and Transportation and Warehouse did not add any jobs. Manufacturing added 17,000 jobs. The forecast called for a gain of 30,000 new manufacturing jobs.
The so-called household survey reported a drop in the unemployment rate from 8.9% to 8.8%, even as the labor force increased by 160,000. However, the labor force participation rate remained unchanged at 64.2%. This is still below participation rate of 64.9% from years ago.
How can the labor force expand, but the participation rate increase? This is the result of an expanding U.S. population. It is generally agreed that the U.S. economy needs to add approximately 200,000 new jobs each month just to keep pace with the expanding population.
Not all of the numbers were good. Average Hourly Earnings were unchanged on a month-over-month basis and remained unchanged at a pace of +1.7% on a year-over-year basis. Therein lies the problem. Wages are not keeping pace with commodities prices. Consumers, especially middle-income and lower-income consumers, are being squeezed and must make difficult decisions between discretionary spending and heating their homes, fueling their car, putting enough food on the table or taking vacations, buying new appliances, or improving their homes.
Many businesses are also being squeezed. The Average Hourly Earnings data and the Average Weekly Hours data indicate that business spending on labor has not kept pace with corporate profits. Many businesses continue to find it difficult to pass along price increases to consumers as consumers may put off purchases rather than pay higher prices. To compensate for a lack of pricing power, companies continue to squeeze workers by trying to get more production from them and not offering much in the way of pay increases. Unless wage growth takes hold, higher commodities prices could be a drag on consumption. Even the Fed (and individual Fed officials) have lowered their growth forecasts.
Speaking of Fed officials, Minneapolis Fed president Narayana Kocherlakota stated in an interview that the Fed may need to raise short-term interest rates by year-end if underlying inflation rises. Inflation hawks and bond bears (who are usually equity bulls) ran with this story and began predicting an interest rate blow-out to anyone who would listen.
Mr. Kocherlakota believes that higher commodities prices may bleed into core inflation and require the Fed to raise rates. He uses the oft-cited Taylor Rule (which we have mentioned previously) to support his case for higher policy rates. Mr. Kocherlakota believes that inflationary pressures could result in a 75 basis point Fed Funds rate increase according to the Taylor Rule. He makes no mention of whether or not the 75 basis point increase would follow, precede or accompany a selling of U.S. treasury securities holdings accumulated between two rounds of quantitative easing.
According the Taylor Rule, an effectively negative Fed Funds rate was required to boost price pressures (and economic growth) prior to the Feds launch of two rounds of quantitative easing. A 75 basis point increase of the Fed Funs rate may only get the effective Fed Funds rate back to 0.00% or so if QE holdings remain on the Fed’s balance sheet.
We do not dispute that the Fed will change its bias to one of less accommodative Fed policies, but how it may begin to tighten remains unclear. The Fed could remove much stimulus by selling its U.S. treasury holdings without raising the Fed Funds rate. Simply not purchasing additional U.S. treasuries would result in effective tightening of monetary policy. Whether the Fed chooses to first raise rates or reduce the size of its balance sheet remains a question, but it is likely that the first move the Fed will make is to cease QE2 purchases in June.
Although they do not get the media attention given to the inflation hawks, there are a number of Fed officials who do not believe that QE2 purchases will be curtailed. Cleveland Fed president Sandra Pianalto said yesterday that “several important factors will keep inflation in check" and that among them, are "the continuing slow growth in wages, which helps determine the cost of producing goods and services and, in turn, the prices set by firms" and "retailers' reluctance to raise prices in the face of strong competition and soft business conditions."
This morning, New York Fed president William Dudley said in a speech in San Juan, Puerto Rico that he currently does not see a reason for reversing Fed policy in what remains a “still tenuous” recovery. He also termed the recovery as being “far from the mark” of the Fed’s goals of full employment and price stability. It is believed that Mr. Dudley’s view of the economy and Fed policy is similar to that of Fed Chairman Ben Bernanke. Also, the New York Fed president is usually the most influential of the presidents of the regional Fed banks.
Mr. Dudley went on to state:
“We must not be overly optimistic about the growth outlook. A stronger recovery with more rapid progress toward our dual mandate objectives is what we have been seeking. This is welcome and not a reason to reverse course.”
We would like to be clear that there is little contention on the street that the Fed will begin removing stimulus. However, how, when and to what degree the Fed removes stimulus is the subject of much disagreement. Based on recent comments from Fed chairman Bernanke and New York Fed president Dudley, the first step in removing Fed stimulus is likely to be the follow through on QE2 in June. Following that, it is likely the Fed will analyze economic data and gauge the markets’ reaction to both the economic data and the ending of QE2. If the recovery looks like it is gaining more traction and / or core inflation begins to spike, the Fed could raise the Fed Funds rate, begin reducing the size of its balance sheet or a combination of both.
Judging by the pace of the recovery, the population-replacement-like pace of job growth, a lack of wage growth and the lack of business pricing power that has been observed thus far, it is probably unlikely that we will see a spike in shot-term interest rates. Using Mr. Kocherlakota's favored Taylor rule as a guide and considering the unprecedented stimulus it has required just to get the economy to the current pace of recovery, it might turn out that not much tightening will be necessary to reign in inflation end keep growth under control. We doubt that many Fed officials are fearful of an overheating economy.
Following this morning’s economic data prices of long-dated treasuries are little changed. The price of the benchmark 10-year U.S. treasury note is up 3/32s to yield 3.46%. The price of the 30-year U.S. government bond is up 4/32s to yield 4.50%.
There is a possible phenomenon which some investors may have failed to consider, that being the possibility that the removal of Fed stimulus is considered by market participants to be anti-inflationary resulting moderating the rise of long-term interest rates. You might recall that following the launch of QE2 last November, long-term treasury yields began to rise due to fears that the latest round of Fed stimulus would prove to be inflationary. The reverse may be true when QE is halted and, eventually, removed.
When the Fed raises the Fed Funds rate, the response from fixed income market participants (at some point during the tightening cycle) is that the Fed has tightened more than enough to combat inflation and begins to move capital farther out on the yield curve. Since QE is akin to lowering the Fed Funds rate, the removal of QE2 could have the same effect as raising the Fed fund rate.
Bloomberg has posted a revised interest rate forecast as per their survey of fixed income market participants. The current year-end 2011 forecasts are as follows:
Interest Rate Forecasts Q4 2011 Q1 2012 Q2 2012
30-year: 4.95% 5.14% 5.23%
10-year: 3.89% 4.10% 4.21%
2-year: 1.33% 1.68% 1.95%
3-month USD LIBOR 0.62% 0.89% 1.27%
Fed Funds Target Rate .25% 0.50% 1.00%
As you can see, the street does not believe that interest rates are poised to take off, but rather rise gradually. If these forecasts come close to fruition, a laddered portfolio with a duration on the belly of the curve 5 to 7 years out (with maturities out top 10 years) may prove to be advantageous. Step-ups could provide some cushion against modestly higher long-term rates, but floaters adjusting off of short-term benchmarks, such as LIBOR, may disappoint investors.
The truth of the matter is that the recovery sucks. This is due to two factors.
1) The economy is not fundamentally capable of growth rates seen during recoveries of the past two decades. A perfect storm of evermore accommodative Fed policies and ever easier lending standards combined to fuel economic growth by promoting borrowing.
2) Consumers will have to continue to deleverage.
The economy will recover slowly and peak at what will be a disappointing level for many Americans spoiled by getting what they want when the want it.
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