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.
Wednesday, May 18, 2011
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.
Sunday, March 27, 2011
Taylor Made
No surprises in Friday’s GDP numbers as all were in line with or very close to street consensus estimates. The final read of Q4 2010 GDP indicates that the economy grew at a pace of 3.1%. Although today’s data were encouraging, there are concerns that higher energy prices and the aftermath of global events could erode consumers’ purchasing power, slowing down the pace of the economic recovery.
One economist told Bloomberg News:
“We’re seeing the effects of rising gasoline prices and we’re going to see a negative impact from the earthquake start to show up because of bottlenecks in the global supply chain. Recent data suggests the expansion is a little softer than anticipated.”
The lower than expected University of Michigan Confidence data indicates that consumers are being squeezed by higher food and energy prices. The report is more distressing than it may appear. This is the Final read of the March data. The prior 68.2 was a preliminary report of March data. The February data indicated a index number of 77.5. That is quite a drop between February and March. Today's index of 67.5 was the lowest read of University of Michigan Confidence since a report of 67.4 in November 2009.
There has been renewed interest in forecasting when the Fed will raise the Fed Funds rate. What many people fail to realize is that the Fed can (and probably will begin to change monetary policy without raisin the Fed Finds rate. That will probably come next year. How and why can the Fed begin to change monetary policy without raising rates? I will try to explain.
First, one must understand the Taylor Rule. Simply stated, the Taylor Rules indicates how much a central bank should raise or lower interest rates in response to the divergence of actual inflation rates versus target inflation rates or, in the case of the Fed which does not have an official inflation target, the divergence of the prevailing rate of inflation versus the desired rate of inflation (believed to be in an approximate range of 2.0% to 2.5%).
Using the Taylor rule as a guide, the Fed Funds rate should be in negative territory. However, since the Fed Funds rate cannot be negative (borrowers cannot be paid to borrow money), the effectively lower interest rates, the Fed has engaged in quantitative easing. The result is that short-term interest rates are effectively below zero. This is what Mr. Diclemente means when he says: “asset purchases and commitment language together are the equivalent of lower overnight rates.”
Although the street consensus forecast calls for the Fed to leave the Fed Funds rate unchanged until early to mid 2012, this does not mean that the Fed will not move to a tightening bias. Here are examples of Fed tightening other than raising the Fed Funds rate:
1) Letting QE2 run its course by June and not engage in QE3.
2) Selling its bond holdings. The Fed does not necessarily have to sell its holdings outright. It can engage in reverse repos (A.K.A. reverse repurchase agreements). In a reverse repo, the Fed temporarily sells securities to counterparties with the intention of repurchasing at a later date at a predetermined price. By executing reverse repos, the Fed can temporarily remove money from the system. This effects a Fed tightening without reducing the size of its balance sheet. The Fed can engage in reverse repos (or repos for that matter should it want to add money to the system) enabling it to fine tune policy to economic conditions. The Fed tested the waters and executed a small amount of reverse repos yesterday to test the waters.
3) Jawboning: The Fed could and probably will begin to use language hinting at a less accommodative policy stance. That usually causes market participants to change their trading or investment strategies. The usual result is higher short-term yields. Note: Long-term yields often do not respond in kind (and sometimes remain little changed or even fall) in response to Fed tightening, resulting in a flattening yield curve.
The point I am trying to make is that raising the Fed Funds rate is not the only way, and probably will not be the first way, in which the Fed removes stimulus from the system. Those who are waiting for actual short-term rates to rise may have to wait at least another year before that happens.
Investors should not myopically view higher short-term rates as the Fed’s only method of moving to a tightening bias. They should also be cautioned against making the mistake of believing that higher short-term rates automatically equates to higher long-term rates.
The goal of higher short-term rates is to quell inflation. If inflationary pressures are abated, there would little reason for long-term rates to rise very high. If the Fed is successful, we could see a scenario in which the halt and reversal of quantitative easing accomplish much of the desired inflation abatement and could be followed by only a modest Fed Funds rate increase. Assuming the Fed will be successful in combating inflation, long-term rates during the forthcoming interest rate cycle may also peak at levels below to what we have become accustomed.
The street consensus is in line with this scenario. Here are the Q2 2012 street consensus estimates for interest rates across the yield curve as compiled by Bloomberg News among at least 40 respondents per area of the yield curve.
Fed Funds: 1.00%.
Three-month USD LIBOR: 1.25%.
Two-year Note: 1.95%.
Ten-year Note: 4.25%
Thirty-year Bond 5.25%.
Although the forecast is for higher rates across the curve, the forecast does not call for extraordinarily high interest rates. Considering that QE has effective policy interest rates below zero, a Fed Funds rate of 1.00% may have a similar effect as a 200 basis point (or more) Fed Funds rate increase had during previous interest rate cycles. Where will the Fed Funds peak during the next cycle? It is too early to even forecast, but given the relatively weak economic underpinnings and the slow pace of the recovery, Fed Funds rates may not have to be very high to rein in inflation. It is not inconceivable that the Fed Funds rate peaks at 3.00% or less during the next interest rate cycle.
Last year, a well-respected economist cautioned me that the absolutes during this recovery, including interest rates, could be lower than to what we have become accustomed. In such a scenario, staying overweighted in cash or focusing one’s portfolio in short-term benchmark floaters could be a poor strategy. However, because only relatively-small long-term rate increases are necessary to result in sharp price declines in long-duration securities, one may not wish to overweight the long end of the curve. As is common in life, the answer may lie in the middle.
The belly of the curve, between three five and ten years, may offer the best returns on a risk / volatility-to-reward basis. Our suggestion to investors would be to not try to time the markets, peg a specific area of the curve or focus on a product which may outperform should market conditions play out in a specific fashion and structure a diverse portfolio which should perform well under a variety of market conditions.
One economist told Bloomberg News:
“We’re seeing the effects of rising gasoline prices and we’re going to see a negative impact from the earthquake start to show up because of bottlenecks in the global supply chain. Recent data suggests the expansion is a little softer than anticipated.”
The lower than expected University of Michigan Confidence data indicates that consumers are being squeezed by higher food and energy prices. The report is more distressing than it may appear. This is the Final read of the March data. The prior 68.2 was a preliminary report of March data. The February data indicated a index number of 77.5. That is quite a drop between February and March. Today's index of 67.5 was the lowest read of University of Michigan Confidence since a report of 67.4 in November 2009.
There has been renewed interest in forecasting when the Fed will raise the Fed Funds rate. What many people fail to realize is that the Fed can (and probably will begin to change monetary policy without raisin the Fed Finds rate. That will probably come next year. How and why can the Fed begin to change monetary policy without raising rates? I will try to explain.
First, one must understand the Taylor Rule. Simply stated, the Taylor Rules indicates how much a central bank should raise or lower interest rates in response to the divergence of actual inflation rates versus target inflation rates or, in the case of the Fed which does not have an official inflation target, the divergence of the prevailing rate of inflation versus the desired rate of inflation (believed to be in an approximate range of 2.0% to 2.5%).
Using the Taylor rule as a guide, the Fed Funds rate should be in negative territory. However, since the Fed Funds rate cannot be negative (borrowers cannot be paid to borrow money), the effectively lower interest rates, the Fed has engaged in quantitative easing. The result is that short-term interest rates are effectively below zero. This is what Mr. Diclemente means when he says: “asset purchases and commitment language together are the equivalent of lower overnight rates.”
Although the street consensus forecast calls for the Fed to leave the Fed Funds rate unchanged until early to mid 2012, this does not mean that the Fed will not move to a tightening bias. Here are examples of Fed tightening other than raising the Fed Funds rate:
1) Letting QE2 run its course by June and not engage in QE3.
2) Selling its bond holdings. The Fed does not necessarily have to sell its holdings outright. It can engage in reverse repos (A.K.A. reverse repurchase agreements). In a reverse repo, the Fed temporarily sells securities to counterparties with the intention of repurchasing at a later date at a predetermined price. By executing reverse repos, the Fed can temporarily remove money from the system. This effects a Fed tightening without reducing the size of its balance sheet. The Fed can engage in reverse repos (or repos for that matter should it want to add money to the system) enabling it to fine tune policy to economic conditions. The Fed tested the waters and executed a small amount of reverse repos yesterday to test the waters.
3) Jawboning: The Fed could and probably will begin to use language hinting at a less accommodative policy stance. That usually causes market participants to change their trading or investment strategies. The usual result is higher short-term yields. Note: Long-term yields often do not respond in kind (and sometimes remain little changed or even fall) in response to Fed tightening, resulting in a flattening yield curve.
The point I am trying to make is that raising the Fed Funds rate is not the only way, and probably will not be the first way, in which the Fed removes stimulus from the system. Those who are waiting for actual short-term rates to rise may have to wait at least another year before that happens.
Investors should not myopically view higher short-term rates as the Fed’s only method of moving to a tightening bias. They should also be cautioned against making the mistake of believing that higher short-term rates automatically equates to higher long-term rates.
The goal of higher short-term rates is to quell inflation. If inflationary pressures are abated, there would little reason for long-term rates to rise very high. If the Fed is successful, we could see a scenario in which the halt and reversal of quantitative easing accomplish much of the desired inflation abatement and could be followed by only a modest Fed Funds rate increase. Assuming the Fed will be successful in combating inflation, long-term rates during the forthcoming interest rate cycle may also peak at levels below to what we have become accustomed.
The street consensus is in line with this scenario. Here are the Q2 2012 street consensus estimates for interest rates across the yield curve as compiled by Bloomberg News among at least 40 respondents per area of the yield curve.
Fed Funds: 1.00%.
Three-month USD LIBOR: 1.25%.
Two-year Note: 1.95%.
Ten-year Note: 4.25%
Thirty-year Bond 5.25%.
Although the forecast is for higher rates across the curve, the forecast does not call for extraordinarily high interest rates. Considering that QE has effective policy interest rates below zero, a Fed Funds rate of 1.00% may have a similar effect as a 200 basis point (or more) Fed Funds rate increase had during previous interest rate cycles. Where will the Fed Funds peak during the next cycle? It is too early to even forecast, but given the relatively weak economic underpinnings and the slow pace of the recovery, Fed Funds rates may not have to be very high to rein in inflation. It is not inconceivable that the Fed Funds rate peaks at 3.00% or less during the next interest rate cycle.
Last year, a well-respected economist cautioned me that the absolutes during this recovery, including interest rates, could be lower than to what we have become accustomed. In such a scenario, staying overweighted in cash or focusing one’s portfolio in short-term benchmark floaters could be a poor strategy. However, because only relatively-small long-term rate increases are necessary to result in sharp price declines in long-duration securities, one may not wish to overweight the long end of the curve. As is common in life, the answer may lie in the middle.
The belly of the curve, between three five and ten years, may offer the best returns on a risk / volatility-to-reward basis. Our suggestion to investors would be to not try to time the markets, peg a specific area of the curve or focus on a product which may outperform should market conditions play out in a specific fashion and structure a diverse portfolio which should perform well under a variety of market conditions.
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