the never ending fed merry go round - balance … · the never ending fed merry go round ... rather...
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The Never Ending Fed Merry Go Round
The bulls have been watching the stock market rise without many corrections over the past seven
years. In fact, the market has not had a significant decline since this bull market started in March
of 2009. Clearly, the reason for such an extended equity rise was due to the Fed pumping in
enormous amounts of money into the financial system. In doing so, U.S. monetary policy has
distorted and inflated the price of stocks, bonds and anything else that trades, including precious
art, residential and commercial real estate. In other words, the market is not the economy.
This nonsensical monetary stimulation policy was not limited to the U.S. The rest of the world
followed the U.S. as well as Japan, who has been doing a similar monetary policy for the past 27
years with virtually no success. As we have noted in prior articles, the Bank of Japan has just
recently decided to use negative interest rates to stimulate their economy. Negative interest rates
are also being used by the European Central Bank in order to boost a stagnating European
economy. In China, though rates are not negative, the People’s Bank of China (PBOC) has
“doubled down” and added huge amounts of debt over the past seven years. In fact, the
government debt has grown to 243% of GDP over the last seven years. But, as noted time and
time in this space, none of this has worked in stimulating real economic growth in the U.S. or
around the world.
As frequent readers have heard from me (maybe too many times), I have been extremely critical
of Central Banks and their “experimental” policies and the “unintended consequences” that
may occur from these policies. Consider the following “unintended consequences” of the Fed’s
“experiments:”
Debt is future consumption denied. Bringing future demand forward by lowering interest
rates to zero just digs a gigantic hole in future demand. Funny thing, the future eventually
becomes the present, and instead of a brief recession of low demand we get an extended
recession of weak demand and over-indebted households and enterprises. Sound familiar?
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Enabling and sponsoring massive systemic speculation is reckless and destructive. Capital is no longer allocated on productive returns (i.e. real investment), but on the
speculative gains to be reaped with the Fed's free money for Wall Street. You would have
thought the bubble building central bankers would have realized this by now.
Buying assets to artificially prop up markets completely distorts the markets' ability to
price assets based on real returns and real risk. If you have not already noticed, we no
longer have free capital markets. Rather, the 12 people in the Eccles building are planning
the markets/economy and the winners and losers. (Reminds me of the USSR Politburo).
As James Grant so perfectly and succinctly summarized:
“Future citizens will reflect on this so-called PhD standard (that runs the world) with the
following realization:
"My generation gave former tenured economics professors discretionary authority to
fabricate money and to fix interest rates... We put the cart of asset prices before the horse
of enterprise… We entertained the fantasy that high asset prices made for prosperity,
rather than the other way around.”
Let’s cut to the chase. The Fed's entire policy boils down to a tsunami of debt. The whole point
of ultra-low interest rates is obviously to induce households to borrow and spend, and thereby
trigger a virtuous cycle of rising demand, increasing production, more jobs and income and even
more consumer spending. That’s Keynes 101.
But it is not working. In the U.S. we have now had 90 straight months of virtually zero interest
rates and the Fed’s balance sheet has been expanded by $3.5 trillion. No one would or could
argue that these policies are NOT extreme!
And what are the fruits of these extreme policies? We are now in month 83 of the
WEAKEST ECONOMIC recovery EVER in the storied history of the U.S. And household
income is still 5% below its level in the fall of 2007. Sadly, there are still 45 million people on
food stamps – one out of every seven Americans. But yes, the stock market is trading close to
all-time record highs.
So something doesn’t add up to put it kindly. The truth is the Fed’s entire radical regime of ZIRP
and QE has not “stimulated” the struggling main street economy. Instead, it has showered Wall
Street speculators with trillions of windfall gains.
“Monetary stimulus is a one-time parlor trick. It only works when there is business and
household balance sheet space left to leverage, thereby permitting spending derived from
current production and income in the manner of Say’s Law to be boosted with spending
derived from incremental borrowings.
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Under conditions of peak debt, therefore, the Keynesian credit magic ceases to
‘stimulate’ the main street economy. Instead, it never leaves the canyons of Wall Street,
where it cycles in an incendiary spiral of leveraged speculation and the
systematic inflation of financial assets.” – David Stockman (Former OMB Director)
The Story of Three Bubbles
One way to observe the effects of Fed-induced yield seeking speculation is to look at the graph
below, which shows household net worth (wealth) as a percent of personal disposable
income. If history is any guide, the graph deserves special attention because of what it seems to
imply for the markets and economy going forward.
The Story of Three Bubbles
Let’s review the three Fed induced bubbles since 2000.
Bubble #1: Household net worth as a percent of disposable income increased dramatically in the
mid-1990s. The first rise in household wealth ended because of the bursting of what is known as
the Dot.com bubble. Its collapse precipitated the 2000 recession.
Bubble #2: Household wealth as a percent of disposable income rose quickly, increasing by
125% from 2002 to 2006 only to collapse again precipitating the 2007 – 2009 Great Recession.
With the helping hand of the Alan Greenspan’s Federal Reserve, the large increase in household
wealth was largely driven by rising equity prices and an equally large and, as it turned out,
unsustainable rise in house prices. Not surprisingly, house prices and household net worth both
peaked in 2006.
Bubble #3: Once again, household net worth has increased dramatically. Since the end of 2012 it
has increasing by nearly 100% to 640% of disposable income. This is scary; not just because
it is an incredibly large rise in wealth in a short period of time, but because we all know what
followed in the past two bubble cycles. The bubble burst with very bad consequences for the real
economy.
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Now, an optimist could argue that a high value of financial assets relative to disposable income
is actually a good thing. They might say that rising financial assets reflects increased saving by
households. Unfortunately (as shown below), since 2000 saving as a fraction of household
income has plunged to half the savings rate observed in the previous half-century. Americans are
saving less not more! A realist would state that the elevated (artificial) level of financial
assets reflects extreme valuations, not an increase in the rate of savings or investment. Thank you Ben and Janet!
Savings has Fallen!
Life after QE
“We frontloaded a tremendous market rally to create a wealth effect... The Federal Reserve is
a giant weapon that has no ammunition left.” – Former Dallas Fed President Richard Fisher
If you have attended a CFO roundtable or a webinar over the past 12 months, one of the slides I
frequently show is the correlation between Quantitative Easing (QE) and stock market (S&P
500) performance. As you can quickly glean from the following graph (courtesy of Merrill
Lynch), when QE programs (QE1, QE2, Operation Twist and QE3) were in effect the stock
market rose steadily, but
when the QE programs
stopped a funny thing
happened. The stock market
went down.
The long term results tell the
story. During QE operations,
equity markets rose a
cumulative 176% from
December 2008 through
October 2014.
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And when the QE programs were halted (even for brief periods – see “gray” shaded areas) the
equity markets declined a cumulative 55% over the same periods! In other words, once the
steroids are removed the market traded to economic reality.
Academics often say a correlation is not necessarily causation, but to this spectator it tells me
everything I need to know about why the market is where it is today. To be blunt, the stock
market is where it is today because of the Fed’s reckless “bubble building” monetary policies
designed to create a wealth effect and stimulate consumption.
As shown in the following graph, despite a couple of 10% downdrafts, without the Feds ‘pixie
dust’ the S&P50 has remained virtually unchanged over the past 18 months since the Fed ended
QE3 in October 2014. Also, unlike the QE era, the past 18 months were punctuated with sharp
volatile slides. As you can glean from the graph below, equities peaked in December, ahead of
the Fed’s initial liftoff in its short-term rate target to the current 0.25% to 0.5%. But equities
declined after global markets swooned, along with the strong dollar, falling oil, and other
commodities, and the widening of credit spreads. Then, when Fed officials began to back off
from calls for as many as four rate hikes this year, risk markets rallied from their February lows.
More recently, the blue chips have ebbed and flowed like the tide unable to reach new highs.
The Equity Markets are Addicted to QE
The Never Ending Fed Merry Go Round
Importantly, recessions are not the driver of financial markets, but it is the market that ultimately
drives recessions. This is why the Federal Reserve is so focused on keeping asset prices elevated
in order to mitigate a loss of consumer confidence and consumption, which would push the
economy into a recession.
Because of this, the Fed will have a difficult time in reversing their extremely loose monetary
policy. Every time they have tried to reverse it, the stock market drops, and now they are scared
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to death of trying to raise rates again after the decline the market took in January, not long after
the first rate hike in December.
Yet, the Fed minutes last week highlighted a committee that continues to want to raise rates
whenever they can push it through. However, what normally happens after such hawkishness in
the current environment is either the data doesn't ever quite get there for them to pull the trigger
or the global market takes fright by enough for them to have to postpone their plan. I'm not sure
this time is any different. (See diagram below.)
With that said – the probability of a June hike has moved from 4% to 32% after the Federal Open
Market Committee minutes. Fed funds futures contracts further out in the year have also seen a
reasonable re-pricing. The probability of a July move is now up to 47% from 28% just prior to
the minutes and 19% on Monday, while a move by December has gone from 56% at the start of
the week to 65% on Tuesday and to 75% post meeting.
While it’s encouraging that the Federal Reserve wants to get out of “the Japanese trap” of the
“addiction to free money,” the timing is far from ideal: Another rate hike at the same time U.S.
growth is running below 2%, corporate earnings are falling, manufacturing is flat-lining, and
valuations for both bonds and stocks are still very overvalued is a potentially toxic mix.
The Never Ending Fed Merry Go Round
If the Fed decides to raise rates at this time, while most other central banks continue their
stimulus plans, the results could be disastrous. If the Fed does move this year, it could drive short
term rates higher, the U.S. dollar higher and the stock market lower.
Fed Threatens Rate Hike
Markets Tank
Fed Delays Hike
Markets Recover
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If I am correct, and the stock market drops sharply after the first hike, I suspect they will make
the first hike the last hike for the year. In fact, if they really fear the market as much as I think
they do, they could even go back to QE-4. But, in my opinion, if they do the investors will not
continue to be the Fed’s flunkies any longer and the market will still fall sharply knowing there
is no way out of this mess.
The Flattening Yield Curve
Last week, Bloomberg noted the two-year yield rose, stating that it “surged 13 basis points this
week, the biggest climb since the week ended November 6. The 10-year note yield rose 14 basis
points this week, also the most since November.” Oh My! It’s pretty amazing that the biggest
weekly bond selloff in half a year is a measly 14 basis points. The yield on the long bond rose a
trivial three basis points.
Remember: 2016 was the year when, in the aftermath of the Fed's first tightening cycle in a
decade, the yield curve was supposed to not only rise substantially, but also steepen, providing a
much needed boost to net interest margins (NIMs) credit unions and banks. That has not
happened, and as a result of the Fed's relent (according to which the Fed will no longer hike four
times in 2016, but at least two, and according to the market zero), yields have tumbled on the
long end of the yield curve as the yield curve has steadily flattened.
In fact, flattening has been the operative condition going all the way back to late 2013. In
particular, the spread between the two-year and 10-year Treasury has dipped to its lowest level
since 2007 and is presently trading in the mid-90 basis points range. Given that a curve
narrower than 100 basis points has correctly signaled three out of the past four recessions;
it is fair to pay attention to what ‘Mr. Market’ thinks.
Flat Yield Curve Portends Slow Growth
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The actual yield curve action is recessionary-looking. If the economy was truly strengthening,
the long end of the curve would be rising far faster than the short end as more hikes get priced in.
If the Fed manages to get in a couple hikes (I am still extremely skeptical), the already
compressed yield curve is likely to get flatter and flatter.
And a flat yield curve is not conducive to increased bank lending or bank profits.
In addition to rates, equities, currencies and commodities have been the most impacted by the
Fed's recently hawkish rhetoric. The Dow has seen several 100+ point days, both up and down
over the past week. Oil has shown encouraging signs, rising 8% over the past week, although its
gains have not translated to other commodities.
Most important, I have often cited the stronger U.S. dollar as one of the biggest challenges facing
the Fed. In addition to its role in trade, the U.S. dollar also affects emerging markets sovereigns
and corporates (which issue debt in US Dollars) with tightening credit conditions in the US
having an immediate impact on their local economies. The bottom line is the Fed drives the
dollar; the dollar doesn’t drive the Fed. If the Fed hikes aggressively, the dollar will rise and all
markets (commodities, equities and bonds) will adjust accordingly.
The Last Resort
At present, there is about $39 trillion of outstanding G10 government debt. Negative yielding
debt accounts for 35% ($9 trillion) of all G10 debt. On the other hand, the U.S. accounts for
almost 60% of all positive-yielding debt and 89% of the positive yielding debt which has a
maturity of less than one year. Also, U.S. debt accounts for 74% of the positive yielding G10
debt in the one- to five-year sector.
Thus, given that the U.S. dollar denominated debt is still extremely attractive vs. most high grade
sovereign debt; I expect an increase in demand from foreign investors that are seeking refuge
from a negative rate environment. This trend would be further strengthened with a rising dollar.
In other words, the U.S. is truly the last resort. The world cannot essentially find yield anywhere
else.
Where are they supposed to turn? Long story short, Treasury rates are not going up any time
soon with the one caveat that the Fed goes rogue and raises rates much more aggressively than
the market has priced in.
Election 2016
As poll after poll indicates “the Donald” continues to gain ground on Hillary. The Trump
campaign will need to convince more independents to come to his side by the fall. The key to
this is can Trump convince those unhappy Sanders supporters that Clinton is nothing but the
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status quo, figuring that they don't want to see her in office? In other words, a vote for Trump
would at least be a vote for an outsider who will not be afraid to shake things up.
The Silver Lining
At any rate, we now have our candidates for the Democratic and Republican parties. I personally
expect that as the Democrats continue to turn on its own party members; Trump will enjoy a nice
gain in support at least from many Sanders supporters who are irate that they are not being heard
over the ever important "Superdelegate" voices that Hillary covets so much. And of course,
Trump isn't wasting any time adding fuel to that fire.
Superdelegates
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Market Outlook and Portfolio Strategy
With the economy now more than 83 month into an expansion, which is long by historical
standards (average recoveries last 61 months), the question for you to answer is:
Are we closer to an economic recession or a continued expansion?
Your answer should have a significant impact on your investment outlook as financial markets
tend to lose roughly 30%-40% on average during recessionary periods. However, with margin
debt at record levels, revenues and earnings deteriorating and interest rate spreads narrowing,
this is hardly a normal market environment within which we are currently invested.
Let’s take a step back. Given the plethora of commentary strongly suggesting that the U.S.
economy is nowhere near recession, I thought it was time to revisit some key economic themes
as the backdrop against expectations for stronger economic growth, rising inflationary pressures
and an increase in interest rates and expectations.
This is how I see the macro landscape:
1. U.S. growth continues to slow. Remember it’s the “rate of change” not the absolute level
of growth that matters. And growth has been trending lower. Nominal GDP growth could
slow to a 2.5 - 2.8% range for the year. The slower pace in nominal GDP would continue
the 2014-15 pattern, when the rate of rise in nominal GDP decelerated from 3.9% to 3.1%.
2. U.S. consumption and employment growth slowing are more important to the Fed than
CPI. At +2% year-over-year, the latest jobless claims report was the first year-over-year
acceleration to positive since 2012. Prior to 2012, you’d have to go back to 2007 to find
the last time claims were rising.
3. Long term yields have declined significantly year-to-date, and the Treasury 10s-2s spread
compressing to new cycle lows is not exactly a bullish indicator. The resulting flattening
of the yield curve sends a signal of slowing economic growth, Michael Darda, chief
economist and market strategist at MKM Partners, points out. Fed officials appear to
believe the opposite, which is contrary to 160 years of data, he observes. Who’s right?
Mr. Market or the Fed?
4. U.S. inflation is reflating from deflationary lows – that’s not to be confused with a
breakout of hyperinflation. Slow top line growth suggests that spurts in inflation will
simply reduce real GDP growth and thus be transitory in nature.
5. If the Fed raises rates (June) into this slow-down, they’ll be the catalyst for a stronger U.S.
dollar and deflation (lower yields) again.
In conclusion, if Yellen and Co. hikes for the sake of hiking, she’ll truly prove that she’s not
politically tied to the Democrat party. Then again, she’ll probably blow up the commodity, stock,
and bond markets all at once right before the election.
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Over the next few months there will likely be increased uncertainty surrounding Fed policy and
VOLATILITY will remain HIGHER than NORMAL. And undoubtedly, there could be sharp
moves higher and lower. Our recommendation in dealing with this increased volatility is to
capitalize on periods of weakness (rising rates). Buy the dips. Try to avoid chasing short term
rallies.
Overall, from a longer term perspective, we advocate a fully invested profile consistent within
the risk appropriate framework of each credit union. Maintaining an “agnostic interest rate”
ladder strategy remains a simple yet prudent approach to investing in today’s new normal
environment.
In terms of sectors we continue to favor being on the “yield side of the trade” by diversifying
into select high quality, short duration bank notes. As we have highlighted for quite some
time, banknotes currently provide a significant yield and income advantage over comparable
short duration Agency bullets. Over the past two months, we have seen increased interest in
banknotes from credit unions and we expect that trend to continue as credit unions diversify their
investment portfolios with the ultimate goal of optimizing income.
Credit unions open to active management (sector rotation or security swaps) may want to explore
swapping out of short Agency bullets (booking gains) and investing proceeds in comparable
duration banknotes. Finally, floating rate bank notes are also quite attractive for those credit
unions that are concerned that rates will be rising or have balance sheet risk exposure to rising
rates. It should be noted that bank notes, unlike many floaters, do not have CAPs. As such, the
floating rate will adjust as the benchmark (LIBOR, T-Bills) rate rises.
Bank Note Yields vs. Agency Notes
Bank Notes Agency Bullet Yield Pick-Up
1Year 1.18% 0.69 % 0.49%
2Year 1.56 0.85 0.71
3Year 1.88 0.98 0.90
4Year 2.13 1.10 1.03
5Year 2.36 1.35 1.01
For more information on bank notes please click here for an article on Bank Note article and/or
contact your Institutional Fixed Income Representative.
In terms of relative value, please click here for the Relative Value Analysis.
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More Information
For more information about credit union investment strategy, portfolio allocation and security
selection, please contact the author at [email protected] or (800) 782-
2431, ext. 2753.
Tom Slefinger, Senior Vice President, Director of Institutional Fixed Income Sales, and
Registered Representative of ISI, has more than 30 years of fixed income portfolio management
experience. He has developed and successfully managed various high profile domestic and
global fixed income mutual funds. Tom has extensive expertise in trading and managing virtually
all types of domestic and foreign fixed income securities, foreign exchange and derivatives in
institutional environments.
At Balance Sheet Solutions, Tom is responsible for developing and managing operations associated
with institutional fixed income sales. In addition to providing strategic direction, Tom is heavily
involved in analyzing portfolios, developing investment portfolio strategies and identifying
appropriate sectors and securities with the ultimate goal of optimizing investment portfolio
performance at the credit union level.
Information contained herein is prepared by ISI Registered Representatives for general circulation and is distributed for general
information only. This information does not consider the specific investment objectives, financial situations or particular needs of
any specific individual or organization that may receive this report. Neither the information nor any opinion expressed constitutes
an offer, or an invitation to make an offer, to buy or sell any securities. All opinions, prices, and yields contained herein are
subject to change without notice. Investors should understand that statements regarding future prospects might not be realized.
Please contact Balance Sheet Solutions to discuss your specific situation and objectives.