What Did We Learn Last Week?

FOMC minutes and the employment report last week provided more reasons to expect another 100 basis point increase in the fed funds rate over the next 12 months.  The minutes noted that the Fed Staff expects GDP growth to be “above trend” for the foreseeable future and the unemployment rate to be below the long-term sustainable rate.  That implies that a degree of monetary restraint is appropriate.  Monetary stimulus is no longer the best policy path.  Fiscal stimulus now in place reinforces the need for monetary restraint.  Several Committee members made that point at the FOMC meeting.

Many members also noted that if economic fundamentals mandated continued gradual increases in the funds rate, that rate would be above what they estimate to be the long run neutral rate sometime in 2019.  That neutral rate is generally regarded to be in the 2 3/4% to 3% range.  Thus, most members expect the actual rate to be 3% or higher by the second half of next year.  That is why the Committee dropped the sentences that said that monetary policy would remain accommodative.  It is accommodative now but will likely become restrictive next year, according to the current outlook.

Finally, the Committee increased the amount of balance sheet reduction to $40 billion per month starting July 1.  That will increase again to $50 billion per month in October.  This, at a time when Treasury auction sizes are being increased in order to fund a deficit that is headed for $1 trillion.

The June employment report was entirely consistent with the Committee’s view that the labor market is very strong.  There are now reports of labor shortages throughout the land.  Some FOMC members cited labor shortages as a potential constraint to GDP growth.  A healthy increase in the labor force pushed the unemployment rate to 4% in June, but that is regarded as another indication of a strong labor market.  It is widely acknowledged that the average hourly earnings data are understating the rise in wages now underway.  The FOMC minutes again cited reports from business contacts that cost are rising much faster now that only a few months ago.  That was also the message from the latest ISM reports.

These are the classic ingredients for a bear markets for bonds.  Perhaps because most market participants have not experienced a prolonged rise in rates and bond yields, they expect this episode of rising yields to be over soon (or even over already).  History does not support that optimistic outlook.  To be sure, this is not like the brutal days of the 1970s and 80s, but it is probably a sufficiently bearish outlook that the negative returns seen in the first half for long-duration sectors are likely to persist during the remainder of 2018.

Fed is Getting Serious

The big news today was not just another 25 basis point increase in the fed funds rate, but also the tougher tone of the statement and the dot charts.  The Committee believes the natural rate of unemployment is around 4.5%, but the actual rate is projected to be around 3.5% late this year and next year.  The implication for policy is obvious.  Also, the statement acknowledges that inflation is now very close to the 2% target.  The statement also dropped the line that said the funds rate would for some time stay below the long-run level.  That eliminated their “forward guidance” constraints and could be viewed as creating room for more aggressive moves if needed.  Policy normalization is proceeding as planned, said Chairman Powell.

The median prediction for the funds rate at year end is now 2.4%, versus 2.1% in March.  That means two more increases this year.  By the end of 2019, the rate is projected to be near 3% and only slightly higher in 2020.

Remember, also, that the pace of balance sheet reduction moves from $90 billion this quarter to $120 billion in the third quarter.  This, at a time when Treasury auctions are increasing in size almost every month.  More Treasury issuance and fewer Fed purchases would suggest that the future path of Treasury yields is upward.  The FOMC is likely to be sustaining that uptrend at least through next year.

Today we have a funds rate near 2% and a yield on the 10-year Treasury near 3%.  Even with some additional curve flattening, a funds rate near 2 1/2% at year-end would probably be associated with a 10-year yield in the 3 1/4% to 3 1/2% range.  That would imply negative returns on Treasuries maturities beyond seven years.

 

A “Symmetric” Fed

I did not count how many times the word “symmetric” appeared in the FOMC minutes, but it seemed to be in every paragraph.  It was used to emphasize that the Committee’s 2% inflation target should be viewed as a central tendency, not as the peak rate the Fed will accept.  They will tolerate some overshoot, just as they tolerated an undershoot for the past two years.  In other words, they will not tighten aggressively if the inflation rate were to move somewhat above 2%.

Markets focused on this as good news that the rise in the fed funds rate will remain slow.  That should not have been a surprise.  The FOMC has been saying this ever since they started raising the rate.  It does not mean, however, that the odds for another three increases in 2018 have dropped.  They are still probably above 50%.

The most likely path for the funds rate is a steady rise to around 3% in 2018-19.  What are the odds that a 3% yield on the 10-year Treasury can coexist with a 3% fed funds rate?  Probably quite low.  The Treasury yield would probably be in the 3 1/2% to 4% range.  That would suggest that it is still too early to be buying long-duration Treasuries.

 

Walking On Eggs?

Two items last week were worrisome for the municipal market.  Both involved Illinois credits, but the problems described are not limited to Illinois.  The first was the announcement that the Chicago Board of Ed is selling bonds this week with a rating of B and minimum denominations of $100,000.  It is bad enough that a school district is far into junk status  (subprime bonds?), but by trying to prevent individual investors from buying the bonds, they are essentially saying, “we do not want to punish small investors should we default on these bond”.

The second item was a press report that in Harvey, IL. the annual required contribution to its pension funds exceeds it annual income.  If they made those pension payments, there would be no money for essential services.  So, they are not making the payments and the funds are grossly underfunded.  How do they get out of this mess?

These unfunded pension problems are shared by a host of states and municipalities, and at some point, they must be addressed.  I fear that many municipalities will use bankruptcy as the solution, and the courts will impose serious haircuts on the bond holders.  That was true in Detroit and is unfolding in Puerto Rico.  The full faith and credit status of GO bonds is not equal to the political clout of pension recipients.  States cannot declare bankruptcy, but those bonds could get downgraded to junk status before they figure out a solution to these problems.  That, combined with bankruptcy filings by smaller entities, could spark selling of munis by individual investors.  Yes, that would be irrational, but as Keynes said, “markets can stay irrational longer than…”

I am not suggesting that investors should be selling their muni bonds or bond funds.  But, they should probably not be reaching for yield these days.  Check the credit status of the bonds they own, and use fund managers that have avoided steeply negative returns during previous periods of market stress.  That stress might not be imminent, but to stretch for yield now in this market is, in my view, akin to walking on eggs.  It might work, but might not be worth the risk.

 

 

Lots to worry about this week

Economic data, an FOMC meeting and a Treasury refunding announcement will make for an interesting week.  Already today we saw that the Fed’s favorite inflation gauge, the core PCE deflator, is now at 1.9% YOY, practically at the Fed’s target.  The FOMC statement on Wednesday might have a sentence that acknowledges the recent movement of inflation into or very close to the target range.  That would probably increase the odds of three more rate increases this year.  This is a meeting in which the Committee typically keeps the rate unchanged.  The press release, however, could remind the bond market not to get complacent over the outlook for monetary policy.

The Treasury will also remind the markets that their cash needs will be substantial after this quarter.  April 15 always brings a big cash inflow, keeping financing needs manageable this quarter.  But, with spending about to ramp higher, the cash needs will almost certainly require sizable increases to the note and bond auctions during the second half.  Some of those details might be discussed on Wednesday when the Treasury releases the auction schedule for next week’s refunding.

The first days of the new month always include the release of the ISM manufacturing index and the monthly employment report.  The ISM index has been well into growth territory (some would say boom territory) and should stay there tomorrow.  It has been a long time since we cared about the supplier deliveries component of this index, but now it is warning that companies are having difficulty filling orders.  Delivery times have been increasing in recent months, as have prices paid.  If, on Friday, employment increases close to 200,000 and average hourly earnings register another solid gain, that report together with the ISM index would give the FOMC ample justification for three, not two, rate increases in 2018.

 

The Yield Curve Is A Mis-Leading Indicator

Once again, the relatively flat yield curve has become the topic of a host of media and analysts’ reports.  A flat curve is thought to presage a recession and an attendant decline in bond yields.  That gives far too much credence to what has often been an unreliable indicator of future economic activity and bond market developments.

To argue that a flat curve has predictive power for the economy is to confuse correlation with causation.  In most previous cycles, by the time the curve had become flat or inverted, short-term rates and bond yields had risen to levels that were high enough to choke off economic activity.  In particular, the rise in mortgage rates was sufficient to produce a step decline in home construction, which has always had a significant multiplier effect on GDP.  It was the level of rates and yields that caused the recessions, not the configuration of the curve.

One could argue that in 2004-2006, bond yields stayed relatively low as short term rates increased some 400 basis points, and the consequent curve flattening correctly predicted a recession.  Even then, however, housing was the better leading indicator.  It was not apparent until much later the degree to which home purchases were being financed with ARMs that were priced off of short-term rates.  Thus, the rise in short rates caused a sharp contraction in housing activity, even though bond yields and rates on fixed rate mortgages did not rise much.  So, those looking for signs of a recession should probably watch the housing data, not the shape of the yield curve.

The same could be said to bond market participants.  The econ textbooks tell us that a flat curve means that the “market” is anticipating only small additional increases in bond yields.  The problem is that those market predictions are often wrong.  Those who have tested this hypothesis have found the curve to be a very unreliable predictor of the movement in bond yields.  For example, had one purchased long bonds when the curve inverted in late 1978, he would have lost almost half his investment by late 1981.

A better explanation for the current flattening is expressed in the latest Barron’s, quoting BMO strategists who cite exceptionally heavy Treasury issuance weighted toward the shorter maturities along with Fed rate increases as pressuring short term rates.  Another quote points out that the low level of rates and yields hardly suggest financial tightness.  That implies that it is still too early to begin buying long bonds.  The key question is always what levels of short rates and bond yields will slow business activity.  Unfortunately, if anyone knows, they are not sharing that insight.

Where Are The Vigilantes?

The CBO estimates of deficits exceeding $1 trillion as far as the eye can see at a time when the economy is at full employment should be another warning that a bear market in bonds is probably the most likely scenario for the foreseeable future.  Whatever happened to countercyclical stabilization policies?  We now have an accommodative Fed policy and a procyclical fiscal policy.

The minutes of the March FOMC meeting show that Fed officials are getting more concerned.  Most members increased their growth projections after seeing the tax cuts and spending increases.  In a telling sentence, they worried that predicting the eventual impact of these fiscal initiatives was difficult because there is little history of such a policy when economic resources were fully employed.  Actually, there was one–the Johnson-Nixon period of Great Society spending along with wartime spending.  The Fed, under Arthur Burns, accommodated that spending by being too slow to raise rates.  The results were not friendly to the bond markets.

Inflation is, and will continue to be much lower now, but it is apparently starting to strengthen.  Most FOMC members are now much more comfortable that inflation will soon be in the target range and, therefore, more comfortable with additional rate increases this year and next.

If they exist, the bond vigilantes have yet to react to an ill-timed procyclical shift in fiscal policy.  If they are placated by signs of slower first-quarter growth, they should recall that we see this seasonal pattern almost every year.  The consensus estimate of 2018 GDP growth near 3% implies faster growth during the rest of the year.  That is when the effects of the tax cuts and increased spending will begin to emerge.

And, to finance those deficits, the Treasury will forced to add to an already very heavy pace of debt sales.  Bids in the auctions last week were not very enthusiastic.  They could become less so in the months ahead, unless yields become more attractive.

 

Lessons From QI

The pattern of first-quarter bond market returns suggests a few lessons. One is to avoid long durations.  Here are the returns by maturity segment:

1-5 years      Corp. -0.8%   Treasury  -0.6%  Hi Yield  -0.23  Muni -0.10%

10 years+    Corp. -2.2%   Treasury  -3.15%  Hi Yield -2.8% Muni –1.6%

While even the 2-3-year sectors suffered negative returns in the quarter, returns were far worse for maturities 10-years and longer.

Another lesson is to stay with the weaker credits.  High yield corporates continued to outperform investment grade corporates and Treasuries.  BBB corporates did not have a great quarter, but they did outperform the single A credits.  BBB munis outperformed the stronger credits by approximately 25 basis points.  The only sectors to post positive returns were high yield munis and CCC corporates.

Lesson three is to not rely on a flattening of the yield curve to “protect” the longer maturities.  The 2-year to 30-year spread narrowed by 10 basis points, but that was not sufficient to prevent steeply negative returns from the 30-year bonds.

Lesson four is that TIPS  do not “protect” against negative returns when the Fed is tightening.  Yes, they outperformed nominal Treasuries, with a total return of -1.02% for the quarter versus -1.21% for the nominal Treasuries.  But investor clients who think TIPS should perform well when inflation is expected to increase will be unhappy with negative returns.

Lesson five might be to mind the fundamentals.  The economy is at full employment, the funds rate is rising and Treasury borrowing is building.  These are not positive fundamentals for the bond markets–especially for the long durations.  Credit sectors can continue to outperform as long as a recession appears unlikely.

On that point, there is now some talk about the economy slowing enough to keep the Fed on hold.  But, we have seen  weaker economic data in the first quarter of almost every year for the past ten years.  Those data have not been precursors of slower growth.  The ISM manufacturing index released yesterday suggested good GDP growth.  The new orders component stayed above 60, a very strong level.  The most likely scenario is still a funds rate 50 to 75 basis point higher at year-end.  In that event, the pattern of returns for all of 2018 could mimic the Q1 patterns.

A Fair Warning From The FOMC

The FOMC has issued a warning to bond investors that the pace of rate increases is more likely to accelerate than decelerate over the next two years.  The press statement acknowledged that the economic outlook has strengthened and the projections for the fed fund rate have become more bearish.  Seven of the 15 Committee members now envision four rate increases in 2018, pushing the rate to the 2 1/4-2 1/2% range by year-end.  Eleven members have the rate in the 3-4% range by year end 2019.

It hard to envision how the yield on the 10-year Treasury note could be below 3% if the funds rate is at 2 1/8% or possibly 2 3/8% at year-end.  The yield on the 2-year note would probably rise 30-40 basis points and, even with some additional curve flattening, the 10-year yield could increase 20-30 basis points.  That would spell steeply negative returns on the longer Treasury notes and bonds.  Remember, at year-end, the market will likely be anticipating a funds rate around 3% in 2019.

A more stimulative fiscal policy at a time when the economy is at or very near full employment is clearly a problem for the FOMC.  They will not say that directly, but the why else would the majority bump up their rate and GDP forecasts?  Perhaps in the weeks ahead Fed officials will discuss this, as they prepare the markets for a more forceful “policy normalization” process.  The minutes of this meeting should also contain discussions of the implications of fiscal stimulus for the appropriate path of Fed policy.

Behind the Curve

Fed officials use the term “self-sustaining expansion” to describe an economy in which household spending and capital spending are sufficiently healthy to produce good growth without monetary or fiscal stimulus.  The employment report for February strongly suggests that is where we are now in this cycle.  That followed a Beige Book that reported labor shortages and building wage pressures in almost every Fed District, and was followed by a Barron’s cover story on the implications of scarce labor.

Yet, the FOMC is satisfied with a policy they call accommodative.  They are accommodating above-trend growth at a time when the economy is at full employment and fiscal policy has become more stimulative.  Some FOMC members even call financial conditions exceedingly easy.  Even if the fed funds rate is raised  25 basis points next week, it will still be “ridiculously low for this stage of an expansion”, according to a quote in Barron’s.

Where are the bond vigilantes?  I am not convinced they ever existed, but if they did, we need them now.  They have been in a coma induced by years of central bank largesse.  If they were to awaken, a 3% yield on the 10-year Treasury would be merely a rest-stop on the way to 3 1/2%.