Beige Book

The Fed’s Beige Book released today makes a rate increase on March 21 a virtual certainty.  If concerns about below target inflation were keeping some FOMC members on the fence, the comments in this book should get them into the higher-rates camp.  Labor markets are tight throughout the nation, companies in most Districts are reporting labor shortages and wages are rising due to those tight market conditions.  Prices are also increasing in many Districts. Residential construction is being curtailed by shortages of labor and materials.

When the Committee meets March 20-21, the President of the Minneapolis Fed will probably be the only member still advocating no rate increase.  One wonders what economy he is monitoring.  If future Beige Books read as strong as this one, four rate increases in 2018 will be the most likely policy path.

A Rough Start

For bond owners, 2018 is off to a poor start.  Virtually every market sector has posted negative YTD returns.  The 30-year Treasury bond has a YTD return of -7%, the investment grade corporate market return is -2.4% and the municipal market return is -1.5%.  TIPS have returned -1.9% and even the high yield corporate market posted a return of -0.3%.  High yield continues to be the best performing sector, as it was in 2016 and 2017.

The relatively poor performance of the investment grade corporate market might be the biggest surprise this year.  That market had been consistently outperforming Treasuries until last month.  With greater interest income, those corporates should resume posting better returns than Treasuries in the months ahead.

Munis continued the pattern of outperforming Treasuries that began last year.  The muni market could have even weaker supply calendars in 2018, now that advance refundings are no longer possible.  Muni-Treasury yield ratios have already declined to near the pre-crisis ranges, and seemed destined to drop even more this year.

One should never forecast with a straight-edge, but Chairman Powell seems very comfortable with at least three rate increases this year.  By this time next year, the funds rate could be 2 1/4%-2 1/2%.  In that event, the yield on the 10-year Treasury note would probably be around 3.50%.  What does that imply for total returns over the next 12 months?

Returns from Treasuries and high grade munis maturing beyond five years would very likely be negative.  Returns from BBB munis with maturities of 10 years or less could be positive.  Returns on A/BBB corporates with maturities of 10 years and shorter are likely to be positive–perhaps in the 2-4% range.  Spreads are sufficient to allow yields on those credits to rise no more than, and possibly somewhat less than, yields on comparable Treasuries.  If so, the better coupon income would be enough to produce positive returns.

This type of scenario analysis still favors high yield by a substantial margin.  The spread between the yield on the high yield index versus the yield on the Treasury index is around 350 bps–at the bottom of the range that is typical for this stage of the economic cycle.  That spread could, however, narrow some if the economy performs well.  In that event, the high yield market might be expected to produce total returns in the range of 3-6% over the next 12 months.

While the rest of 2018 might not be as negative for bonds as January-February, the ranking of YTD returns might be a useful guide for the months ahead.  Avoid the longest duration segments–the short-to-intermediate maturities have a much better chance of producing positive returns.  Accepting credit risk rather than duration risk is still the preferred strategy.

FOMC Ups the Ante

The FOMC minutes released today left little doubt about the outlook for the funds rate.  It is headed higher in 2018–the only question is how much higher.  The consensus forecast  had been two or three 25 basis point increases.  Now, that consensus will probably become three or four increases, pushing the rate a full percentage point higher by year-end.

Healthier economic data, a tax cut and better growth overseas were cited by the majority of the Committee as reasons to expect that “the rate of growth in 2018 would exceed their estimates of its sustainable longer-run pace.”  This at a time when labor markets are already tight, wages appear to be strengthening and more businesses report, “some more ability to raise prices to cover higher input costs”.

As if that weren’t enough, many members of the Committee think that financial conditions have remained very easy, despite the increases in the fed funds rate.  In previous minutes, only a few expressed that view.  A number of participants said they had “marked up” their growth forecasts and several others worried that the upside risk to the outlook may have increased.  Thus, a majority agreed that further rate increases would be appropriate–a slightly more aggressive wording than in earlier minutes.

The bond market did not like the tone of these minutes, for good reasons.  It correctly interpreted them to suggest a much higher probability of a funds rate well above 2% by year-end.  That probability was not taken very seriously until this afternoon.

A New Conundrum?

Chairman Greenspan called the failure of bond yields to rise as the funds rate rose in 2004-06 a conundrum.  The failure of bond yields to fall as stock prices tanked last week could be viewed as a new conundrum.  Over the past nine years, Treasuries could be relied upon to rally whenever stocks faltered.  If, however, we consider the fundamentals now confronting bonds, their recent behavior is not that puzzling.

Until recently, bonds could celebrate a drop in equity prices because central bank policies could be relied upon to keep rates low.  Economies were growing too slowly and inflation was too  low.  Now, the U.S. is at full employment and the rest of the world is much healthier.  Central banks everywhere are reducing or planning to reduce stimulus.

In the U.S., the impact of the Fed’s rate increases and balance sheet reductions is exacerbated by an acceleration of Treasury borrowing.  Tax cuts and spending plans are pushing the Federal deficit to over $1 trillion in fiscal year 2019–double the 2017 deficit.  Until this year, deficits were shrinking.

A relatively flat yield curve and a big increase in Treasury issuance at a time when the Fed is buying fewer notes and bonds is a much different set of fundamentals than in the conundrum year of 2004.  If the curve was as steep as in 2004, perhaps bond yields might not rise very much as short term rates trend higher.  But with the curve already quite flat, it is not puzzling that fears of higher short-term rates push yields higher and total returns negative on the longer maturities.

When bond fundamentals were benign, it was easy for investors to buy Treasuries when stocks faltered.  The psychology was that the Fed would remain supportive.  That is not the psychology today.  Rallies in stocks still elicit selling of longer Treasuries, but declines in stock prices are apparently not sufficient to offset the negative bond market fundamentals.  Perhaps it is not a new conundrum–merely a new set of fundamentals.

Duration Bites

For a long time now (admittedly somewhat early) I have been warning of the dangers inherent in the long durations on bonds at the low yields of 2016-17.  In previous cycles, when yields were higher, the duration of the 30-year Treasury bond was typically around 15 years.  For most of last year, it was almost 22 years.  The same was true for long AAA municipals.

Since Jan. 1, the risks associated with those long durations have become only too apparent.  In January, total returns were -2.4% and -3.7% on the 10- and 30-year Treasuries and -1.6% on the longest munis.  Returns have been even uglier the first two days of February.  In the corporate high yield market, where interest income is greater and durations are shorter, returns have been positive.

Once again, a flattening yield curve and low yields overseas did not “protect” the long maturities.  The 2-30-year Treasury spread narrowed 5 basis points in January, but that was not sufficient to prevent painfully negative returns from the long maturities.  Yields in foreign markets rose in step with U.S. yields.  The yield on the 10-year German bund is up 30 basis points this year.  Those have been the patterns during every market selloff since the lows in yields in 2016.

This 2018 selloff has brought yields into much better alignment with market fundamentals.  Those fundamentals start with a strong economy.  The ISM and employment reports for January were reminders that the cyclical expansion has become quite robust.  The FOMC all but promised more rate increases this year and the Treasury projected a pace of debt issuance twice that of last year.  This, at a time when the Fed’s balance sheet reductions are at a $20 billion monthly pace and scheduled to increase each quarter.

I thought that the yield on the 10-year Treasury would be around 3 1/4% by year-end.  With a fed funds rate around 2 1/4% by December, the 2-year yield would probably be around 3% and, even with more curve flattening, the 10- and 30-year yields would probably be around 3 1/4% and 3 1/2%.  That, in my view, is still a reasonable outlook.

It is an outlook that implies more negative returns over the next 11 months on Treasuries and AAA munis maturing in 10 years and longer.  The outlook is somewhat  better for A/BBB munis and much better for investment grade and high yield corporates.  Corporate spreads are not generous, but still acceptable for a period of good economic growth.

Forecasting is always dangerous, but forecasting with a straight edge is especially foolhardy.  It was a mistake to assume that yields would stay at 2017 levels indefinitely, and it is probably just as wrong to assume they will keep rising indefinitely.  This correction might not be over, but it has created much better values in the intermediate segments of the bond markets.  It is probably still too early to start buying the longer maturities.

James Baker Redux?

Take a look at a chart of Treasury yields in 1987.  The yield on the 10-year note was around 7 1/4% as the year began, dropped to 7% in late January, and then began a fairly steady rise to around 9 1/2% by mid-September.  That rise was largely in response to the Fed’s pushing the fed funds rate from around 6 1/4% in January to 7 1/4% by September.

By mid-October, however, the 10-year yield was above 10%, reflecting anticipation of more Fed tightening and nervousness about a weak dollar.  That nervousness turned to dismay when, over the weekend of Oct. 17-18, Treasury Secretary James Baker said that the U.S. was happy with a week dollar.  By the morning of Monday, Oct. 19, the dollar and the bond market were in free fall.  The 10-year yield shot well above 10%.  The stock market was also selling off prior to that Monday, but the rout in bonds apparently was the last straw.  By noon on Monday, it was the stock market that was getting all the attention.

Now, we have a Treasury Secretary and a President promoting a weaker dollar at a time when the bond market is anticipating further increases in the fed funds rate.  While rising inflation is not currently a concern, FOMC members cannot be happy about a strategy of imposing tariffs, weakening the currency and expanding the deficit at a time when the economy is at full employment.  Dollar weakness provides more ammunition to those Committee members who argue that financial conditions are easier now than when the fed funds rate was at 1/4%.

The FOMC on Wednesday will almost certainly keep the funds rate unchanged, but the policy statement could easily read more hawkish than six weeks ago.  Economic data have strengthened since the last meeting, the Beige Book found more wage and price pressures and, eventually, tariffs/dollar weakness boost inflation.  A policy of gradual normalization is getting harder to defend.

The State of the Union speech could also be unsettling if the President restates his views on trade and the dollar and promises major infrastructure spending initiatives.

To be sure, economic fundamentals are less bearish for bonds now than in 1987.  Nevertheless, this could be a week in which the bond bulls finally admit that a yield of 3% on the 10-year note cannot be ruled out.


Don’t Like TIPS

Now that inflation is increasing some, recommendations to own TIPS are proliferating.  I don’t agree for several reasons:

  1. TIPS yields are too low.  In an era of low yields, compounding interest income is the only way investors can build even a modicum of wealth.  Capturing incremental income becomes essential to achieving acceptable returns, and Treasuries do not offer enough income.  For example, since 1/1/2010, the Treasury and TIPS market have produced average annual returns of only 2.9% and 3.3%.  The investment grade corporate market has returned 5.5% per year and the high yield corporate market has returned 7.9% per year.  Even the muni market has returned a percentage point per year more than TIPS.  Compounding those better annual returns made a big difference to portfolio values over  the last eight years.
  2. TIPS perform poorly as market yields rise.  TIPS yields rise along with Treasury yields, albeit somewhat slower.  Thus far in 2018, total return for the TIPS market is -0.9%, only slightly better than -1.2% from nominal Treasuries.  Returns from corporates have been mostly positive.  If the rise in yields were to become severe, TIPS would very likely suffer steeply negative returns.  In 2013, the total return for the TIPS market index was -9%.  In the second half of 2016, it was -2.2%.  I have heard some say that if you expect a big jump in inflation, buy TIPS.  No, because in that event the Fed would tighten more aggressively, market yields would probably rise sharply and returns on all but the short-maturity TIPS would probably be very negative.
  3. Tips are not reliable indicators of future inflation or even of inflation expectations.  Over the past five years the inflation forecast implied by TIPS spreads has varied from as high as 2.6% in 2013 to 1.6% last June.  It is around 2% now.  That spread always increases when Treasury yields rise, as in 2013 and this year, because TIPS yields rise more slowly.  The spread always narrows (implied inflation rate gets smaller) when nominal yields are declining, as in the first half of last year.  Inflation expectations are usually thought to change slowly, not as often as the TIPS spreads would imply.
  4. There are better ways to hedge against a rise in inflation.  One example would be a short-duration portfolio of investment grade and/or high yield corporates.  The short durations would moderate price declines, and the continuous run-off of maturing issues allows for the purchase of higher yielding issues.  Thus, yields on these portfolios tend to rise as market rise.  The higher coupon income from the corporates would be expected to produce much better returns than a portfolio of short-duration TIPS.  That was true in 2013 and 2016 when the short duration corporates produced positive returns while most TIPS returns were negative.

To be sure, owning corporate bonds entails credit risk.  That risk escalates during recessions.  If, therefore, interest rates and market yields were to rise to levels that could induce a recession, it would be a good strategy to sell corporates and buy TIPS.  But in view of the most likely path of the economy in 2018, it is, in my view, still too early to be buying TIPS.

Beige Book–A Stronger Tone

The Fed’s Beige Book released today had a few notable changes from previous books.  The following sentence has not been seen in  years: “Firms in some Districts noted an ability to increase selling prices”.  Until now, that ability had been entirely absent in this cyclical expansion.  The book also mentioned pressures on input prices in manufacturing, construction and transportation sectors.  Labor markets were described as tight, such that there were more wage increases reported than in the previous Book six weeks ago.  Economic growth was described as moderate in most Districts and businessmen were reported as optimistic about the 2018 outlook

The big news in this Book was that wage pressures are strengthening and that firms are starting to incorporate higher costs into their selling prices.  Those anecdotal reports are consistent with signs of somewhat more inflation in the latest PPI, CPI and ISM releases.  If the FOMC members pay any attention to this briefing book (and they apparently do) they should be less nervous about pushing the fed funds rate higher.  Markets are not expecting a rate increase on Jan. 31, and that is probably still the most likely outcome from that meeting.  Nevertheless, these reports of wage pressures and a degree of pricing power together with the exceptional momentum in equity prices could spark a spirited debate over the potential costs of moving too slowly toward a “normal” setting for the funds rate.

Good Data=Nervous Bond Markets

The first-week-of-the month data released last week described an economy with good forward momentum–enough momentum to be troublesome to bond market participants.

Both ISM indices stayed well into growth territory, and the key new orders components remained at very healthy levels.  The manufacturing index was especially impressive, and it contained hints of more inflation.  The prices paid index remained elevated and delivery times continued to increase.  Supply chains are apparently becoming strained.  That is consistent with reports that manufacturers are having difficulty expanding output due to labor shortages.  There are also reports of a shortage of trucking capacity.

Sales of new cars and trucks were described as disappointing because they failed to match year-ago levels.  But sales in December 2016 were very strong, and the annual selling rate last month of almost 18 million units was actually very good.

The jobs report last Friday fit the pattern seen most of last year–sufficient employment growth to keep unemployment low.  The 0.3% increase in average hourly earnings and anecdotal reports of labor shortages suggest faster wage growth in 2018.

Together, these data ratify the Fed’s strategy of policy normalization.  Stock prices also support the contention of several FOMC members that financial conditions are no tighter now than they were when the fed funds rate was 1/4%.  Nothing in last week’s data or FOMC minutes argued against a forecast of a much higher fed funds rate by this time next year.

Bond markets might be starting to take that risk more seriously.  A rally after the “weaker-than expected” employment report on Friday could not be sustained.  This week, the CPI report on Friday will be examined closely.  The inflation data are probably now the most important to the markets, because low inflation is the only argument against a steady rise in the funds rate.  Before Friday, Treasury auctions of 10-year notes and 30-year bonds could test the current levels of Treasury yields.

Worrying about the curve for the wrong reasons!

The FOMC minutes released yesterday recorded that several members of the Committee are worried that a flat yield curve “foreshadows” an economic slowdown and therefore the Fed should think twice about pushing the fed funds rate higher in 2018.  That is another example of analysis that ignores current conditions that make past relationships misleading.  The reason flat yield curves preceded recessions in past cycles is that by the time curves became flat, short term rates and bond yields were high enough to cause a recession.  Today, with rates the lowest of our lifetime, another 100 basis point increase in the funds rate to around 2 1/4-2 1/2% would probably not be sufficient to cause a slowdown.  

Investors, however, should worry about flat curves because they impart more market risk to long duration securities.  When curves are steep, short-term rates can rise and bond yields often rise far more slowly.  For example, in 2004 and 2015, before the Fed began to raise the funds rate, the 30-year to 2-year spreads were as great a 300 basis points.  Bonds performed remarkably well as the funds rate rose.  Once the curve is flat, however, it tends to move up in parallel fashion if short-term rates keep rising.  The extreme example was in 1978 when the curve became flat with 2- and 30- year yields at around 8.50%.  By 1981, the yield on the 30-year reached 15%,  Ouch!  Beware of long maturities when curves are flat and short-term rates are likely to keep rising.