Oct 1. A bet for higher rates
Trump has been meeting with Fed Chair candidates and said an announcement is two to three weeks away. The current Fed is leaning for a December rate hike, and the market is on board with that assessment, pricing odds of about 2 in 3. There have been plenty of Fed speeches identifying the importance of inflationary expectations, relating incoming data to the trajectory of rate increases, and discussing the decline of R* (the real short term interest rate with unemployment at the natural rate and inflation at the 2% target).
The market appears to be pretty certain of a spurt of growth related to increased Federal and private spending for storm rebuilding, and is also buying into the idea that a tax plan will be passed. Though opposition will surely grow due to projected increases in the government’s deficit, it doesn’t seem to have galvanized.
Let’s consider the longer term perspective of where rates are currently and the shape of the yield curve. The ten year yield ended Friday at 2.32% and the thirty year bond at 2.85%. In the past five years since 2012, the range on tens has been 3.02% to 1.36% (post-Brexit). The halfway mark is around 220, and tens are just above that point. The 2yr to 10yr spread at 85 bp is near its low since 2009. While near one year euro$ calendar spreads have perked up (peak one-yr is now EDZ17/EDZ18 at 38.5), everything from EDM18/EDM19 on back is 25 bps or lower, signifying perhaps one hike per year.
The point is this: there’s a lot of pontificating about the fine points of monetary policy and how inflationary expectations might be nudged a bit higher. But the interest rate market has NEVER believed in the Fed’s projections, and is currently priced somewhat tentatively with respect to both growth and inflation. Stocks are heartened by lower regulation, the tax plan, and low funding rates. From a longer term risk/reward perspective, the bet has to be a move to higher ten year rates. It’s just as simple as that. The back end of the curve is NOT pricing much in the way of economic improvement or an increase in inflation. What if both occur?
Given the 30 bp jump in the ten year yield over the past three weeks, and continued tension with N Korea and Catalan, there could easily be a bounce in bonds. But the longer term perspective has changed.
A few weeks ago I wrote about Kevin Warsh as a possible Fed Chair candidate. One of his concerns is misallocation of capital as a result of rates that have been repressed. I agree with that viewpoint, and we’ve obviously seen corporations splurging on cheap financing to buy back their own shares (and dilute balance sheets). Tangentially related is the idea that capital spending has been weak. Well sure, if you’re buying back stock because rates are low and opportunities for growth seem scarce, forgoing capital investment makes intuitive sense. Another Fed Chair candidate is Jerome Powell, a current Governor. In one of his recent speeches he said low productivity was a concern. A lack of capex ties into the idea of low productivity. To address this, the new tax proposal includes a five year window to immediately write off capital expenses.
The government is likely to spur spending (and increase the deficit). Companies may thus see opportunities for growth and increase capex (according to the NFIB it’s already happening). Rather than buybacks, companies may spend more on productive enterprises, and tax benefits will surely outweigh increases in interest rates. There may be ‘pent-up’ demand regarding capital spending.
In terms of the Fed, I don’t think Warsh is going to be the guy. There are 2 risks, one is that it will appear to be a favor to Ron Lauder (friend of Trump and Warsh’s father-in-law), and second, it’s probably not a good idea to rock the low-rate centrist boat at the Fed. More likely to be Powell or Yellen.
A couple of other thoughts.
Bridgewater laid out 5 reasons raising rates was a mistake 1) Not enough inflation and risks of overheating are low 2) Risks are asymmetric to the downside 3) Tightening faster than built in to the curve are likely to trigger negative wealth effects because effective durations of assets are very long 4) Economic sensitivites to rate changes are greater than normal due to high global indebtedness and pensions/healthcare obligations, and 5) A downturn would be intolerable to those with lower incomes and wealth and will increase social tensions. [Summary from Business Insider]
That contrasts sharply with an assessment (on Bloomberg) by Brett Gillespie of Ellerston Capital. “Inflation is going to jump dramatically in the next year.” Economic modeling by Gillespie’s group suggests that a confluence of dynamics, from agriculture to energy, drove down the U.S. inflation rate in the middle of this year. That’s poised to change in coming months, sending six-month annualized gains in the consumer price index excluding food and energy to 3 percent, he said.
Let’s consider these two viewpoints. First, Bridgewater describes the current environment, and postulates that rates can’t rise because it would be too painful. As alluded to above, the curve just isn’t pricing it. On the topic of misallocation, the argument tacitly accepts the idea that the Fed has forced investment into longer dated riskier assets and has suppressed yields to the point that pension and healthcare obligations can’t be met. That’s ALREADY increasing social tensions. Rate increases will cause a great unwind, and it won’t be pretty. Well, things aren’t always pretty.
The other side suggests inflation may lead the debate. Perhaps a bit dubious given last week’s release of Core yoy PCE at only 1.3%. However, oil has been firming, the USD has been weak, and the Atlanta Fed Wage growth tracker, while having gone sideways this year, is still 3.4%. The dynamics of this particular line of thought need to be fleshed out, but the idea is not to take the Bullard stance and extend the idea of a persistent regime out into the future [link to June 2016 paper below], but rather to use the Druckenmiller idea of catalysts that may make the future look quite different from its current situation.
In terms of an inconvenient market movement consider this, 30 year JGB has been pegged all year between 75 bps and 90 bps. (I prefer to watch 30y as BOJ caps tens below 10 bps). This week it closed 86 bps. A move above 100 bps would signal a problem.
There are a lot of Fed speakers this week including Powell on both Tuesday (Regulatory Reform) and Thursday (Treasury market), Yellen Wednesday, Dudley Friday after the Employment Report. Other speakers include Kaplan on Monday, Bullard Wednesday, Williams and Harker Thursday, Bostic, Kaplan, Rosengren and Bullard again on Friday.
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| 9/22/2017 | 9/29/2017 | chg | |
| UST 2Y | 145.7 | 147.5 | 1.8 |
| UST 5Y | 188.7 | 192.1 | 3.4 |
| UST 10Y | 226.1 | 232.1 | 6.0 |
| UST 30Y | 279.4 | 285.2 | 5.8 |
| GERM 2Y | -68.2 | -69.2 | -1.0 |
| GERM 10Y | 44.7 | 46.4 | 1.7 |
| JPN 30Y | 80.9 | 85.8 | 4.9 |
| EURO$ H8/H9 | 29.0 | 32.0 | 3.0 |
| EURO$ H9/H0 | 16.0 | 17.5 | 1.5 |
| EUR | 119.48 | 118.14 | -1.34 |
| CRUDE (1st cont) | 50.66 | 51.67 | 1.01 |
| SPX | 2502.22 | 2519.36 | 17.14 |
| VIX | 9.59 | 9.51 | -0.08 |
https://www.federalreserve.gov/newsevents/speech/powell20170601a.htm
