We saw an “inverted” yield curve briefly near the end of August 2019, six months before we entered the pandemic-induced recession… That continued a streak of this indicator remarkably preceding the previous eight recessions.
That’s important because this is NOT what we’re seeing today.
There’s no doubt that the longer-term, market-controlled 10-year Treasury rate has been rising lately.
This behavior is healthy.
Today, it’s almost an afterthought that the Federal Reserve is buying $120 billion in bonds per month, keeping yields positive to begin with. This is the point we’ve reached in history.
The traditional fixed income bond market is broken, thanks to the Fed.
Excess debt accumulates in part because the price of debt (interest rates) is increasingly artificial. Politically-appointed central bankers manipulate interest rates and credit terms in order to achieve desired admirable policy outcomes, like higher employment and economic growth. Elected officials create subsidy programs that encourage yet more borrowing. And while they can point to a link between low rates and their targets, they ignore or forget about some of the unintended consequences.
These well-intentioned efforts may help some people, but they have side effects. Borrowing costs are widely mispriced, bearing little connection to the actual risk of a given loan. This is unfair to both borrowers and lenders. They pay/receive too much or too little. It is the inevitable result when committees, instead of markets, set important prices.
Economic fundamentals didn’t do this. A committee decided to encourage home purchases and did so by making it cheaper to finance those purchases. The predictable result is a housing boom. Or, in the current case, amplification of a boom that was already happening for demographic and other reasons.
This has benefits. The construction activity creates jobs. Lower mortgage payments leave people more cash to spend on other things. But it also obscures reality. No one really knows what their home is worth. The same for many other asset classes, and for the loans underlying them. We don’t really have a bond “market” anymore. It broke long ago, and now we have a bond regime that exists outside the discipline of market forces.
Here is what the Bank of Japan did Friday:
BoJ Governor Kuroda doesn’t want any part of a further rise in yields and quashed any thoughts that he would widen the YCC range from the current level of 20 basis points from zero. He said, “Personally I believe it’s neither necessary nor appropriate to expand the band. There’s no change in the importance of keeping the yield curve stable at a lower level.” Yields fell sharply in response with the 10-year down by 3.6 bps to just under 10 bps. It was 16 bps one week ago. The 40-year yield was down by 4 bps to .72% vs .82% one week ago. Again I’ll say, they want higher inflation but then panic when rates go up. What they are now finally learning is the danger of what they wish for.
The same thing is happening in Europe and elsewhere. I firmly believe that at some point the Federal Reserve will begin to buy large quantities of longer-dated securities, taking interest rates down and driving a stake into the heart of those who want higher returns for the risks they are taking. That point is likely when the market drops (say) 20%. Until then they just let things rock along. The Federal Reserve is going to give us return-free risk.
This strategy hurts retirees since ultra-low rates robs them of a real return on safe money. So now retirees (not our clients) have far too much exposure to stocks, taking far too much risk, seeking a positive, real return that can support their spending.
Interest rates hit their lowest levels in 5,000 years of recorded history last summer, and they’re still not far above those levels today. (It’s true… Just check out Sidney Homer’s classic work, A History of Interest Rates, which is often called “The Yield Book.”)
What happens when you force investors into an asset class they don’t especially want or understand? Well, price comes from supply and demand. Artificially generated demand leads to artificially higher prices, and that is what we see in the stock market today. A survey in the year 2000 shows that investors expected future returns from the stock market would be 15% per year. I think current investors have similar expectations. They think stocks only go up, because the Fed will intervene if they don’t. Anyone who owns passive index funds (our clients don’t) will endure a major drawdown at some point. I can’t say exactly when but it’s going to hurt.
But…It is springtime and the flowers will soon be in full bloom. If we have our health, family and friends, then that is what is important
US Economy
- The ISM Manufacturing PMI report topped market forecasts, showing US factory activity accelerating in February. The report points to further gains in the nation’s industrial production.
- However, slower factory activity in China suggests that US manufacturing will moderate in the months ahead.
- Hiring improved, but many factories have trouble finding qualified workers.
- The recent increase in bond volatility (MOVE) points to a stronger US dollar, lower Gold prices and slower factory orders ahead.
- The residential – nonresidential construction spending divergence continues
- There has been significant underspending in US infrastructure over the past few years
- Lodging and retail commercial mortgages have the highest delinquency rates.
- Auto loan delinquencies have been rising.
- Homebase small business data suggest that hiring is rebounding.
- The ISM Services PMI report showed some loss of momentum last month as growth in new orders slowed sharply
- Rising input prices are becoming problematic.
- The ADP private payrolls report was disappointing, suggesting that the job market recovery remains tepid.
- Despite persistently strong survey data in the manufacturing sector, factory hiring appears to have stalled.
- Housing shortages are severe across most metro areas.
- Homebuilders are increasingly “pre-selling” housing amid robust demand.
- Rising costs and supplier bottlenecks for building materials have been a challenge for homebuilders.
- Home prices used to be in the CPI. Now they aren’t. Only rent is.
- Year-over-year, the CPI is only up 1.4%. The rent is up 2.0%, but the Case Shiller National Home Price Index (December) is up a whopping 10.3%.
Weekly Jobs Numbers
- US employers added 379,000 jobs in February. The leisure and hospitality segment alone added 355,000.
- Much of this increase reflects restaurant jobs as states and cities further relaxed virus restrictions.
- Many of the new positions were part-time.
- Less encouraging was a drop in hours worked from 34.9 to 34.6, which meant a decline in average weekly earnings even though average hourly earnings rose.
- The rebound in labor force participation has stalled.
- The more comprehensive U-6 unemployment rate, which includes part-time workers who want full-time jobs, was unchanged at 11.1%.
- Construction jobs fell, possibly related to the winter storm hitting Texas and elsewhere.
The report is good news and progress should continue if vaccinations keep the virus at bay.
After rising to 14.8 percent in April of last year, the published unemployment rate has fallen relatively swiftly, reaching 6.3 percent in January. But published unemployment rates during COVID have dramatically understated the deterioration in the labor market. Most importantly, the pandemic has led to the largest 12-month decline in labor force participation since at least 1948. Fear of the virus and the disappearance of employment opportunities in the sectors most affected by it, such as restaurants, hotels, and entertainment venues, have led many to withdraw from the workforce. At the same time, virtual schooling has forced many parents to leave the work force to provide all-day care for their children. All told, nearly 5 million people say the pandemic prevented them from looking for work in January. In addition, the Bureau of Labor Statistics reports that many unemployed individuals have been misclassified as employed. Correcting this misclassification and counting those who have left the labor force since last February as unemployed would boost the unemployment rate to close to 10 percent in January.
You count as “unemployed” if you actively look for work. Powell says, I think correctly, millions want to work but for various reasons haven’t been looking. So, they don’t count and the unemployment rate is artificially low.
Long-term unemployment is approaching the financial crisis peak.
The Fed
If you re-read Powell’s statement, you should realize that he has changed Fed policy’s benchmarks.
When Ben Bernanke initially launched QE, the “constraints” around ultra-accommodative monetary policy were price stability and full employment. Those “guideposts” were 2% inflation and 5% unemployment as measured by the U-3 report from the Bureau of Labor Statistics.
Over the last decade, the Federal Reserve stated that an “accommodative policy” was necessary to achieve 2% annualized inflation. Unfortunately, inflation ran well below the target level the majority of the time.
When it came to reaching the goal of “full employment,” the Fed achieved that goal for only a brief period between 2016-2018. At this juncture, the Federal Reserve did try to lift interest rates and reduce their balance sheet. Unfortunately, markets quickly lost 20% in Q4 2018 and the Fed reversed course quickly.
The issue with the U-3 report following the “Financial Crisis” was that it only “appeared” the economy regained full-employment. In reality, such was merely a function of a shrinking “labor force.”
Furthermore, employment, which is the backbone of consumer confidence, has not increased strong enough to create sustainable economic growth above 2%. Notably, the number of full-time jobs, which are critical to sustaining a family, has continued to decline.
The reality is that both inflation and “full-employment” fell well short of the promises of “monetary accommodation.”
The Fed now realizes their constraints are a trap.
Very subtly, the Federal Reserve has changed their benchmarks to allow the continuation of “monetary policy” indefinitely. In other words, by changing the benchmark, the Fed has now assured itself excess flexibility never to tighten monetary policy in the future.
For stock market bulls, the good news is that “QE-Forever” is now “a thing.”
The problem is the Fed is trapped.
As seen in 2018, when the Fed does try to tighten monetary policy, such immediately causes a bond market tantrum and a stock market crash. With inflation expectations surging, such suggests the Fed should start hiking rates and reducing bond purchases. However, if they did that, the market will crash, further impeding consumer confidence which barely rose from the 2020 lows.
Not surprisingly, with an implicit guarantee by the Federal Reserve of continuous “monetary accommodation,” the market rallied back strongly on this week. The problem, however, is the stock market is now thoroughly detached from the underlying economy.
Over the last decade, monetary policy inflated asset prices to more extreme levels while the real economy struggled. The Market-Cap best characterizes this detachment to the economy. Since corporations derive their revenue from economic activity, there is a logical assumption of fair valuation.
Since It Didn’t Work, Do More.
The Fed’s interventions and suppressed interest rates have continued to have the opposite effect intended. See charts below to illustrate this point.
From Jan 1st, 2009 through the end of 2020, the stock market rose by an astounding 200%, or roughly 18% annualized. With such a large gain in the financial markets, one would expect a proportional growth rate in the economy.
After bailouts, QE programs, interventions, monetary and fiscal programs totaling more than $37 billion, cumulative real economic growth was just 21.52%.
While monetary interventions are supposed to be supporting economic growth through increases in consumer confidence, the outcome has been quite different.
Low to zero interest rates have incentivized non-productive debt and exacerbated the wealth gap. The massive increases in debt have harmed growth by diverting consumptive spending to debt service.
However, the hope is that while it didn’t work over the last decade, maybe doing more will be “different this time.”
The Keynesian view that “more money in people’s pockets” will drive up consumer spending, with a boost to GDP being the result, has been wrong. It hasn’t happened in 40-years.
While mainstream economists believe more stimulus will create robust economic growth, no evidence supports the claim.
More importantly, while the Federal Reserve may not raise interest rates any time soon, the bond market may well take care of that problem for them. As shown below, that is a process already well underway with an adverse event likely closer than many expect.
The Fed’s problem comes when a burst of inflation and rising rates collide with the massive debt levels overhanging the economy.
The reality is the Fed has left unconventional policies in place for so long after the “Financial Crisis,” the markets can no longer function without them.
But…It is springtime and the flowers will soon be in full bloom. If we have our health, family and friends, then that is what is important.
5 Ways to Make Today a Better Day
- Look for the good.
- Appreciate the little things.
- Be a helper.
- Tell someone they matter.
- Give more than you take.
All content is the opinion of Brian J. Decker
