Bonds & Interest Rates
The Federal Reserve is an interesting study in public relations. The Fed has twelve districts that release statements and publish studies. The Federal Reserve Board is comprised of seven members who often make public statements about monetary policy. The chair of the Federal Reserve Board also testifies and conducts Q&A sessions with the media. Often, statements coming from the various sources within the Fed seem to be highly contradictory and confusing, something that serves a purpose in the realm of monetary policy.
Fed Cares About Inflation Expectations
Experienced investors know central bankers care about their legacy, as most professionals do. While casual investors may believe all the Fed cares about is higher stock prices, the Fed is genuinely concerned about allowing inflation to get ahead of them. If inflation expectations begin to pick up, it can change habits, which ultimately can lead to real world inflation.
Fisher’s Shot Across The Bow
On Sunday night, The Wall Street Journal published an opinion piece by Richard Fisher, president of the Federal Reserve Bank of Dallas. The text serves as a warning to complacent investors that the Fed cannot keep interest rates near zero indefinitely. The op-ed opens with a single sentence paragraph:
“I have grown increasingly concerned about the risks posed by current monetary policy.”
That is a pretty strong opening statement meant to get the attention of investors and businesses impacted by interest rates.
Making The Same Mistakes?
If you were investing during the dot-com bubble, you remember the Fed failed to tighten margin requirements, which allowed speculation to run rampant. The Fed is often criticized for “keeping rates too low for too long” between 2003 and 2005. For example, the Federal Funds Rate was at 2.25% in January 2005. In the July 27, 2014 Wall Street Journal (WSJ) opinion piece, Fisher states:
“I believe we are at risk of doing what the Fed has too often done: overstaying our welcome by staying too loose, too long.”
Incentives To Take On Risk
Fisher noted that Janet Yellen was also aware of the potential risks of maintaining the Fed’s current stance. From Fisher’s WSJ piece:
“In her recent lecture at the International Monetary Fund, Fed Chair Janet Yellen said, ‘I am also mindful of the potential for low interest rates to heighten the incentives of financial market participants to reach for yield and take on risk, and of the limits of macroprudential measures to address these and other financial stability concerns.’ She added that ‘[a]ccordingly, there may be times when an adjustment in monetary policy may be appropriate to ameliorate emerging risks to financial stability.’ I believe that time is fast approaching.”
Investment Implications – Good To Be Aware Of
Should we sprint for the equity exits after reading Fisher’s comments? No. However, it is good to be aware of the Fed’s willingness to raise rates sooner than many market participants believe. The risk is not related exclusively to a rate increase. It is the timing of the rate increase that could catch some investors off guard.
How do we use all this? Fed policy is one of many inputs impacting the battle between bullish economic conviction and bearish economic conviction. As noted on July 28, the market will guide us if we are willing to listen. Not much has changed this week. Therefore, the 80% confident 20% concerned analysis in this week’s video still applies. Therefore, we continue to hold a mix of stocks (SPY), leading sectors (XLK), and a relatively small stake in bonds (TLT).
The possible market-spooking outcome this week or in the weeks ahead is if the Fed signals an interest rate hike may be coming sooner rather than later. Again, it is not the act of raising rates that matters, but the timing.
About Chris Ciovacco
Chris Ciovacco is the Chief Investment Officer for Ciovacco Capital Management, LLC.
While we are busy arguing whether the Fed’s exit will consist of rising rates, reverse repos or the trimming of its massive portfolio, the Fed may well be fooling all of us. Investors must have been swallowing lots of blue pills not to see the illusion hiding in plain sight.
Let’s assume that we will indeed get a rate hike next year, and that the Fed will have figured out how to implement it. We may get our exit all right, but it’s not the sort of exit most appear to be expecting. That’s because in our humble view, an “exit” ought to reflect a path towards normalization, away from financial repression, back to an environment where pensioners might once again be able to live off income generated from their savings.
If anyone dares to take a red pill, you will learn that interest rates net of inflation, i.e. real interest rates, have not only continued to be negative, but become more negative of late, meaning inflation has started to inch upward. For normalization to occur, interest rates must move higher faster than the pace of inflation; and not only do real interest rates need to move higher, they ought to move into positive territory to suggest we might be exiting financial repression.
The chart above shows real interest rates in the U.S. versus the Eurozone. While pundits focus on the fact that the European Central Bank (ECB) now has a negative rate on deposits, most forget the inconvenient truth that real interest rates are higher in the Eurozone than the U.S. Not only are rates higher in the Eurozone, but the gap has also been widening. Yet, investors appear to be embracing the storyline that rates will be lower for longer in the Eurozone, as we have the Fed about to raise rates.
The above chart shows headline consumer price inflation (headline CPI). Given that the Fed (unlike the ECB) focuses more on core inflation, below is a comparison of core CPI in the U.S. versus Eurozone:
Critics of the Fed suggest that U.S. inflation is higher than reported, further increasing the threshold to get us away from financial repression.
In the meantime, ECB head Draghi is trying to convince investors that rates in the Eurozone will stay lower for longer; Draghi has even said that real interest rates are negative and are likely to become more negative over time. The relevance to this discussion is simply that there’s a central banker being frank. And the reason he is so frank may well be that it is far more difficult to induce inflation in the Eurozone than in the U.S.
In the U.S., we see inflationary pressures come up in pockets. Full-time employees, for example, appear to have pricing power, even as the Fed’s preferred gauge of all employees remains fairly stable. In our assessment, we have a bifurcated recovery where those with assets, those with jobs, do well, but the have-nots are left behind. And because Fed Chair Yellen cares about Main Street, she wants to keep rates low until the have-nots have recovered from the Great Recession.
Are economically disadvantaged Americans really so different from Portuguese workers? At the risk of grossly oversimplifying the respective challenges, keeping rates low to help out those left behind might allow inflation to creep up elsewhere. Conversely, consider the prosperous end of the spectrum? Clearly there are differences between wealthy Americans and the German economy, but inflation has been creeping up in their respective domains.
What is different between the Eurozone and the U.S. is that the U.S. economy is far more sensitive to the markets, whereas the Eurozone economy is dependent on the health of banks. And given the ongoing balance sheet challenges faced by Eurozone banks, I don’t think one needs to be a rocket scientist to determine that inflationary pressures more easily build in the U.S.
In the U.S., much of the economic recovery is based on asset price inflation: when homeowners are no longer ‘upside down’ in their mortgage, they might be better consumers. As asset prices have floated higher the wealth effect might get consumers to spend more. Aside from the problem that lots of folks have been left behind in this so-called recovery, it may be at least as much of a challenge that such a recovery is rather unstable, as the “progress” may be lost if asset prices come back down. Positive real interest rates could create immense headwinds.
The other big challenge is that we might not be able to afford positive real interest rates. When Yellen was asked about the impact of higher rates on the federal deficit, she dodged the question. However, if indeed we went back to historical levels in interest rates then, based on Congressional Budget Office (CBO) projections on deficits, we might be spending $1 trillion more a year simply to pay interest on our debt. Given the gridlock in Congress may make it impossible to achieve the necessary reforms to either raise the revenue or cut taxes sufficiently to make U.S. deficits sustainable, the Fed has a tremendous incentive to keep rates low…
As we discussed in more depth in our recent Merk Insight ‘Instability the New Normal?’, one of the Fed’s biggest achievements is to compress risk premia, to make risky assets appear less risky (as evidenced, for example, by low volatility in the stock market or low yields available in the junk bond market). If the Fed indeed were to pursue an ‘exit,’ odds are that risk premia would go back up – a more fearful environment may cause substantial headwinds to the economy (as well as asset prices). Again, a major incentive for the Fed to keep rates low.
Yellen appears to be aware of at least some of these forces as she recently testified that headwinds to the economy may well persist even as the Fed raises rates.
To make a long story short, yes, nominal rates may be rising. But don’t count on real rates moving up, let alone into positive territory, anytime soon. Indeed, I fear inflation may be picking up much faster than interest rates. In that environment, Draghi’s predictions of rates becoming more negative over time will very much apply to the greenback as well.
And before people lash out at me for downplaying the challenges in Europe, don’t read me wrong: I very much agree that Europe is a mess; it has always been a mess and is likely going to remain a mess. But that’s not the question I’m addressing here. All I’m arguing is that real interest rates in the Eurozone are likely to remain higher than in the U.S.
It shouldn’t come as a surprise that we like gold in this environment: a) because real interest rates are negative; and b) because we expect real interest rates to remain negative for a long time. In fact, if you look at how incentives are aligned, they point towards inflation, as both the U.S. government and consumers – given their high debt loads – might want inflation to debase the value of their debt. It’s foreigners holding U.S. debt that suffer the most from U.S. inflation as they have an interest in preserving the purchasing power of the debt. As foreigners are not voting, it speaks volumes about the path of least resistance – or at least the path of greatest temptation.
Market Buzz – It isn’t a secret to anyone paying attention that we have been frolicking in a historically low interest rate environment since 2009. Low interest rates are a natural occurrence during times of economic distress as capital tends to flow into the government bond market which is viewed as a safe haven for investors looking to wait out the storm. Central banks (aka U.S. Federal Reserve) also engage in stimulus initiatives aimed at keeping interest rates low to encourage borrowing, spending and economic development. When the economy starts to turn the corner, interest rates begin to rise as capital flows out of the bond market and governments ease off on stimulus.
With the general consensus supporting a gradual improvement of the U.S. and global economies, forecasters a many have been throwing in their two-bit conclusions on when we should start to see interest rates rise back to (or at least close to) historical levels. Not in recent memory was the voice of these pundits so strong as in June of last year when a sudden spike in rates had the herd calling the “turn of the corner” on interest rates and for 4% plus yields on the 10-year bond by the second half the following year (right about now). But as the old adage goes…”the loudest ship is usually empty.” The 10-year yield did increase over 50% from a historic low of 1.72% in April 2013 to 2.63% only 4 months later causing calamity for interest rate sensitive stocks (particularly dividend stocks and REITs), but then ever so quickly tapering off and more recently continuing its descent downward. As of Friday, the 10-year yield was 2.26% or close to the lowest it has been since May of 2013.
The markets on the other hand have never been happier…literally. As of the close on Friday, the TSX Composite and the S&P 500 continue to hover at historic highs. Stocks tend to benefit from low interest rate environments. On one hand, low interest rates make it easy to borrow capital cheaply. On the other hand, investors are more willing to bid up valuations on stocks as they can’t generate a reasonable return in the bond market. But in spite of what appears to be euphoria in the stock market, low interest rates to not insinuate a rosy outlook for economic growth….quite the opposite actually. Generally speaking, an analysis of short and long-term bond yields (illustrated by something called the yield curve) currently indicates that the outlook for economic growth is in fact bleak.
Thankfully at KeyStone, we think it is a bit of waste of time to focus too much on “he said, she said” with the stock and the bond markets. At this point (or at any point for that matter), it is pretty much impossible to say if the stock market will be correct, the bond market will be correct, or if they will somehow agree to meet in the middle. An investor could literally drive themselves nuts trying to analyze the ins and outs of macroeconomics. Focusing on individual companies and their individual fundamentals proves to be much easier and more effective.
So what is an investor to do in these unusual markets? First off, don’t listen to opinionated forecasters. Most of them just try to extrapolate the current trend. The stronger the opinion someone has on their forecast; the weaker the forecast (generally speaking). Secondly, follow this advice:
1. Stick to profitable, cash flow generating businesses that can be purchased at reasonable valuations (remember that the antonym of reasonable is unreasonable).
2. Try to avoid companies with too much debt (they won’t do well when interest rates do rise).
3. Maintain a strategy of focused diversification (8 to 12 stock portfolio).
4. Keep some cash on the sidelines for when good opportunities arrive (anywhere from 10% to as much as 50%).
5. Don’t speculate (save that for Vegas).
6. Don’t trade aggressively (target a minimum time horizon of 1 to 3 years on stocks).
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Although Fed Chairwoman Janet Yellen said nothing new in her carefully manicured semi-annual testimony to Congress last week, her performance there, taken within the context of a lengthy profile in the New Yorker (that came to press at around the same time), should confirm that she is very different from any of her predecessors in the job. Put simply, she is likely the most dovish and politically leftist Fed Chair in the Central Bank’s history.
While her tenure thus far may feel like a seamless extension of the Greenspan/Bernanke era, investors should understand how much further Yellen is likely to push the stimulus envelope into unexplored territory. She does not seem to see the Fed’s mission as primarily to maintain the value of the dollar, promote stable financial markets, or to fight inflation. Rather she sees it as a tool to promote progressive social policy and to essentially pick up where formal Federal social programs leave off.
Despite her good intentions, the Fed’s blunt instrument policy tools of low interest rates and money supply expansion can do nothing to raise real incomes, lift people out of poverty, or create jobs. Instead these moves deter savings and capital investment, prevent the creation of high paying jobs, and increase the cost of living, especially for the poor (They are also giving rise to greater international financial tensions, which I explore more deeply in my just released quarterly newsletter). On the “plus” side, these policies have created huge speculative profits on Wall Street. Unfortunately, Yellen does not seem to understand any of this. But she likely has a greater understanding of how the Fed’s monetization of government debt (through Quantitative Easing) has prevented the government from having to raise taxes sharply or cut the programs she believes are so vital to economic health.
But as these policies have also been responsible for pushing up prices for basic necessities such as food, energy, and shelter, these “victories” come at a heavy cost. Recent data shows that consumers are paying more for the things they need and spending less on the things they want. But Yellen simply brushes off this evidence as temporary noise.
In her Congressional appearances, Yellen made clear that the end of the Fed’s six-year experiment with zero percent interest rates is nowhere in sight. In fact, the event is less identifiable today than it was before she took office and before the economy supposedly improved to the point where such support would no longer be needed. The Bernanke Fed had given us some guidance in the form of a 6.5% unemployment rate that could be considered a milestone in the journey towards policy normalization. Later on these triggers became targets, which then became simply factors in a larger decision-making process. But Yellen has gone farther, disregarding all fixed thresholds and claiming that she will keep stimulating as long as she believes that there is “slack” in the economy (which she defines as any level of unemployment above the level of “full employment.”) Where that mythical level may be is open for interpretation, which is likely why she prefers it.
The Fed’s traditional “dual mandate” seeks to balance the need for job creation and price stability. But Yellen clearly sees jobs as her top priority. Any hope that she will put these priorities aside and move forcefully to fight inflation when it officially flares up should be abandoned.
These sentiments are brought into focus in the New Yorker piece, in which she unabashedly presents herself as a pure disciple of John Maynard Keynes and an opponent of Milton Friedman, Ronald Reagan, and Alan Greenspan, figures who are widely credited with having led the rightward movement of U.S. economic policy in the last three decades of the 20th Century. (Yellen refers to that era as “a dark period of economics.”)
Perhaps the most telling passage in the eleven-page piece is an incident in the mid-1990s (related by Alan Blinder who was then a Fed governor along with Janet Yellen). The two were apparently successful in nudging then Fed Chairman Alan Greenspan into a more dovish position on monetary policy. When the shift was made, the two agreed “…we might have just saved 500,000 jobs.” The belief that central bankers are empowered with the ability to talk jobs in and out of existence is a dangerous delusion. As her commitment to social justice and progressivism is a matter of record, there is ample reason to believe that extremist monetary policy will be in play at the Yellen Fed for the duration of her tenure.
For the present, other central bankers have helped by taking the sting out of the Fed’s bad policy. On July 16 the Wall Street Journal reported that the Chinese government had gone on a torrid buying spree of U.S. Treasury debt, adding $107 billion through the first five months of 2014. This works out to an annualized pace of approximately $256 billion per year, or more than three times the 2013 pace (when the Chinese government bought “just” $81 billion for the entire calendar year). The new buying pushed Chinese holdings up to $1.27 trillion.
At the same time, Bloomberg reports that other emerging market central banks (not counting China) bought $49 billion in Treasuries in the 2nd Quarter of 2014, more than any quarter since 3rd Quarter of 2012. These purchases come on the heels of the mysterious $50 billion in purchases made by a shadowy entity operating out of Belgium in the early months of this year (see story).
So it’s clear that while the Fed is tapering its QE purchases of Treasury bonds, other central banks have more than picked up the slack. Not only has this spared the U.S economy from a rise in long-term interest rates, which would likely prick the Fed-fueled twin bubbles in stocks and real estate, but it has also enabled the U.S. to export much of its inflation.As long as this continues, the illusion that Yellen can keep the floodgates open without unleashing high inflation will gain traction. She may feel that there is no risk to continue indefinitely.
But as the global economic status quo is facing a major crisis (as is examined in this newsletter), there is reason to believe that we may be on the cusp of a major realignment of global priorities. Despite her good intentions, if Yellen and her dovish colleagues do not receive the kind of open-ended international support that we have enjoyed thus far in 2014, the full inflationary pain of her policies will fall heaviest on those residents of Main Street for whom she has expressed such deep concern.
Peter Schiff is the CEO and Chief Global Strategist of Euro Pacific Capital, best-selling author and host of syndicated Peter Schiff Show.
Catch Peter’s latest thoughts on the U.S. and International markets in the Euro Pacific Capital Summer 2014 Global Investor Newsletter!
This week, Bank of Canada Governor Stephen Poloz took the opportunity once again to talk down the Canadian dollar, as he has at almost every opportunity since he took the helm of the central bank.
His plan has been working for the most part as the Canadian dollar has been on a downward trajectory since Mr. Poloz took over. It eroded in the first quarter of the year, and rebounded in the second, most recently trading in a range of about US$0.93 to US$0.94.
The central bank has for some time now held what is known as a neutral bias, which means it’s sending no signal to the markets of whether the next move in its benchmark rate could be up or down. Governor Poloz, however, has left the door open to a rate cut, which has had helped hold the currency down. And the weak jobs report from Statistics Canada last week helped feed into that.
“While there’s no disputing the Canadian manufacturing sector has been in secular decline for more than 30 years, the Loonie has been a pivotal factor in driving activity,” senior economist Benjamin Reitzes of BMO Nesbitt Burns said in a research note this week.
“Clearly the run to parity had a devastating impact on the sector,” he added, referring to his research – posted in chart from below – that shows how the movement in the currency has affected factory jobs, with a lagging impact.
“The only good news here is that the chart suggests we may be nearing a bottom on manufacturing employment. Indeed, if the Loonie weakens as we expect, that could mean some improvement in a year or two.”
This past Wednesday, shrugging off a recent surge in inflation as temporary, the Bank of Canada warned the country’s economy does not yet have enough steam to grow without the bank’s help and said it could just as easily cut interest rates as raise them.
The central bank, as expected, kept its key overnight rate at a low 1%, the stimulative level at which it has been for 46 months. But Governor Stephen Poloz made clear he is worried about downside risks to the economy after “serial disappointment” with global growth in recent years.
“Monetary conditions today are highly stimulative and it’s evident that we don’t have a process of natural growth in the economy yet,” he told a news conference.
The central bank said it would keep its policy stance “neutral,” meaning its next move could be either a tightening or easing.
Small-Cap Opportunities in Exports?
While we see the potential for opportunities to present themselves in the Canadian export sector in a lower dollar environment, we are careful not to base our analysis strictly on this one factor. While the current bias appears to be for a lower Loonie, this is far from a fait accompli.
At this stage, we prefer to invest in quality companies, be they Canadian exporters or Canadian energy producers for example that are already profitable and well run and would benefit further from a lower Loonie, but do not require that type of environment to be profitable and ultimately successful.
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