Bloomberg – Fed’s Patient-or-Preemptive Clash Looms as Inflation Misses Goal
Former Federal Reserve Chairman Alan Greenspan, in year nine of a U.S. economic expansion, conceded in 1999 that patience was sometimes a better policy than his doctrine of preemptive interest-rate moves because “the future at times can be too opaque to penetrate.” For some Fed officials, these days look like one of those times to wait for clarity. Faith in preemption — the Greenspan-era strategy of setting of monetary policy based on forecasts to get ahead of where the economy was going — is beginning to falter among some officials. That’s because in the current expansion’s ninth year, inflation isn’t accelerating as they predicted for reasons that aren’t yet understood, even as the labor market tightens and global growth improves.
‘Neutral’ Rate Dropping, Are Tighter Financial Conditions Finally on the Way?
Bloomberg – Fed Neutral Rate Estimate Drops, Lowest in Over Two Years
The so-called neutral U.S. interest rate fell in the second quarter by the most since 2010, according to a widely-cited estimate produced by Federal Reserve economist Thomas Laubach and San Francisco Fed President John Williams. The theoretical rate known in economic circles as “r-star” — which is adjusted for inflation and would neither stimulate nor restrict an economy growing at its trend pace — declined to -0.22 percent, from 0.12 percent in the first quarter. In comparison, the Fed’s benchmark rate, adjusted for core inflation, is currently -0.35 percent, which suggests the central bank is nearly at a “neutral” monetary policy setting, according to the model.
Surely that will cause long-term yields to rise and financial conditions to finally tighten, right? Maybe not. The structure of the bond market these days is such that there’s a good chance conditions will continue to loosen, further underpinning demand for riskier assets ranging from equities to high-yield debt to emerging-market currencies. To understand why, first consider that institutions that needed very high quality securities to comply with new regulations designed to make the financial system safer have been somewhat crowded out by the Fed’s purchases. They will now have the opportunity to buy Treasuries and the resulting demand should help contain long-term yields. At the same time, officials such as New York Fed President William Dudley have hinted there will be a pause in rate hikes during the initial stages of balance-sheet normalization, which should also help support the market.
ECB Likely the Most Watched Central Bank in 2018
Reuters – Fed balance sheet plan may equal three rate hikes for emerging markets
According to calculations by IIF, one of the most authoritative trackers of global capital flows, this will slice just over $200 billion off the U.S. central bank’s balance sheet next year, assuming it keeps reinvesting some of the money for the time being. Sonja Gibbs, one of the IIF’s senior directors, also estimates that just a $65 billion drop in the Fed’s Treasury holdings would equate to a $6.5 billion to $7 billion drop in emerging market portfolio flows — bond and equity purchases by foreigners — all else being equal. “That in turn is about equal to a 25 basis point (Fed) rate hike in terms of impact,” Gibbs added.
Where policy goes now is key. Markets doubt how far the Fed might get with its tightening, and seem unflustered by the prospect of the central bank shrinking its balance sheet. Investors may be too relaxed, but in the absence of fiscal stimulus and inflation, much higher yields for Treasurys might be hard to achieve in the near term. The European Central Bank, meanwhile, is set to move out of emergency-policy territory. Support for low yields on German bunds is likely to diminish as the ECB starts to move gently towards an exit from its bond purchases. While policy rates are likely to remain ultra-low for a long time to come, that implies a steeper yield curve in Germany, with the central bank exerting less influence over longer-term interest rates.
U.S. Treasuries Need a Wellness Check
Bloomberg – Volatility Gauges Tumble to New Lows Amid Complacency Fears Bank of America MOVE Index closes at an all-time low on Monday
The markets are alive with the sound of ‘zzzzzz’ as the latest trading session marks yet another another record low for volatility gauges. Bank of America’s MOVE Index, which gauges volatility in the U.S. Treasury market, has tumbled to an unprecedented 46.9 at the close of Monday’s trading session. The move means investors in the world’s largest bond market are shrugging off the potential for price swings, even as two titans of the industry up their bets on an uptick in U.S. inflation.
The Wall Street Journal – Inflation Tame in June, Complicating Fed’s Rate Decision Officials have been expecting a pickup in prices as the economy improves, but it isn’t appearing
Some Fed officials have expressed concern in recent weeks about pushing ahead with interest-rate increases in light of the softening inflation data. Federal Reserve Bank of Philadelphia President Patrick Harker said last month the recent slowing path of inflation gave him pause over whether the central bank should raise its benchmark interest rate for a third time this year. Overall the economy appears to be advancing at a steady but unspectacular pace. Consumer spending propelled economic growth in the second quarter, the Commerce Department reported last week. Gross domestic product, a broad measure of economic output, rose at a seasonally and inflation adjusted annual rate of 2.6%, aided by a 2.8% growth rate for consumer spending. That was up from the first quarter’s 1.9% growth pace for household outlays.
What is happening to the world economy? Here are some answers, in seven charts. They reveal a world undergoing profound changes. The most important transformation of recent decades has been the declining weight of the high-income countries in global economic activity. The “great divergence” of the 19th and early 20th centuries, when today’s high-income economies leapt ahead of the rest of the world in terms of wealth and power, has gone into remarkably rapid reverse. Where once there was divergence, we now see a “great convergence”. Yet it is also a limited convergence. The change is all about the rise of Asia and, most importantly, of China.
U.S. Treasury’s International Capital Statistics Update
Tables and comments detailing foreign investment through May 31, 2017 with data released on July 18, 2017. This month, we take a look at foreign investors net purchases of U.S. assets.
A decent year in stocks. As the table below shows, the stock market is having a decent year.
Large cap stocks leading the way. As the next chart shows, large cap stocks (blue) are leading the way as small cap stocks (red) lag badly.
Market Cap weighted beats equal weight. Another way to show that large capitalized stocks are powering the overall market higher is the next chart. It shows the S&P 500 stocks market cap weighted (blue) and equal-weighted (orange). It is unusual for market cap to outperform equal weight by this degree.
Growth beats value. The chart below shows the S&P 500 pure growth (orange) and pure value (blue). “Pure” means the S&P 500 universe is out into one of these two groups. Growth is dominated by large capitalization technology stocks (i.e., FAANMG) which explain why pure growth is handily outperforming.
The best and worst sectors. The S&P 500 has 11 sectors. The two best (info tech and healthcare) and the two worst (energy and telecom) are shown below.
The most positive and negative influences on the S&P 500. The S&P also has 11 “x” sector indices. These are indices that exclude a specific sector. We show the two best and worst x-sectors below.
This is useful as it shows how much a sector influences the overall S&P 500 (by subtracting the “x sector from the overall S&P 500 in blue). So x-energy is up 12.93% versus 11.05% for the overall S&P 500. This means that the energy sector dragged down the overall S&P 500 1.88%. Conversely, x-info tech is up 8.76% against 11.05% for the overall S&P 500. This means the info tech sector has pushed up the overall S&P 500 2.29%.
The interactive chart below can be used to view the total returns for any or all of the 34 indexes provided under the “select an index” dropdown menu. The date range can be adjusted at the bottom of the chart.
Bitcoin continues to fascinate observers and frustrate some owners with its exceptionally high volatility in recent weeks. Now back above $2000, Bitcoin has fought off two sharp declines since the end of May.
One contributor to higher volatility is the dramatic fall in volume after the regulatory intervention by the Peoples Bank of China. See the second tab in the story point below. Volume fell by more than 90% and has not recovered.
If you click to the third tab you can see the share of volume by currency. The USD has been slowly gaining share since the intervention but the CNY still accounts for the 2nd largest share of volume followed by EUR and JPY.
The chart below shows various tenors of interest rates since the initial FOMC hike on December 17, 2015. 10-year yields are almost exactly where they were prior to this hike. 30-year yields are actually lower over this time period.
At the same time, yields on the short end of the curve have marched much higher. A look at 3-month T-bills shows yields have shot up 84 basis points.
The Federal Funds market is showing no signs of reviving. The Fed still targets the federal fund’s rate. They do this by using tools like fixed rate reverse repos and Interest on Excess Reserves (IOER). This suggests they think it will return some day. But as the chart below shows, this market’s volume is still down 90% from its peak and still bumping around a 40 year low. It is showing no signs of reviving. Should the Fed consider abandoning this target for another interest rate benchmark?
Measuring Political Risk. The Economist Intelligent Unit compiles Political Risk measures for 132 countries at last count. The next chart shows the 10 countries with the lowest political risk. Pretty standard stuff (Denmark then Luxembourg are the lowest).
The next chart shows the 10 countries with the highest political risk. Britain is on this list! Right above it is the Congo and Iraq. Right below it is Cambodia and El Salvador.
The reason is understandable, Brexit. But Britain with a higher risk that Cambodia? Similar to the Congo? We would argue this rating is more about the “intellectuals” at The Economist making a political statement about their disapproval of Brexit more than an honest assessment of Britain’s actual political risk.
Using the interactive chart below, you can view the political risk for any country over any period you choose.
How safe is Trump? The bettors are giving him much better than a 50% probability of stay in office until the end of next year.
The blue line below shows a 50-day moving average of the total trading volume in actual high-yield bonds as measured by TRACE. In the 50 days ending July 19, $7.66B of high yield bonds traded on an average day.
The green line shows the 50-day average of the total dollar volume (price multiplied by shares) for the 25 largest high-yield ETFs. HYG accounts for roughly two-thirds of this total. In the 50 days ending July 19, $1.56B of high-yield ETFs traded on an average day.
The red line, which shows the ratio of the green line to the blue line, shows the ETF market is currently 20% the size of the underlying cash market.
This is how one-fifth of the high-yield market now trades.
By contrast. the chart below shows the same metric for investment grade. Only 4% of investment grade market trading is driven by ETFs. Other than high yield, this is a large number when compared to other ETF sectors. It shows how dominant high yield is relative to its underlying cash market.
The black market rate of Venezuela’s currency continues to collapse resulting in hyperinflation and a worsening situation in the country. Note that in the last year the black market rate went from 1,010 Bolivars to buy a dollar to 8,481 Bolivars today. A drop of 88%.
At this rate of currency depreciation over the last year, prices in Venezuela would need to rise 833% in the last year to keep pace with inflation. This is not happening with wages. But, as the next chart shows, the Venezuelan stock market is keeping pace with this hyperinflation rate (for now). It went up by 970% in the last year (blue) leading to a 27% currency adjusted rate (red now). Venezuela’s stock market has 15 liquid stocks with Mercantil Servicios Financieros, C.A. and Banco Provincial, S.A. account for 85% of their stock market’s capitalization. Mercantil Servicios is a junk rated credit and Banco Provincial is no longer rated.
Financial Times – Dollar sinks on failure of healthcare reform US currency hits 10-month low as hopes fade for Trump economic stimulus
The dollar has been a barometer of prospects for the Trump administration’s efforts to enact pro-growth policies of tax cuts and fiscal stimulus. As the administration has become bogged down in the past six months handling healthcare reform and dealing with the Russia scandal, the reserve currency has steadily retreated. Lacklustre economic data, notably a weaker tone for inflation and retail sales for June, have prompted the bond market to reduce the likelihood of further interest rate increases from the US Federal Reserve.
The WSJ Dollar Index has now unwound the boost it got from the election of Donald Trump in November, and is down about 6.5% this year. The greenback’s key counterpart, the euro, is up close to 10% in 2017. Early Tuesday, the euro rose above $1.15 for the first time since May 2016, reaching the top of the range it has been in since the start of 2015 under the influence of monetary-policy divergence between Europe and the U.S. The transformation in the dollar and euro’s relative fortunes in 2017 has been remarkable. The focus at the start of the year was on the U.S. Federal Reserve and its efforts to raise interest rates; now the European Central Bank has stolen the spotlight as it tacks gently away from ultraloose policy settings.
Wall Street Journal – Dollar Doldrums Mean Easier Money
The Goldman Sachs Financial Conditions Index, a widely-watched gauge, was at its lowest since late 2014 this week. The lower the index, the looser the flow of money, based on factors like bond yields and the value of the dollar against its peers. Much of that is the result of a falling greenback. The WSJ Dollar Index, a measure of the U.S. currency against 16 others, is down 6.5% since the end of last year. The index was down another 0.6% Tuesday morning at its lowest level since October, before the presidential election spurred a big surge in the dollar.
No rate hikes are coming at the July, September or November Fed FOMC meetings. The earliest rate hike might be at the December 13, 2017 FOMC meeting, but even that has a less than 50% probability as of today. I’ll update those probabilities using my proprietary models in the weeks and months ahead. The white flag of surrender came in two public comments by two of the only four FOMC members whose opinions really count. The four voting members of the FOMC worth listening to are Janet Yellen, Stan Fischer, Bill Dudley and Lael Brainard.
Donald Trump’s appeal last November was linked to two factors. Both are now putting the valuation bubble in equities at risk. The first factor was his emphasis on stimulus — tax reform, infrastructure spending and fewer regulations — that has pushed markets to higher and higher levels. The new administration was targeting at least 3 percent annual growth in real gross domestic product, well in excess of levels that the U.S. economy has experienced since the financial crisis. The second component of the Trump campaign presented the U.S. trade deficit as a sign that the country was being treated unfairly by its trading partners. The remedy was to impose higher tariffs on imports, with China and Mexico mentioned as specific targets. Fear that the trade restrictions the candidate threatened during the campaign would dominate the incipient administration was the reason U.S. equity futures plunged during the hours immediately after the election results were known. Retaliation by trading partners to new tariffs would have slowed global economic growth and demand, resulting in a headwind for equities.
Still, the market’s high valuation in the face of declining earnings growth and a tepid U.S. economy means some of the rally was likely driven by policy expectations. More than half of the respondents to a survey of nearly 1,100 clients conducted by Cornerstone Macro last month said they expected Congress to pass a significant tax bill before the 2018 midterm elections. The question to ask, says Cornerstone’s Andy Laperriere, is what would happen to stocks if all investors gave up on a tax cut? The answer: They would probably go down.
Wall Street Journal – Bank Earnings Are Coming: Five Things to Watch Calm markets, the Fed and lighter lending are among the factors seen influencing second-quarter results
The Federal Reserve’s decision to raise short-term interest rates in June, the fourth rate increase since December 2015, should boost banks’ lending income. The rates banks charge on credit cards, home equity lines of credit and other types of loans vary depending on the Fed’s target. Those higher yields will help push net-interest income at the median big U.S. bank up by 6.2% in the second quarter, according to analysts at RBC Capital Markets.
Bloomberg – The Study Europe’s Rate-Setters Should Read A new paper shows why the longer rates stay low, the fewer benefits they bring.
A key argument for hurrying up with a monetary tightening is that negative rates have hurt bank profitability, restricting lenders’ ability to give credit to families and firms. But is it really the case? How low can interest rates go before they become a drag on the economy? A new way of thinking about this problem comes from a working paper by Markus Brunnermeier and Yann Koby at Princeton University. The two scholars believe there is a “reversal interest rate” below which a central bank prompts lenders to cut back on their lending, instead of increasing it. This boundary creeps up over time, setting a limit to how long central banks should keep interest rates low.
Bloomberg – The Fed Needs a Better Inflation Target A higher goal, with more public support, would benefit the central bank and the economy.
Today, a group of economists published a letter urging the U.S. Federal Reserve to consider a monumental change in policy: raising its target for inflation above the current 2 percent.
I signed the letter. Here’s why.
The inflation target helps define how much stimulus the Fed can deliver when it lowers interest rates to zero (a boundary below which the central bank has been unwilling to go). In a higher-inflation environment, a nominal fed funds rate of zero results in a lower real, net-of-anticipated-inflation rate — the rate that economists typically see as most relevant for consumer and business decisions. If, for example, people expect inflation to be 3 percent, then a zero nominal rate translates into a negative 3 percent real rate — a full percentage point lower than the Fed could achieve if expected inflation were 2 percent.
Financial Times – Bank shares hit as Treasury yield curve flattens
Net interest margins for financials been depressed for an extended period
An important measure for US bank profitability plumbed an eight-month low on Tuesday, pressuring the shares of lenders and highlighting doubts in the bond market over the prospect of an acceleration in the economy and inflation this year. The difference in yield between two and 10-year Treasury notes narrowed 2.5 basis points to 84.99 bps, the lowest level since October 3, according to Bloomberg data. This closely watched relationship climbed to a post-election high of 135.5bp in late December, predicated on President Donald Trump’s pro-growth policies boosting inflation and sparking higher interest rates in the future.
Bloomberg View – A Few Big Stocks Don’t Tell the Whole Market Story
Investor nervousness over concentrated gains in the markets is nothing new. The FANG stocks — Facebook, Amazon, Netflix and Google — accounted for a large part of the S&P 500 gains in 2015, as well. AQR’s Cliff Asness looked at the impact of individual stocks on the S&P 500 from 1994 to 2014 and compared those results to the 2015 FANG-driven market. Asness showed what the impact on overall market performance would have been if you removed the best performing stocks each year