Fed’s 1995 Script Playing Out Again

March 26, 5:00 pm EST

Yesterday we talked about the yield curve inversion.

It was driven by the Fed walking up the fed funds rate (i.e. “normalizing rates”) over the course of the past three years.  As we discussed yesterday, with global central banks pinning down the long-end of the yield curve through QE (now led by the BOJ), there were few things better telegraphed than the U.S. yield curve inversion.

The market is now pricing in a 66% chance of a rate cut by the end of the year.  The market is arguing that the rate hike the Fed made in December, was a mistake.

When have we seen this script before?  1995.  As we discussed coming into the year, 2018 was the first year since 1994 that cash was the best producing major asset class (among stocks, real estate, bonds, gold).  And the culprit was an overly aggressive Fed tightening cycle in a low inflation recovering economy.

The Fed ended up cutting rates in 1995 and spurring a huge run up in stocks (up 36%).  That’s the bet people are making again.  But I suspect we’ve already seen the equivalent of a cut through the Fed’s dovish posturing since early January.  Remember, they went on a media blitz the first several days of January, dialing down expectations that there would be any more tightening.

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Should We Be Concerned About the Yield Curve Inversion?

March 25, 5:00 pm EST

There was a big technical break in the interest rate market on Friday.   And the yield curve inverted.

What does it mean, and should we be concerned?

First, when people talk about the yield curve, they are typically talking about the yield on the 3-month Treasury bill versus the yield on the 10-year government bond.  The latter should pay more, with the idea that money will cost more in the future (compensating for inflation and an “uncertainty about the future” premium).

When the 10-year is paying you less than you could earn holding a short term T-bill, the yield curve is said to be inverted.  And this dynamic has predicted the past seven recessions.  Why?  Because it typically will be driven by a tighter credit environment, namely banks become less enthused about borrowing in the form of short term loans, to lend that money out in longer term loans.  Money dries up. Unemployment goes up. Demand dries up. Economy dips.

With this in mind, today the 3-month treasury bill pays 2.44%. And the 10-year government bond pays 2.41%.  The spread is negative which makes for an inverted yield curve.

Now, while an inverted yield curve has preceded recessions with a good record, we’ve also had inverted yield curves and no recession has followed.

What isn’t talked about much, is why the yield curve is inverting this time.  It sort of spoils the drama to talk about the “why”.  Unlike any other time in history, we have an interest market that has been explicitly manipulated by global central banks for the past decade (via global QE).  And we have one major central bank (the Bank of Japan) remaining as a buyer of unlimited global assets (that includes U.S. 10 years, which pushes the 10-year yield lower).

Remember, the Bank of Japan’s policy of targeting their 10-year government bond yield at zero, means they will be a buyer of unlimited bonds to push JGB yields back toward zero (price goes up, yields go down).  And when the tide of global rates is rising, pulling UP their yields, they will be a buyer of whatever they need to, to push things back down (and they’ve done just that).

What does that mean?  It means, as the Fed has been walking its short-term benchmark rate higher, the “long-end” of the interest rate market (the 10-year yield) has been anchored by central bank buying – buying by all major central banks for the better part of a decade, and now led by the BOJ.  That has kept a lid on the U.S. 10-year government bond yield, and global government bond yields in general.

With this at work, there have been few things better telegraphed than a U.S. yield curve inversion, as the Fed has told us for years that they will march their short-term rate beyond the anchored 10-year yield.
It’s often dangerous to say “this time is different”, but I think it’s fair to say that the past yield curve inversion/recession analyses don’t compare, when you have both components (the front-end and the long-end) completely controlled by global central banks for more than a decade.  Join me here to get my curated portfolio of 20 stocks that I think can do multiples of what broader stocks do, through the end of the year.
Bonds Look Overdone … Maybe From A Mueller Fear Premium

March 22, 5:00 pm EST

Stocks have swung around this week and will finish down just around three-quarters of one percent since last Friday.

The media loves to make a big deal out of a daily decline in stocks, which they did this morning.

But let’s look at some charts and some perspective.

We’ve talked about the Fed’s actions this week.  As I’ve said, with solid growth, low unemployment, subdued inflation and the risks outstanding that Brexit and/or a U.S.-China trade deal could go bad, they are in the position where they can telegraph flexibility in policy, which could even include a cut or more QE.  Again, a lesson learned from the Fed’s mistakes of the past 10 years — set the expectations bar too low, not too high.

With the Fed’s clear pivot over the past three months, we’re getting this technical breakdown in U.S. yields… 

This is now over 75 basis points lower than the peak in market rates in November. That’s a big adjustment. This means we’ve had nine quarter-point rate hikes by the Fed since 2015, for a total of 2.25 percentage points.  Yet, if we look at the post-crisis low in market interest rates, which was just prior to the 2016 election (1.32% in July of 2016), this morning the market was only adjusting for about half of those Fed hikes.

So, in November of last year, the interest rate market was pricing in nearly all of the Fed’s normalization in rates.  Now, the market is pricing in just half of it.  What does that mean?

Again, as I said on Wednesday, I would say this is a market pricing in theworst-case scenario – a no deal with China.  And I would say, at this stage, that’s an extreme view.

What about German yields? 

Today, the German government bond yields slipped back into negative territory for the first time since 2016.  Isn’t this, and the global QE-induced status of the U.S. yield curve, signaling recession ahead?

There was indeed some softer data out of Europe today, but the real driver of negative German yields is simply U.S. yields.  The spread between German and U.S. 10-year yields, peaked last November at a record 278 basis points when the Fed was going one way, and the ECB was going the other.  With the Fed and the ECB now facing virtually the same direction on monetary policy, that spread is narrowing.  Bottom line, U.S. yields go down, German yields go down – especially given that the worst-case scenarios for both central banks (Fed and the ECB) are global growth oriented (namely, China).

Does the interest rate market, which is reflecting  a combination of pro-active central banks and market speculation on a worst-case scenario outcome, mean stocks should be going down?

If we look back at the last time the Fed pivoted from hiking, to sitting on their hands … and the last time German yields were negative, stocks went UP.  That was 2016.  If you bought the S&P when German yields went negative and sold them when German yields returned to positive territory, you made about 4%.

With this in mind, stocks run into this big trendline today and hold.  This will be a key technical spot to watch.
Bottom line:  I suspect the bond move is way overdone, and stocks are a buy on the dip.  Still, the swings in stocks and the recent memory of December, should have the Trump team inclined to get a trade deal done.
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Fed’s Strategy Reset: Set The Bar Low

March 21, 5:00 pm EST

Stocks came back strong today as the market has had a little more time to digest what the Fed signaled yesterday.

As we discussed yesterday, the Fed has effectively eased monetary policy since the December stock market rout, by slamming the breaks on their “rate normalization” plan.

They’ve gone to great lengths to communicate to markets that they willnot kill the economic recovery.  Moreover, they’ve told us that they will do whatever it takes to keep the economc recovery going.

Now, let’s talk about the signal they gave in the economic projections they released yesterday.

They dialed down what they call their “terminal” or “neutral rate.” In the long run, this is benchmark interest rate that they believe is neither contractionary nor expansionary for the economy.  When the Fed started the rate normalization process, they thought the terminal rate was 3.5%.  Now they think its 2.78%.  Does this imply they think the economy is in a new normal of lower growth and lower inflation?

Probably not.  First, the Fed has had an abysmal record of predicting rates, inflation and growth in the post-crisis era.  Throughout, they have been way overly optimistic.  And as markets have taken cues from the Fed, their bad predictions have bitten them. Arguably, they mis-set expectations and that led to negative surprises, which ultimately forced the Fed to keep emergency level policies maybe lower and longer than what would have been necessary had they guided expectations better.

Jeff Gundlach, one of the world’s best bond fund managers, made this comment today regarding the Fed’s forecasts …
I agree.  But if we look at the forecasts the Fed published yesterday, I suspect there may be a new motivation for these projections.  Instead of using this document as a way for Fed members to pontificate on the future of the economy, I think they are using it as a way to manage down expectations, just as a company sets a low bar on earnings expectations — so that they can beat them.
Maybe a lesson learned from the mistakes of the past 10 years — set the expectations bar too low, not too high.
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Fed Reset Is A Pre-Emptive Strike Against The Worst Case Scenario

March 20, 5:00 pm EST

The Fed met today and confirmed the signaling we’ve seen since early January.

With the luxury of solid growth, low unemployment and subdued inflation, they have been signaling to markets, since January, that they will do nothing to rock the boat.  That move has restored confidence and stock prices (a reinforcing loop).

So, the Fed has gone from mechanically raising rates (as recently as December) to sitting on their hands.  And today they are forecasting no further rate hikes this year, and they are ending the unwind of their balance sheet in September (ending quantitative tightening).

This all looks like a move to neutral, but given the rate path they had been telegraphing up until the end of last year, this pivot is effectively easing — especially since these moves look like pre-emptive strikes against the potential of Brexit and U.S./China trade negotiations going bad.

With that, we have a big technical break in the bond market today.  The U.S. 10-year government bond yield (chart below) broke this important trendline today.

 

This trendline represents the “normalization” of market rates following the Trump election.  Following the election, with the optimism surrounding Trumponomics, the market started pricing OUT the slow post-recession economic growth rut, and pricing IN the chance that we could see a return to sustained trend growth.

So, what is it pricing in now?  I would say its pricing in the worst-case scenario – a no deal with China.

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For Tech Giants, Compliance Costs Will Change The Business Model

March 19, 5:00 pm EST

We’ve seen the verbal and Twitter shots taken by Trump at the tech giants since he’s been in office.  And the threats have slowly been materializing as policy.

We get this today …

 

With this in mind, we’ve talked quite a bit about the domestic leveling of the playing field. The tech giants (Facebook, Amazon, Netflix, Google, Twitter …) are on the regulatory path to being held to a similar standard that their “old economy” competitors are held to.  They may have to pay for real estate (i.e. bandwidth). They may be scrutinized more heavily for anti-competitive practices.  And they may be liable for content on their site, regardless of who created it.

The latter was the subject of the Trump tweet today.  And he was asked about it in a press conference.  He said we “have to do something about it.”  He called the discrimination and bias “collusion” from the tech giants.

The regulation is coming. And depending on the degree, at best, it changes the business models of these “disrupters.” At worse, it could destroy them.  Imagine, Facebook and Twitter being held liable for things their customers are saying on their platforms.  That’s endless compliance to ward of business killing liabilities.

As compliance costs go UP for these companies.  The cost goes UP for consumers. The model is changed.

On a related note, remember, last September the S&P 500 reshuffled the big tech giants.  Among the changes, they moved Facebook, Google and Twitter out of the tech sector and in to the telecom sector (re-named the “Communications” sector”).

Here’s what that sector ETF looks like since …
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Fed Meeting This Week, But They Have Already Told Us Where They Stand

March 18, 5:00 pm EST

Stocks open the week in breakout mode.

We’ve now taken out the December highs, the levels that preceded the sharp 20% plunge.

So, now we have this chart as we enter a week with a Fed meeting on the agenda.

 

This leaves us up 13% on the year, and with another 4% climb to regain the October all-time highs.

The Fed meets this week.  With a relatively light data and news week, the Fed will get plenty of attention.  But remember, we know exactly where they stand.  They want to maintain confidence in the economy.  And they know the stock market is an important contributor (and can be a dangerous detractor) to confidence.  They need stocks higher.

That’s why on January 4th, the Fed responded to the plunging stock market by marching out the current and past two leaders of the Fed to tell us the “normalization phase” on interest rates was over (i.e. no more rate hikes).

And that’s why on March 10th (just a week ago), in response to a 4% one-day plunge in Chinese stocks and some loss of momentum in the U.S. stock market rebound, Powell followed the script of his predecessor Ben Bernanke, and spoke directly to the public through an exclusive 60 Minutes interview, to reassure the public that the economy was in good shape, and that the Fed was there to ensure stability.  If you bought stocks after both interviews, you felt no pain and have been rewarded handsomely.

With the above chart in mind, below is the chart we looked at to start the year, as we discussed the potential for a V-shaped recovery following the Fed’s January 4th strategic pivot.
From my January 4th Pro Perspectives note:
“We entered the year with the idea that the Fed would need to walk back on its rate hiking path this year (possibly even cutting, if the stock market environment persisted).  And today, just days into the new year, we get the Fed Chair Powell, former Fed Chairs Yellen and Bernanke telling us that the Fed is essentially done of the year, unless things improve … [as for stocks] We broke a big level today on the way up in the S&P 500 (2520) and it looks like a V-shaped recovery is underway, to take us back to where stocks broke down on December 3rd.  That would be 12% from current levels.” So, far so good. The Fed has stabilized confidence.  The question now is, do we get a deal with China soon?  If not, we may find a rate cut, in the near future for the Fed.  The former Minneapolis Fed president, and former voting FOMC member, is calling for a cut, as a pre-emptive strike to a slowdown.Remember, 2018 was the first since 1994 that cash was the best producing major asset class (among stocks, real estate, bonds, gold).  The culprit was an overly aggressive Fed tightening cycle in a low inflation recovering economy.  The Fed ended up cutting rates in 1995 and spurring a huge run up in stocks (up 36%).

Join me here to get my curated portfolio of 20 stocks that I think can do multiples of what broader stocks do, coming out of this market correction environment.
Bottom May Be In For China

March 15, 5:00 pm EST

As we end the week, let’s take a look at what China is doing to stimulate the economy.

If the world has been worried about global growth, because of the toll that trade reform is taking on China, then the actions China has been taking, and has discussed overnight, should be THE focus for markets — in addition to the status of a U.S./China trade deal.

Remember, by the end of last year, much of the economic data in China was running at or worse than 2009 levels (the depths of the global economic crisis).  It’s clear that the era of double-digit growth in China is over (at the expense of the rest of the world).  The question is, how low can it go, without threatening an uprising against the regime.  They seem to be willing to do ‘whatever it takes’ to defend the 6% growth number.

With that, as we’ve discussed, for a sustained recovery in global growth, expect others to follow the lead of the U.S. with big fiscal stimulus and structural reform (i.e. Europe, Japan …. and China).  With the news overnight from Chinese Premier Li (who has been the pointman for U.S./China trade negotiations), China is preparing an assault on the growth slowdown.  He’s promising an aggressive mix of monetary and fiscal stimulus.

They are looking to do large-scale tax cuts. They’ve promised billions of dollars infrastructure spending.  They’ve already cut the reserve requirement for banks five times in the past year – and they are looking to do more to motivate bank lending.  And they are targeting to create 13 million jobs this year in the manufacturing sector and in small business.

As we’ve discussed, Chinese stocks are reflecting optimism that a bottom is in for the trade war and for Chinese economic fragility.

 
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The Bond Markets Is Sending A Signal: Manipulation

March 14, 5:00 pm EST

Wall Street has a lot of adages that many follow, and few question (but they should).

One of them:  The bond market is smarter than the stock market.

The logic is that bond market investors are better and quicker at interpreting news and information than stock investors.  As such, the belief is that bonds will be pricing in the more probable outcome before stocks.

So, is there a signal to be taken from the behavior of the 10-year yield?  While stocks have fully recovered the losses of December, you might expect the bond market to reflect the ease in uncertainty (i.e. moving back higher, along with stocks).  But bond yields are back near the lows of early last year, and appear to be pricing OUT some (and threatening to price out all) of the optimism that followed the Trump election.

 

With that, at 2.60% on the U.S. 10-year government bond yield (a global benchmark interest rate), is there an element of worst-case scenario for the global economy being priced in?  I’d say with the U.S. economy growing at 3%, and stocks at these levels, even when the 10-year was at 3.25%, bonds were (to some degree) pricing the worst-case scenario.

So, why are bond yields as low as 2.60%?  Smarter market participants?  No.  It’s intervention/manipulation.  Sure, the Fed has put the brakes on its policy direction.  The ECB has reversed course on policy!  China is easing.  But, most importantly, the Bank of Japan is still executing on an unlimited QE campaign.

The Bank of Japan’s yield targeting policy gives it the license to buy unlimited assets.  They have been and will continue to buy U.S. government bonds, and they continue to be the anchor for global interest rates.  And it’s safe to say, they are acting with plenty of coordination with the other major central banks in the world (namely, the Fed).

Bottom line:  The interest rate picture is signaling one very clear action.  The Bank of Japan is still engaging in full throttle QE. 

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Why Global Markets Haven’t Been Troubled By Brexit

March 13, 5:00 pm EST

We haven’t talked much about the Brexit drama.

Why?  Because it has been noisy, yet unlikely to create any shock-waves through the global economy.

Even the knee-jerk reaction to the Brexit vote in 2016, didn’t have staying power.  The uncertainty that was quickly manifested in global stocks, was just as quickly reversed.  You can see it in the S&P chart below …

 

Why the sharp reversal?  And why isn’t Brexit a big shock risk?

We had seen a similar movie before: Grexit.  Greece’s EU and EMU partners talked tough about a “my way or the highway” bailout plan, which included harsh austerity. But when push came to shove, the Greek’s stood their ground, resisted the harsh austerity measures that came with the bailout, and it quickly became clear that Europe had more to lose, than did Greece, by the Greeks leaving the EU and (most importantly) leaving the euro. The Greek’s had negotiating leverage.  And they got concessions.
In the case of Brexit, the EU partners started with tough talk too, promising a dark and ugly future for the UK.  But the EU had/has plenty of risk (i.e. others following the lead of Britain … ex. Italy, Spain).  Clearly they both need each other to thrive.  The UK loses if the EU implodes.  The EU loses if the UK implodes.

The populist movement that gave us Grexit, gave us Brexit and then the Trump election, and recently a new government in Italy with an “Italy first” agenda.  It’s a movement of reform.  And reform is now becoming the norm, not the extreme. We’re hoping to see reform in China now too.

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