The Fed decided to hike interest rates by another quarter point yesterday. That was fully telegraphed and anticipated by markets. That’s the third rate hike this year, and the fifth in the post-crisis rate hiking cycle.
Still, the yield on the 10-year Treasury note (the benchmark market determined interest rate), moved lower today, not higher — and sits unchanged for the year.
We talked earlier in the week about the biggest central bank event of the month. It wasn’t the Fed, but it will be in Japan next week. Japan’s policy on pegging their 10-year yield at zero has been the anchor on global interest rates.
When they signal a change to that policy, that’s when rates will finally move.
With this divergence between what the Fed is doing (setting rates) and what market rates are doing (market-determined), people have become convinced that the interest rate market is foretelling a recession coming — i.e. short term rates have been rising, while longer term rates have been quiet, if not falling. For example, when the Fed made it’s first rate hike in December of 2015, the 30-year government bond yield was 3%. Today, after five rate hikes on the overnight Fed determined interest rate, the 30-year is just 2.72% (lower, not higher than when the Fed started).
This dynamic has created a flattening yield curve. That gets people’s attention, because historically, when the yield curve has inverted (short term rates rise above long term rates), recession has followed every time since 1950, with one exception in the late 60s.
And it turns out, this “flattening of the yield curve” indicator, historically (and ultimate inversion, when it happens), is typically driven by monetary policy (i.e. rate hikes — check). In these cases, the market anticipates the Fed killing growth and eventually leading rate cuts! They find more certainty and stability in owning longer term bonds (leaving short term bonds pushing those rates up and moving into long term bonds, pushing those rates down — inverting the curve).
The question, is that the case this time? Or is this time different. It’s rarely a good idea in markets to think this time is different than the past. But in this case, following trillions of dollars of central bank intervention and a near implosion in the global economy, it’s probably safe to say that this time is certainly different than past recessions. Though the Fed is in a hiking cycle, rates remain well below long term averages. And, as we know, we have unconventional monetary policies at work in other key areas of the world — stoking liquidity, growth and skewing demand for U.S. Treasuries (which suppresses those long term interest rates).
So the flattening yield curve fears are probably misplaced, especially given big fiscal stimulus is coming. And when Japan moves off of its “zero yield policy,” the U.S. yield curve may steepen more quickly than people think is possible.
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As the Trump rally continues across U.S. stocks, the dollar, interest rates and commodities, there are some related stories unfolding in other key markets I want to discuss today.
The Fed: Janet Yellen was on Capitol Hill today talking to Congress. As suspected, she continues to build expectations for a December rate hike (which is nearly 100% priced in now in the markets). And she did admit that the economic policy plans of the Trump administration could alter their views on inflation — but only “as it (policy) comes.” I think it’s safe to say the Fed will be moving rates up at a quicker pace than the thought just a month ago. But also remember, from Bernanke’s suggestion in August, Yellen has said that she thinks it’s best to be behind the curve a bit on inflation — i.e. let the economy run hotter than they would normally allow to ensure the economic rut is left in the rear view mirror. That Fed viewpoint should support the momentum of a big spending package.
The euro: The euro has been falling sharply since the Trump win, for two reasons. First, the dollar has been broadly strong, which on a relative basis makes the euro weaker (in dollar terms). Secondly, the vote for change in the America (like in the UK and in Greece, last year) is a threat to the euro zone, the European Union and the euro currency. With that, we have a referendum in Italy coming December 4th, and an election in France next year, that could follow the theme of the past year — voting against the establishment. That vote could re-start the clock on the end of the euro experiment. And that would be very dangerous for the global financial system and the global economy. The government bond markets would be where the threat materializes in the event of more political instability in Europe, but we’ve already seen some of this movie before. And that’s why the ECB came to the rescue in 2012 and vowed to do whatever it takes to save the euro (i.e. they threatened to buy unlimited amounts of government bonds in troubled countries to keep interest rates in check and therefore those countries solvent). With that, the events ahead are less unpredictable than some may think.
The Chinese yuan: As we know, China’s currency is high on the priority list of the Trump administrations agenda. The Chinese have continued to methodically weaken their currency following the U.S. elections, moving it lower 10 consecutive days to an eight year low. This has been the trend of the past two years, aggressively reversing course on the nine years of concessions they’ve made. This looks like it sets up for a showdown with the Trump administration, but as history shows, they tend to take their opportunities, weakening now, so they can strengthen it later heading into discussions with a new U.S. government. Still, in the near term, a weaker yuan looked like a positive influence for Chinese stocks just months ago — now it looks more threatening, given the geopolitical risks of trade tensions.
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The Fed is on deck for tomorrow. The RBA (Australian central bank) was a bit more upbeat overnight, as expected, per our discussion yesterday.
The BOJ stood pat as well overnight, though they extended the timeline on hitting their 2% inflation target. That too, wasn’t much of a surprise. Both the ECB and the BOJ have vowed to do “whatever it takes” for “as long as it takes.” Still, for those looking for more easing out of Japan, they didn’t get it. As we discussed yesterday, their latest policy move to peg the Japanese 10-year yield at zero is in the early days, but is working thus far. It’s flipped the switch on the global market perception of an ever-deepening negative rates world. And it’s led to a weaker yen and higher Japanese stocks. Both good for the BOJ.
So ahead of the Fed tomorrow and the U.S. election results next week, the markets were pricing in a little more risk today. A broad “risk-off” day means stocks go lower, yields lower, crude oil lower, gold higher and the VIX (a good market measure of uncertainty) higher.
As we discussed yesterday, the Fed has all but outright told us a hike is coming in December. But they have explicitly shown us that they are as much, if not more, concerned about a shock to the system, as they are jobs and inflation in this environment. And a hit to confidence, and therefore stocks, qualifies as a shock threat in their view.
With that in mind, they should be a bit more upbeat tomorrow, telegraphing the December move, but they are surely concerned about any confidence shake-out surrounding the election.
Yesterday we talked about the two big central bank events in focus today. Given that the Bank of Japan had an unusual opportunity to decide on policy before the Fed (first at bat this week), I thought the BOJ could steal the show.
Indeed, the BOJ acted. The Fed stood pat. But thus far, the market response has been fairly muted – not exactly a show stealing response. But as we’ve discussed, two key hammers for the BOJ in achieving a turnaround in inflation and the Japanese economy are: 1) a weaker yen, and 2) higher Japanese stocks.
Their latest tweaks should help swing those hammers.
Bernanke wrote a blog post today with his analysis on the moves in Japan. Given he’s met with/advised the BOJ over the past few months, everyone should be perking up to hear his reaction.
Let’s talk about the moves from the BOJ …
One might think that the easy, winning headline for the BOJ (to influence stocks and the yen) would be an increase in the size of its QE program. They kicked off in 2013 announcing purchases of 60 for 70 trillion yen ($800 billion) a year. They upped the ante to 80 trillion yen in October of 2014. On that October announcement, Japanese stocks took off and the yen plunged – two highly desirable outcomes for the BOJ.
But all central bank credibility is in jeopardy at this stage in the global economic recovery. Going back to the well of bigger asset purchases could be dangerous if the market votes heavily against it by buying yen and selling Japanese stocks. After all, following three years of big asset purchases, the BOJ has failed to reach its inflation and economic objectives.
They didn’t take that road (the explicit bigger QE headline). Instead, the BOJ had two big tweaks to its program. First, they announced that they want to control the 10-year government bond yield. They want to peg it at zero.
What does this accomplish? Bernanke says this is effectively QE. Instead of telling us the size of purchase, they’re telling us the price on which they will either or buy or sell to maintain. If the market decides to dump JGB’s, the BOJ could end up buying more (maybe a lot more) than their current 80 trillion yen a year. Bernanke also calls the move to peg rates, a stealth monetary financing of government spending (which can be a stealth debt monetization).
Secondly, the BOJ said today that they want to overshoot their 2% inflation target, which Bernanke argues allows them to execute on their plans until inflation is sustainable.
It all looks like a massive devaluation of the yen scenario plays well with these policy moves in Japan, both as a response to these policies, and a complement to these policies (self-reinforcing). Though the initial response in the currency markets has been a stronger yen.
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We have two big central bank meetings this week–BOJ and the Fed. With that, as we head into the week, let’s look at a key chart.
This chart is from a St. Louis Fed blog post last year. The inflation data, however, is all up-to-date. The Fed says “the chart above shows eight series that receive a lot of attention in the context of policy.”
So according to this chart, last year, as the Fed was building into its first rate hike to move away from emergency level rates and policies, the inflation data was looking soft. The Fed was telegraphing, clearly, a September hike, though six of the eight inflation measures in the chart above were running south of their target of 2% in the middle of last year. The headline inflation number for September, their preferred date of a hike, was zero!
Of course, after markets went haywire following China’s currency devaluation in August of last year, the Fed balked and stood pat. When things calmed, in December, they made their move. And at the same meeting, they projected to hike FOUR times this year. So far it hasn’t happened. It’s been a one and done.
Moreover, as of March of this year, they took two of those projected hikes off the table, and guided lower on growth, lower on inflation and a lower rate trajectory into the future. I would argue removing two hikes from guidance was effectively easing.
But if we look at the chart above, where inflation stands now relative to the middle of last year, when they were all “bulled-up” on rates, the story doesn’t jive. By all of the inflation measures, the economy is clearly running hotter (a relative term). Five of the eight inflation measures are running ABOVE the Fed’s 2% target (the horizontal black line in the chart). Yet, aside from a few Fed hawks that have been out trying to build expectations for a rate move soon, on balance, the messaging from the Fed has been mixed at best, if not dovish.
The Bernanke-led Fed relied heavily on communication (i.e. massaging sentiment and perception) to orchestrate the recovery, but the Fed, under Yellen, has been a communications disaster.
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Global markets continue to swing around today. Remember, the past couple of days we’ve looked at the three most important markets in the world right now: U.S., German and Japanese 10-year government bonds.
In recent days, German and Japanese debt have swung back into positive territory. That’s a huge signal for markets, and it’s sustaining today – with German 10-year yields now at +8 basis points, and Japanese yields hanging around the zero line, after six months in negative territory.
Stocks are on the slide again, though. And the volatility index for stocks is surging again. Those two observations alone would have you thinking risk is elevated and perhaps a “calling uncle” stage is upon us and/or coming down the pike, especially if it’s a bubbly bond market. If that’s the case, gold should be screaming. It’s not. Gold is down today, steadily falling over the past five days.
So if you have a penchant for understanding and diagnosing every tick in the markets, as the media does, you will likely be a little confused by the inter-market relationships of the past few days.
That’s been the prevailing message from the Delivering Alpha conference today in New York: Confusion. Delivering Alpha is another high profile, big investor/best ideas conference. There are several conferences throughout the year now that the media covers heavily. And it’s been a platform for big investors to talk their books and, sometimes, get some meaningful follow on support for their positions.
Interestingly, one of the panelist today, Bill Miller, thinks we’ll see continued higher stocks, but lower bonds (i.e. higher yields/rates). Miller is a legendary fund manager. He beat the market 15 consecutive years, from the 90s into the early 2000s.
Miller’s view fits nicely with the themes we talk about here in my daily notes. Still, people are having a hard time understanding the disconnect between this theme and the historical relationship between stocks and bonds.
Let’s talk about why …
Historically, when rates go up, stocks go down — and vice versa. There is an inverse correlation.
This see-saw of capital flow from stocks to bonds tends to happen, in normal times, when stocks are hot and the economy is hot and the Fed responds with a rate hiking cycle. The rate path cools the economy, which puts pressure on stocks. That’s a signal to sell. And rising rates creates a more attractive risk-adjusted return for investors, so money moves out of stocks and into bonds.
But in this world, when the Fed is moving off of the zero line for rates, with the hope of being able to escape emergency policies and slowly normalize rates, they aren’t doing it with the intent of cooling off a hot economy (as would be the motive in normal times). They’re doing it and praying that they don’t cool off or destabilize a sluggishly growing economy. They’re hoping that a slow “normalization” in rates can actually provide some positive influence on the economy, by 1) sending a message to consumers and businesses that the economy is strong enough and robust enough to end emergency level policy. And by 2) restoring some degree of proper function in the financial system via a risk-free yield. Better economic outlook is good for stocks. And historically, when rates are lower than normal (under the long term average of 3% on the Fed Funds rate), P/E multiples run north of 20 – which gives plenty of room for multiple expansion on expected earnings (i.e. supports the bullish stocks case).
That’s why I think stocks go higher and rates go higher in the U.S. I assume that’s why Bill Miller (the legendary fund manager) thinks so too. It all assumes the ECB and the BOJ do their part – carrying the QE torch, which translates to, standing ready to act against any shocks that could derail the global economy.
But even if the Fed is able to carry on with a higher rate path, they continue to walk that fine line, as we discussed yesterday, of managing a slow crawl higher in key benchmark market rates (like the 10-year yield). An abrupt move higher in market rates would undo a lot of economic progress by killing the housing market recovery and resetting consumer loans higher (killing consumer spending and activity).
We headed into the weekend with a market that was spooked by a sharp run up in global yields. On Friday, we looked at the three most important markets in the world at this very moment: U.S. yields, German yields and Japanese yields.
On the latter two, both German and Japanese yields had been deeply in negative yield territory. And the perception of negative rates going deeper (a deflation forever message), had been an anchor, holding down U.S. market rates.
But in just three days, the tide turned. On Friday, German yields closed above the zero line for the first time since June 23rd. Guess what day that was?
Brexit.
And Japanese 10-year yields had traveled as low as 33 basis points. And in a little more than a month, it has all swung back sharply. As of today, yields on Japanese 10-year government debt are back in positive territory – huge news.
So why did stocks rally back sharply today, as much as 2.6% off of the lows of this morning – even as yields continued to tick higher? Why did volatility slide lower (the VIX, as many people like to refer to as, the “fear” index)?
Here’s why.
First, the ugly state of the government bond market, with nearly 12 trillion dollars in negative yield territory as of just last week, served as a warning signal on the global economy. As I’ve discussed before, over the history of Fed QE, when the Fed telegraphed QE, rates went lower. But when they began the actual execution of QE (buying bonds), rates went higher, not lower (contrary to popular expectations). Because the market began pricing in a better economic outlook, given the Fed’s actions.
With that in mind, the ECB and the BOJ have been in full bore QE execution mode, but rates have continued to leak lower.
That sends a confusing, if not cautionary, signal to markets, which is adding to the feedback loop (markets signaling uncertainty = more investor uncertainty = markets signaling uncertainty).
Now, with government bond yields ticking higher, and key Japanese and German debt benchmarks leaving negative yield territory, it should be a boost for sentiment toward the global economic outlook. Thus, we get a sharp bounce back in stocks today, and a less fearful market message.
Keep in mind, even after the move in rates on Friday, we’re still sitting at 1.66% in the U.S. 10-year. Before the Fed pulled the trigger on its first rate hike, in the post-crisis period, the U.S. 10-year was trading around 2.25%. As of last week, it was trading closer to 1.50%. That’s 75 basis points lower, very near record lows, AFTER the Fed’s first attempt to start normalizing rates. Don’t worry, rates are still very, very low.
Still, the biggest risk to the stability of the bond market is, positioning: The bond market is extremely long. If the rate picture swung dramatically and quickly higher, the mere positioning alone (as the longs all ran for the exit door) would exacerbate the spike. That would pump up mortgage rates, and all consumer interest rates, which would grind the economy to a halt and likely destabilize the housing market again. And, of course, the Fed would be stuck with another crisis, and little ammunition.
As Bernanke said last month, the Fed has done damage to their own cause by so aggressively telegraphing a tighter interest rate environment. In that instance, he was referring to the demand destruction caused by the fear of higher rates and a slower economy. But as we discussed above, the Fed also has risk that their hawkish messaging can run market rates up and create the same damage.
Bottom line: The Fed is walking a fine line, which is precisely why they continue to sway on their course, leaning one way, and then having to reverse and shift their weight the other way.
We watched oil closely earlier this year. The oil price bust ultimately pulled down stocks. And when oil aggressively bounced off of the bottom, stocks recovered alongside, returning to new record highs.
Today it was oil again.
Stocks oscillated near record highs and following an anticipated Fed event last week had continued to tread water. That gives the bears a low risk trade to sell the S&P 500 against the top (as a take profit, hedge or just a trade), holding out hope that gravity would take hold.
It hasn’t happened. But we did get a catalyst to get it moving lower today, with a bigger than expected oil inventory build. That sent oil down nearly 4% on the day.
Oil stocks took a hit. But the broader stock market held up well, losing just 1/2 percent and recovering most of it by the day’s end.
The market still sits at critical levels going into the jobs number on Friday. Yields continue to chop in this ever tightening wedge (below) — a break looks certain on the jobs number. This is a very important chart.
And stocks are positioned close enough to the highs to encourage some profit taking (if the highs get taken out, you put the position back on … if the highs hold, you may have an opportunity to buy it back cheaper).
It remains a macro story – a central bank story. And that’s the mindset of the market as we head into the end of what has been a rather sleepy August.
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Last Thursday, everyone was awaiting the Friday Jackson Hole speech from Yellen. I suggested that, while all eyes were on Yellen, maybe Kuroda (the head of the BOJ) would steal the show: “he could conjure up some Bernanke style QE3. Not a bad bet to be long USD/JPY and dollar-denominated Nikkei through the weekend (ETF, DBJP or DXJ).”
Indeed, Yellen was short on clarity as we’ve discussed in recent days. As of this afternoon, stocks are now unchanged from Thursday afternoon (just prior to her speech). And the 10-year yield is right where it was before she spoke — and looking like a coin flip on which direction it may break. The pain is lower, so it will probably go lower.
As for Kuroda, he did indeed steal the show, at least in terms of market impact. On Saturday, Kuroda hit the wires saying its negative rate policy was far from reaching the limit and said they would act with more QE or deeper negative rates “without hesitation.” That’s a greenlight for buying Japanese stocks and selling the yen (buying USD/JPY).
The Nikkei is up 1.5% from Friday’s close, and USD/JPY is up 2.7% (yen down).
Was Kuroda telegraphing another big round of fresh QE (as Bernanke did in 2012)? Maybe. He said inflation remains vulnerable in Japan and is responding “differently” (i.e. worse) to shocks like falling oil prices.
Inflation in Japan, even after rounds of unprecedented QE, is back in negative territory and has been for five consecutive months of year-over-year deflation. The U.S. economy looks like its running hot compared to Japan. It’s not a bad bet to expect Japan to act first, with more QE, to pump asset prices, and then the Fed would have a little more breathing room to make another hike (either December) or early next year.
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The Fed’s Janet Yellen was the focal point for markets for the week. She had a scheduled speech at the annual Fed conference at Jackson Hole.
When her speech was finally made public Friday morning, the response in markets was uncertainty (the most used word for the past nine years).
Stocks went up, then down. Yields went down, then up.
So what do we make of it? Let’s start with the headlines that hit the wire Friday morning.
The world was wondering if Yellen would support the messaging from some of her fellow Fed members–that a September rate hike is on the table. Or would she continue the backstepping (dovish speak) the Fed has done for the past five months. The answer was ‘yes.’ She did both.
Yellen said the case for rate hikes has strengthened (yellow marker) because the data is nearing their goals (employment and inflation–the white marker). Ah, rate hike. But then she said the Fed expects inflation to hit the target 2% in the next few years (circled)! And then talked about the strategy for more QE. Huh? And then to top it off, she said they might move the goalposts. They might move the inflation target higher, and start targeting GDP. That means they would be happy to leave conditions ultra accommodative until those higher targets are met. Clearly dovish.
As I said Thursday, they want to raise rates to get the financial system closer to proper functioning, but they don’t want to cause a recession. The Fed wants to raise short-term rates, but promote a flatter yield curve (i.e. promote expectations that the economy will continue to be soft) to keep the market interest rates low, which keeps the housing market on the rails and the economic activity on the rails.
Remember, we talked about the piece Bernanke wrote a couple of weeks ago, where he suggested exactly this type of perception manipulation from the Fed, to balance the need to raise rates, without killing the economy.
That looks like the game plan.
Have a great weekend!
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