Tuesday, May 30, 2017

Treasury and Fed Funds Rate

The Federal Reserve seems determined to raise the overnight federal funds rate it controls. Many believe that two or three more 25 basis-point increases this year are all but certain, unless the economy suddenly weakens appreciably or a major financial or political crisis unfolds here or abroad.

The prospect of steady rate increases is a worry to many market participants with the taper tantrum of May and June 2013 still a vivid memory. Then-Fed Chairman Ben Bernanke only hinted at a slowing of Fed security purchases, then running at $85 billion per month, but yields on Treasury notes and bonds rose sharply higher nonetheless. In fact, the Fed didn’t taper until December of that year and finally discontinued adding to its huge portfolio in October 2014.

Interestingly, the taper tantrum may have prepared markets for that eventuality since no cataclysmic actions ensued in the market for Treasuries. Also, stocks, which were propelled by Fed largess since their March 2009 bottom, merely leveled and didn’t sell off, even as the central bank stopped adding more fuel to the equity bonfire. The Fed did, however, pledge to maintain the size of its asset horde by using the proceeds of maturing securities to buy more bonds.

The question now is: How much effect do changes in the fed funds rate have on longer-term Treasury yields? This question assumes that the Fed is the prime mover and Treasury markets follow. But you can argue that causality runs the other way. If investors fear an overheating economy and resulting inflation, they probably would sell Treasuries, pushing bond yields higher. That could worry the central bank, which then delays raising short-term rates. Furthermore, the Fed, along with other major central banks, reduced overnight rates to essentially zero in reaction to the financial crisis and held them there until recent years. So, the Fed was essentially on the sidelines in influencing long-term rates.

As I’ve often said, causality can’t be proven with statistics. After beating a drum, a solar eclipse goes away; that’s 100 percent correlation, but not causality. Still, it’s probable that the causality runs from changes in the fed funds rate to Treasury yields. My firm’s research shows that the highest correlation between the fed funds rate and 10-year Treasury note yields is with the central bank rate leading the note yield by 10 months.

The fed funds rate and yields on 10-year and 30-year Treasuries all increased with inflation from the end of World War II to the early 1980s and then fell with disinflation. So, correlating the raw data would imply stronger relationships than existed. To measure the true effects of fed funds rate changes on long-term Treasury yields, we statistically removed the up and down trends and correlated the deviations that were left.

The statistical fits appear meaningful, though they are much lower than if the trends had not been removed. But again, good statistical fits over time may have no causal relationships. Global steel and meat consumption correlate highly over time, but only because both grow with economic development.

A 100 basis-point increase in the fed fund rate, using our analysis, results in a 46 basis-point increase in 10-year Treasury yields, on average. In other words, about half the change in the fed fund rate spills over to Treasury yields. So the influence is far less than one-to-one. As you’d expect, the spillover from fed funds changes to 30-year Treasury yields is even smaller. A 100 basis-point rise in the fed funds rate results in only a 35 basis-point rise in yields.

The statistical results reflect the entire post-World War II era, but the influence of changes in the fed funds rate on Treasury yields may be even less today. Thirty-year yields are lower, not higher, than when the Fed first raised its reference rate by 25 basis points in December 2015 and then made further quarter-point increases in December 2016 and in March of this year.

One reason for this weaker response may be the Fed’s use of forward guidance to advertise its intentions regarding the future path of rates. The spillover effect on Treasuries may already be in place. Another may be the lack of effectiveness of the fed funds rate in recent years. It’s the rate that banks with excess reserves at the Fed lend to those with deficient reserves. But with the huge amount of excess reserves -- about $2.7 trillion at present -- that have been created by the Fed’s bailout of Wall Street and then quantitative easing, most banks have ample reserves and few need to borrow from other banks in order to meet their reserve requirements.

So the fed funds rate is simply a reference rate with little practical meaning. Market participants believe it measures Fed policy, but the emperor may have no clothes. That’s why the central bank has considered alternatives such as paying enough on bank reserves, currently 1 percent, to make them attractive for banks to hold. That also, in effect, would sterilize those excess reserves because lending to the Fed would, risk-adjusted, be more rewarding than lending them to private borrowers. 

Also, sterilizing excess reserves would remove the likelihood that when the economy resumes rapid growth, which I expect in two or three years, those reserves would be lent and re-lent to eager borrowers. The result could be an explosion of the money supply and velocity, which might propel excess economic demand and inflation. I already look for robust economic growth of 3 percent to 3.5 percent, to be driven by massive fiscal stimuli.

Alternatively, the central bank is thinking about letting its $4.5 trillion portfolio run down by not reinvesting maturing securities. To do so would require great skill and uncommon good luck to avoid squeezing or frightening lenders and borrowers to the point that a recession follows. Indeed, key Fed officials have suggested that the Fed may not return to its $1 trillion pre-crisis portfolio but perhaps keep it at $2 trillion. So it still would have massive excess reserves to deal with.

via bloombergquint

Thursday, May 18, 2017

Six new investing themes

With Trump’s agenda mostly stalled, many investors are swinging to my earlier conviction that much of the post-election euphoria was overblown, at least in terms of instant actions, and are reorienting their sights to the long-term. 

I recommend six long-term economic and investment themes.

1. Huge fiscal stimulus, primarily infrastructure- and military-related, in reaction to mad-as-hell voters who have suffered flat or mostly declining purchasing power for more than a decade. These declines were importantly caused by globalization, probably the most significant international economic development in the last three decades.Despite Marine Le Pen’s loss in this month’s presidential election in France, the populism and anti-globalization sentiments that elected Trump and led to the Brexit vote last June persist.

Major fiscal stimulus could take two to three years to become effective after working its way from congressional approval to actual spending and job creation. Nevertheless, it will constitute a major investment theme and will push U.S. economic growth to the 3 percent to 3.5 percent range, almost double the 2.1 percent average since this business recovery started in mid-2009, the weakest in the post-World War II era.

2. Globalization that shifted manufacturing from the West to Asia is largely completed. Manufacturing’s share of U.S. gross domestic product fell from about 17 percent in 1997 to around 12 percent by 2009, but then flattened. Still, inner workings of the process continue as low-end manufacturing is now moving from China to even-cheaper locales, such as Vietnam and Pakistan.
Many who formerly felt safe in well-paying jobs and looked forward to comfortable retirements while enjoying low-cost imports from China had no idea that they were vastly overpaid by Asian standards -- and that those low-cost imports were coming at their expense. So now they are angry and enthralled by politicians who blame their plight on immigrants and imports, and promise to restore their incomes through protectionist measures.
Those former manufacturing employees in the West who have been re-employed have generally moved to lower-paying areas. Also, hiring since the economic recovery commenced in mid-2009 has been focused on low-paying sectors such as leisure and hospitality. Furthermore, those in manufacturing not only are paid 1.72 times as much per hour as those in leisure and hospitality, but they work 1.56 times as many hours. So their weekly pay is 2.69 times greater.
Still, with the movement of manufacturing and other production from West to East largely completed, the traditional pattern of employment shifts due to technology changes will likely resume. The gap created by globalization remains, but there will probably not be big new waves of displaced workers.

3. Another long-term development with immense economic and investment implications is the worldwide aging of most populations. Fertility rates in most major countries except India are below the 2.1 level needed to maintain, much less grow, the population. The United Nations projects that Japan, China, Germany and Russia will see their populations decline by 2050 while the U.S., Canada and the U.K. will increase due to immigration offsetting low fertility rates. Those populations are projected to grow through 2050.

Japan’s population is already falling as it has the longest life expectancy of any G-7 country and the lowest fertility rate.  In addition, despite the need for new workers as the population falls and ages, women in Japan are still discouraged from entering the labor force. In China, the earlier one child-per-couple policy has slashed the number of prime new labor force entrants by about 400 million.
Pessimists maintain that aging and retiring postwar babies in the U.S., as well as Trump’s anti-immigration policies, will severely limit labor-force growth. At the other end of the spectrum are those who believe robots will replace people to the point that there will be too few earners to buy the nation’s output. I disagree with both views, and forecast real U.S. GDP annual growth of 3.0 percent to 3.5 percent thanks to 2.5 percent yearly rises in new tech-driven productivity and 1.0 percent increases in employment, the historic norms. Plus the labor participation rate, now at 62.9 percent vs. the 67.3 percent peak 17 years ago, should increase if the retirement age is raised. And the participation rate for those over 65 is rising as seniors are healthier and many have inadequate assets to retire.

4. The long-promised Asian Century of global leadership is unlikely to come to pass due to the completion of globalization, the slow shift from export-led to domestic-spending-driven economies, government and cultural restraints, aging and falling populations, and military threats. 

The fascination with Asia started with Japan’s dazzling economic recovery after World War II, which culminated with purchases of U.S. trophy properties such as the Pebble Beach golf course and Rockefeller Center in the 1980's. Rising property and equity prices convinced many in the West that Japan would soon take over the world, but those bubbles burst in late 1989, sending the Nikkei index down 63 percent in less than three years and real estate prices down by 59 percent. Japanese economic growth has averaged just 1.1 percent since then.

With Japan’s decline, Western fascination shifted to the rapidly growing developing economies of the Asian Tigers, but the regional financial crisis that commenced in Thailand in 1997 started a domino-like collapse of neighboring financial markets and economies. With the 2007-2009 recession and financial crisis, export-led Asia suffered along with the economies of the U.S. and Europe. Yet Westerners didn’t abandon Asia, but shifted their admiration to China. 

Chinese real economic annual growth rates nosedived from double digits to a recessionary 6.3 percent during the worldwide downturn, but then revived thanks to the huge 2009 stimulus program. Easy credit fueled a property boom and inflation, both of which were unwanted by Chinese authorities. Also, the growth in exports rebounded back to the 20 percent to 30 percent annual rates seen before the recession. As with the Asian Tigers earlier, many thought Chinese growth was self-sustaining and unrelated to ongoing sluggish economic performance in North America and Europe, especially after China’s gross domestic product topped Japan’s in 2009. 

But like virtually all developing economies, China’s has been driven by exports that directly or indirectly are sold to North America and Europe. And those imports by the West are fundamentally curtailed by sluggish overall economic growth -- the result of deleveraging, the working off of excess debt built up in the exuberant 1980s and 1990s. Annual Chinese export growth dropped from 20 percent to 30 percent in the 2000s to negative territory in February.

Further, globalization is largely completed, curbing that source of emerging-economy advance. And China’s huge total economic size had covered up its still-underdeveloped status. Even with the explosive growth in the past several decades, Chinese GDP per capita in 2016 was $8,030, or just 14 percent of the U.S.’s. Meanwhile, consumer spending in China amounts to just 37 percent of GDP compared to 68.1 percent in the U.S.

China won’t shrivel up and die, but it will be a much less important actor on the global stage as it shifts from commodity-munching exports, housing and infrastructure to consumer spending and services. The same was true of Japan starting in the early 1990s.

There may well be an “Asian Century,” but don’t hold your breath. It took about a millennium for the West to develop meaningful democracy, the rule of law, large middle classes that support domestic economies, and all the other institutions that are largely lacking in developing Asian lands at present.

5. Disinflation that started in 1980 continues with chronic deflation likely, especially as services follow goods in price retreats. The Federal Reserve and every other major central bank have a 2 percent inflation target. They don’t love inflation, which devastated economies and financial markets in the 1970s, when it rose to double-digit levels. But they fear deflation, which curbs consumer spending and capital investment along with economic growth as deflationary expectations set in. When price declines are widespread and chronic, buyers anticipate further declines so they wait for even lower prices. The resulting excess capacity and unwanted inventories force producers to cut prices further. Suspicions are confirmed, so buyers wait for still-lower prices in a self-perpetuating spiral. So deflation is self-feeding, as seen clearly for two decades in Japan.

Also, with deflation, the real cost of debts rises, making them harder to service and inducing financial problems and bankruptcies.

I remain convinced that widespread inflation results from overall demand exceeding supply, and deflation is caused by the reverse. Historically, governments create inflation in wartime with robust spending on top of fully-employed economies. That was the case in the late 1960s and 1970s, when Vietnam War outlays combined with War on Poverty spending. And that led to double-digit inflation rates by 1980. In peacetime, however, supply normally exceeds demand and deflation prevails. In the 96 years of war since 1749, wholesale prices rose 8.2 percent per year on average, but fell by 0.45 percent annually in the 170 years of peace. Assuming that the Trump administration, China, Russia and Middle East terrorists don’t drag the U.S. into a significant armed conflict, deflation is more likely in the years ahead, at least by historical precedent.

6. “The bond rally of a lifetime” that I first identified in 1981, when 30-year Treasuries yielded 15.2 percent, continues. With their safe-haven appeal, lower interest rates abroad and prospective deflation, we look for 2.0 percent yields on the long bond and 1.0 percent on the 10-year Treasury note.

I’ve been pretty lonely as a Treasury bond bull for 36 years. Stockholders and others may hate them, but their quality is unquestioned, and Treasuries and the forces that move yields are well-defined: Federal Reserve policy and inflation or deflation.

In addition, I’ve always liked Treasury coupon and zero-coupon bonds because of their three sterling qualities. First, they have gigantic liquidity with hundreds of billions of dollars’ worth trading each day. So all but the few largest investors can buy or sell without disturbing the market.

Second, in most cases, they can’t be called before maturity. This is an annoying feature of corporate and municipal bonds. When interest rates are declining and you’d like longer maturities to get more appreciation per given fall in yields, issuers can call the bonds at fixed prices, limiting your appreciation. Even if they aren’t called, callable bonds don’t often rise over the call price because of that threat. But when rates rise and you prefer shorter maturities, you’re stuck with the bonds until maturity because issuers have no interest in calling them. It’s a game of heads the issuer wins, tails the investor loses.

Third, Treasuries are generally considered the best-quality issues in the world. This was clear in 2008 when 30-year bonds returned 42 percent, but global corporate bonds fell 8 percent, emerging market bonds lost 10 percent, junk bonds dropped 27 percent, and even investment-grade municipal bonds fell 4 percent in price.

Treasuries sold off with the “Trump Trade” after his election, but revived recently. This reflects deflation prospects since inflation rates and Treasury yields move together -- up in the post-World War II years up until 1980 and then down ever since. Treasuries have also rallied lately due to their safe-haven status and thanks to having a higher yield than other developed country sovereigns, making them more attractive to foreign investors.

via bloomberg

Tuesday, May 16, 2017

Focus on the bigger trade

Successful investors rely on basic analyses of hard facts and trends and try to avoid short-term emotional responses. They evaluate fundamental forces, decide on the investment themes they imply, and then invest.  Of course, their positions are constantly examined in light of new data, and investments are eliminated if the basic atmosphere no longer supports them. Still, successful investments are usually long-term because they flow from forces that are significant and likely to be in place for some time -- years or even decades.

The challenge is to recognize the difference between a sea change of lasting consequences and ephemeral random noise. Most security-market analysts and investors thrive on short-term swings that they interpret as being of huge significance. The media gains attention -- and advertising dollars -- by interpreting every minor wiggle as an earth-shattering event.  So it takes conviction and willingness to stand up to the crowd to stay focused on long-run economic and financial trends and the implied investment implications.

A good recent example of investor overreaction to short-term developments is the “Trump Trade,” the initial response of investors to Donald Trump’s election and Republican control of both houses of Congress that I discussed in a previous column. Stocks, commodities and the dollar leaped as investors seemed to assume that overnight, huge tax cuts, deregulation and fiscal stimulus would propel rapid economic growth and a surge in corporate profits, as well as renewed inflation. Treasuries fell in price as anticipated major tax cuts and fiscal stimulus implied huge new financing from bond issues.

Tuesday, May 2, 2017

Canadians should be worried about NAFTA

Gary Shilling interview above with BNN on Trump's action on Canada and its effects on the Canadian Dollar. 

Click here if the above video does not play.