Title CURVE FLATTENING IMPLIES MARKET AT ODDS WITH FED OPTIMISM

Transcription

1 CURVE FLATTENING IMPLIES MARKET AT ODDS WITH FED OPTIMISM June 16, 2017 By David Ader, Chief Macro Strategist for Informa Financial Intelligence Ader s musings Economic data generally disappoints. Citi Eco Surprise Index lowest in over a year. May Core CPI at 1.7% YoY, lowest since early Headline dips to 1.9%. May Retail Sales slide 0.3% (flat was expected) with control group flat. FOMC hikes to % as expected, sees one more hike this year. Rather a less dovish hike as Yellen talked about the transitory nature of recent soft inflation (mobile phone plans and prescription drugs), but they changed something to is monitoring inflation closely from continues to monitor inflation indicators and global and financial developments. This is a nuance. It moves away from worry about global financial developments to a more intense focus on inflation. Given its behavior of late, this would imply a willingness to err on a more dovish trajectory if inflation falls further under target. Note that they took down both PCE and core PCE expectations this year (to 1.6% from 1.9% and 1.9% to 1.7%, respectively) but left 2018 and 2019 at 2% across the board. This suggests that steady inflation around current levels won t inhibit a hike. They will start balance sheet reduction later this year, starting with $6 bn in Treasuries and $4 bn in MBS and reaching caps of $30 bn and $20 bn respectively about a year later. The process to get to a normalized balance sheet will take a very long time and has to be couched with the potential for expansion when we hit another recession. In the week just passed, the bond market s theme was of a flattening yield curve as the Fed delivered what glibly could be called a hawkish hike while some key economic indicators like CPI and Retail Sales fell well short of expectations. For context, 2s reached new yield highs as the Fed adhered to its projections for more hikes, i.e. the dot plot, while 10s slipped to new yield lows last seen two days after the Presidential election and filling a gap left from that day. This sort of price action offers a bit of market skepticism over the Fed s inflationary optimism. The Fed is sticking to its forecasts for inflation to rise to its targets even as the recent figures have fallen well short of those targets. The bond market certainly buys the hiking story and has adjusted accordingly, but the longer end tells a different story that may serve as a warning that it senses something else going on. While hardly first tier data, a whiff of that may have come the day after the FOMC meeting with May s drop in import prices and its downward revisions. Weaker oil prices have been around for a while and continue as a theme. To be fair, the flattening isn t new and the longer end s rally came with the CPI and Retail Sales disappointments as opposed to a reaction to the Fed. Indeed, prices retreated in the wake of the FOMC though there weren t any great shocks per se. Again, the hike was fully anticipated and Yellen was somewhat dismissive of recent inflation readings as one off reductions. Also expected were at least some of the details about balance sheet reduction to start later this year and at a reasonably moderate pace; it will take years to get to whatever normal is to be and the Fed acknowledged the balance sheet would be larger than pre crisis levels. Once more, it s hardly a surprise but they did say they would be prepared to resume reinvestment if weaker economic conditions warrant it. In other words, the balance sheet has become a permanent monetary policy tool. Direction wise I m a bit nonplussed by it all. With this hike out of the way and Dec Fed Funds at 1.24%, it s fair to say the market s not fully pricing in yet another hike which means we have many months to go to play those odds. More immediate is the timing of the balance sheet reduction (sometime in Q4 seems right), but even there with the small amounts they plan to start with it s hard to see an immediately negative impact on longer rates. 1

2 Dare I suggest we re back to range trading? The answer is yes. I see 10s in a broad channel from about % and a narrow one from %. Momentum is a bit neutral. There was a big volume build up at 2.21% and the 21 and 200 day MAs converge around 2.20% making for an important support area. 2s are up against a something of a trendline line at 1.36% and look a bit oversold. Between there and 1.40% (March yield high) I d be a better buyer. The curve flattening looks a bit extended, i.e. momentum has gotten too rich, and I m inclined to fade it for a trade though would like to see a bit of a shift in momentum measures first. I like selling the belly vs. the wings to test those waters. THEMATIC: I was asked recently to cite five things that are going to drive rates. My response was why only five? But my interrogator had only limited space, so here s what I cited. 1) Pace of Fed hiking. I think pricing in part of one more this year is reasonable, but volatile, and I think that if the Fed go to, say, % within a year the curve would be perfectly flat. 2) Balance sheet reduction. Here their anticipated slow pace makes me a bit less concerned over the impact on the long end, but I m guessing it will otherwise add 5 10 bp a year after they start to where rates would otherwise be. 3) Slow economic growth. If we ve averaged 2% since 2012, I don t see that accelerating at this late stage in the cycle. Too, we have enough evidence to suspect inflation will broadly remain under 2%. 4) Risk assets too beholden to low rates and Trump agenda. With Fed gradually hiking and stimulus plans in doubt, to say nothing of political uncertainty, and tax reductions perhaps postponed, I think risk assets can come under pressure to the benefit of Treasuries. Finally, 5) I worry about rising deficits regardless of Trump s plans and have written about this before. While I m in the Lacy Hunt (of Hoisington Investment Management) camp that large deficits inhibit growth, at least at the onset I would expect larger auctions into what s been an illiquid dealer community which could prove problematic, i.e. higher rates, for a short period of time. IN THE NEWS: Two articles that came out last week caught my attention. One was by Greg Ip in Thursday s WSJ entitled Lousy Raise? It might Not Get Better. ( Ip goes into painful detail about how wages (and in Germany and Japan, too) are moribund and offers some explanation of why and why they remain so. He points out that with US Business selling prices (BLS non farm implicit price deflator) rising at 1.4% over the last five years and Productivity gaining just 0.6% you have a sum of 2% or a proxy for wage gains. That s the lowest in 60 years. He notes, too, that as the expansion matures, firms hire lower skilled, i.e. cheaper, workers and so wage gains are less than they might otherwise be. He adds the wrinkle (clever that) of retiring workers who are replaced with less experienced and cheaper workers. Below is a version of a chart Ip used. 2

3 By the way, this is something of a topic I ve been on for a while, but with a somewhat different approach where I look at Productivity growth along with the Labor Force as a proxy for overall GDP growth. The takeaway is that subdued gains in the former lead to subdued gains in the latter. Another piece I came across was on Bloomberg citing the Stone & McCarthy survey of investors which put exposure to US corporate debt matching an all time high of 37%. Interestingly, the long end of the US corporate market saw the biggest inflow it s third highest since the start of I get it. Yields are low and spreads, even if razor thin, are attractive. But exposure is exposure. Do note that the flipside to the heavy weighting is overall corporate indebtedness which at 45.3% is close to the record high. Woe to credit ratings in a recession. 3

4 CHARTS AND THEMES: What ensues are a series of charts that attempt to build a theme a cautious one in economic terms and simply hit me in the last few weeks. The first is of non farm payrolls MoM with 3, 6 and 12 mo moving averages. The gentle slowing of these is the key take away (well evidenced on the MoM bar chart) and the 3 mo MA slipping under the 6 and 12 mo MA. This bears watching as it could presage a deeper economic slowdown though that s not striking here and now. Rather, it points to a non acceleration in job gains vs. the old expression of hitting escape velocity, something that s remained elusive in this rather long expansion. Sort of, kind of, related to that, is a chart that s been making the rounds in the last several days in the context of a hint that we are late in the economic cycle, a view eloquently espoused by David Rosenberg of Gluskin Sheff among others. The chart in question is of the Unemployment Rate which I ve overlaid with Labor Participation. The counterintuitive point is that the very low UNR (exceeded only in the final two years of the dot com era when Labor Participation was peaking at just over 67% vs. 62.7% today) suggests we are closer to an inflection point, i.e. when labor market improvement stalls, vs. room for more acceleration. The conundrum between modest real wage gains and the low unemployment rate might weigh in on that potential. 4

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6 The week just passed also got the latest report from the National Federation of Independent Business, where I m highlighting what these folks identify as the Most Important problems and, by ranking what are their least most important problems. Let s start with the latter; their least important problems are inflation and financial and interest rates. In other words, my words at least, inflation is not a threat which means they are not seeing price pressures in their supply chain. Other anecdotes like the U Michigan inflation outlook confirm this perspective. But look at what is a problem; Quality of Labor. Cost of Labor is up, too, but is relatively low on the totem pole of problems. You would think it, and wages generally, would be on the rise if there s a need for better quality workers, no? The JOLTs report showed something similar; job openings were up but hirings were down. The two measures tend to move closely. It s so tempting to say this is a precursor to wage gains but maybe it s for a narrow spectrum of the overall labor market. The divergence is curious if nothing else. Another curiosity stemming from NFIB is the very sharp drop in Government Regulations & Red Tape which for the last six years rivaled taxes as their single biggest problem. Now, at 13, it s the lowest it has been since Dec Surely, Trump s executive orders can t be the source of this drop, not at the small business level. Maybe it s anticipation of changes? 6

7 EPFR INSIGHTS. I continue to try to derive some directional implications from Informa EPFR s extensive read on mutual fund and ETF flows, but at the moment am more mesmerized by simply seeing what s happening vs. forcing myself to interpret it. Let s start with All Bond Funds globally vs. the US. Last week (June 7) saw a massive inflow, nearly $16 bn, into bond funds with nearly $9 bn of that into US bond funds of one sort or another. As of June 15, those came off to a still hefty $8.99 bn and $4.49 bn, respectively. Note as a percentage flow into US funds went from 56% to 50%. 7

8 This next chart looks at flows into long term and intermediate term US Funds corporates and Treasuries. What s pretty obvious is that the last few weeks have seen an increase in long corporate fund flows, steady buying of intermediate corporate funds and not all that much drama with government funds. At least this is consistent with findings of the SMR survey referenced above. 8

9 Bringing 30 years of investment strategy experience to his role at Informa Financial Intelligence, David Ader has held senior positions at major investment banks and financial information firms as well as serving on investment policy committees and management teams. Most recently Partner, Head of Government Bond Strategy for CRT Capital, he headed the team voted #1 in U.S. Rates Strategy for 11 years and #1 in Technical Analysis for five years in Institutional Investor s annual survey. Placeholder for Picture David Ader is Chief Macro Strategist for Informa Financial Intelligence. For further information on our products and services, please see: 9

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