Tag Archives: Federal Reserve

US bond market environment, October 2012

October 18, 2012 By in Bond Environment, Current Market Thoughts, securities markets, Strategy Tags: , , , , , , , , , , , Leave a comment

This is the quarterly letter sent by Strategy Asset Managers, LLC, a bond management firm, posted with permission from my friend and mentor, Denis Jamison.

Today’s post sketches out the current situation.  Tomorrow’s wil give Mr. Jamison’s investment conclusions.

a market of bonds

It’s an old saying on Wall Street–this isn’t a stock market but a market of stocks.  In other words, individual stocks can rise or fall regardless of the general direction of the market.  The same can now be said of the fixed income market.  formerly, the direction of interest rates dictated returns across most segments of the bond market.  If Treasuries called the tune and the rest of the fixed income market danced along–some a little slower or faster–but they were all moving to the same beat.

That’s now changed.

Policies implemented by the federal Reserve effectively have eliminated real yields for “riskless” securities like US Treasury bonds.  (By riskless, I mean credit risk–that is, the risk of not getting paid at maturity.  T-Bonds still have plenty of market risk.)  Without government bond yields calling the tune, all sorts of other factors are determining returns in various segments of the fixed income market.

The markets are now being driven by monetary policy designed to:

(1)  keep interest rates at zero for short-term, low-risk investment-like savings accounts and US Treasury bills and notes,

(2)  narrow the yield spread between “safe” investments like US Treasuries ans riskier investments like corporate bonds, and

(3) lower the return spread between fixed income assets and securities with no maturity–like common stocks.

In fact, the Federal Reserve would really like investors to go out and spend their money on real goods and services.  It has stated that zero interest rates are here to stay until the economy has fully recovered–that means much lower unemployment and much stronger economic growth.  Chairman Bernanke, unfortunately, doesn’t have a crystal ball and isn’t telling us when he thinks that will happen.  At the moment, however, he plans no change in interest rate policy through 2014.  Of course, he has pushed out the probable end date of his quantitative easing program before and is likely to do it again.  Market pundits have started referring to the Federal Reserve’s monetary policy as QE unlimited.

When the bank is playing…

…you just keep dancing.  We have just entered the third phase of the Federal Reserve quantitative easing.  in the wake of the 2008 financial collapse.  Essentially, “quantitative easing” means that the Federal Reserve will buy financial assets from banks and put cash in their–the bankers’–hands.  The hope is that, somehow, this money will filter through the system and the banks will loan that money to you and you will buy a house or a car or anything.

Why doesn’t the Federal Reserve just lower interest rates and make the loans cheaper?  Well, interest rates are already at zero so they need to do something else.  Since the banks are stuffed with money, will they loan the money to you?  No, because you don’t have a stellar credit history and your house is under water.  They refuse to take credit risk because they face political and regulatory retribution if they suffer any losses.

Has the quantitative easing program improved the economy?  Not yet, but it has certainly been a windfall for the financial markets.  The S&P market index is up 115% off the 2009 lows and every time it seems to be losing steam, we get another QE program.

Is all this going to end badly?  Probably, yes, but in the meantime don’t fight the Fed, don’t fight the tape and keep dancing.

The quantitative easing programs are having one clear impact–a massive increase in the Federal Reserve’s balance sheet.  The Federal Reserve was created in 1913 through a bill sponsored by two legislators, Carter Glass and Parker Willis.  Mr. Glass later went on to co-sponsor a bill that prohibited commercial banks from being securities firms.  (Interestingly, that 1933 piece of legislation was struck down during the Clinton administration.  Some say the repeal was a root cause of the 2008-2009 financial collapse.) The Federal reserve’s mandate was to provide liquidity to the banking system in times of crisis and to gradually expand the money supply to support non-inflationary economic growth.

Until 2008, the Federal Reserve provided that liquidity to the banking system by gradually expanding its assets through the purchase of government bonds from the banks.  That has changed.  Federal Reserve assets grew from $890 billion in June 2008 to $2.8 trillion most recently.  This is the result of asset purchases made by the Federal Reserve through its various QE programs.  Government bonds account for $1.6 trillion of those assets.  Another $800 billion are mortgage-backed securities and the Fed plans to add about $60 billion a month to that pile.  Unfortunately, the Federal Reserve’s capital base hasn’t kept up with the asset growth.  Now, $55 billion in capital supports those $2.8 trillion in assets–a leverage ratio of 50:1!

So, the Federal Reserve has done an excellent job of reducing leverage in the banking system through the purchase of all those assets and, as an additional benefit, helped keep government borrowing costs low.  But it has transferred a large portion of private sector bank leverage to its own balance sheet.  Any percentage change in the price of the assets on its balance sheet will be reflected fifty-fold as percentage change in the Fed’s capital.

In the movie”It’s a Wonderful Life,” the banker,George Bailey, was lucky enough to have an angel when his depositors make a run on the bank.  I hope Mr. Bernanke has an angel on his side if interest rates ever rise.

 

More tomorrow.

two more years of emergency-low interest rates!

January 31, 2012 By in Current Market Thoughts, from growth to value: the life cycle, growth vs value, Recent Market Action, Shaping a portfolio for 2012, Strategy Tags: , , , , , , , , , , Leave a comment

the January 25th Fed meeting

Last week’s meeting of the Federal Reserve’s Open Market Committee had two important results:

1.  Chairman Ben Bernanke said the Fed funds rate, which has been at effectively 0% for just over three years (since December 16, 2008–how time flies) will likely remain at or near the current low rate into 2014.

2.  The Fed gave more detail than ever before on its thinking about prospects for the US economy and the appropriate level for the Fed funds rate.

The Fed thinks:

–the long-term growth rate of the US economy is  +2.4%-2.5%  a year (vs. 3%+ a decade ago).  The agency is content, however, to allow growth at somewhat above that rate from now into 2014.

–the appropriate long-term level for the Fed funds rate is about 4.5%, which amounts to a 2.5% real rate of interest (“real” means after subtracting inflation from the nominal rate).  This contrasts with the current rate, which is a negative real rate of about 2.5%.

–although the process of normalizing interest rates will probably begin before the end of 2014, the Fed is unlikely to raise the funds rate above 1% until at least 2015.

–despite the immense monetary stimulation going on now, inflation will not be an issue.  It will remain at 2% or below.

–the “natural” rate of unemployment, that is, full employment, is 5.5% of the workforce (in theory, the 5.5% is friction in the system–like people in transit from one employment location to another, or who decide to take a short break between jobs…).

According to the Fed’s projections, the unemployment rate will remain above 8% until some time in 2013.  It probably won’t crack below 7% for at least the next three years.

implications

The forecast itself isn’t a shocker.  The Fed has been talking about slow but steady progress for the economy, with no inflation threat, for some time.  The real news is that the Fed expects the current situation to persist into 2105, a year longer than it had previously indicated.

1.  To my mind, the biggest implication of the Fed announcements is that it makes less sense than ever to be holding a lot of cash.  How much “a lot” is depends on your economic circumstances and risk preferences.  But the Fed is saying that a money market fund or bank deposit is going to yield nothing for the next two years and well under 1% for the year after that.  Yes, you have secure storage in a bank and substantial assurance you won’t make a loss, but that’s about it.

To find income in liquid assets–as opposed to illiquid ones like, say, rental real estate–you have to look to riskier investments, dividend-paying stocks or long-dated bonds.  That in itself is nothing new.  Savers have been reallocating in this direction for the past couple of years.  Last week’s Fed’s message, though, is that it’s much too early to reverse these positions.  If anything–and, again, depending on personal circumstances and preferences–investors should think about allocating more away from cash.

2.  When the process of normalizing interest rates is eventually underway, the yields on long-dated bonds and dividend paying stocks will be benchmarked–and judged–against cash yields of 4%+.  For stocks, a static dividend yield of 3% won’t look that attractive.  At some point, low payout ratios (meaning the percentage of earnings paid out in dividends) and the ability to increase cash generation will become key attributes.  Both are indicators of a company’s ability to raise dividends.

3.  It’s my experience that when the Fed begins to tighten, Wall Street always underestimates how much rates will rise.  Last week, the Fed told us that when the Fed funds rate goes up this time, its ultimate destination is 4.5%.

4.  Investors taking a top-down view, that is, looking for the strongest economies, will have to seek exposure outside the US–which will only look good vs. the EU and Japan.  The main issue is demographics–an aging population.  It’s probably worthwhile to try to figure out what characteristics of the latter two economies, both of which have older populations than the US, are due to social/cultural peculiarities and which are due to aging.  The second set of traits may well turn up in the US market as well.

5.  The mechanics of how growth stocks and value stocks work may change in a slower-growing economy.  It’s hard to know today how that will play out.  True growth stocks may be harder to come by.  Value investors who say they buy asset value of $1.00 at $.30 and sell it at $.70 may have to buy at $.20 and sell at $.60 if there’s less room for second- and third-tier companies to succeed.

I think it’s way too soon to be worrying about anything other than #1.  The rest are thoughts to be filed away for next year, maybe.

employment in the US: the November Employment Situation and JOLTS

December 7, 2010 By in Current Market Thoughts, economics, Shaping a portfolio for 2011, Strategy Tags: , , , , , , Leave a comment

The Labor Department’s Bureau of Labor Statistics released its Employment Situation report for November last Friday. The headline numbers, a 9.8% unemployment rate and the addition of 39,000 jobs vs. the 140,000 that the consensus of economists had predicted, caused a furor both in Washington and in the news media.  Wall Street, however, shrugged the news off, after a brief morning dip.

the Employment Situation

There are, as usual, a couple of quirks in the November report, but nothing that alters the headline number significantly.  The 39,000 gain in jobs breaks out into a boost of 50,000 to private payrolls and a drop of 11,000 in government employees.  Given the parlous state of government finances it seems to me this is a trend that will continue, despite the penchant for elected officials to increase spending no matter what.

The retail sector lost 28,100 jobs, at a time when holiday hiring should be increasing.  Retailers have been announcing that they are in fact adding to their staffs, but a lower rate than in prior years.  So the apparent loss of jobs could well be a function of the way the Labor Department makes its seasonal adjustments to data.  At some point, this should correct itself.

As you may know, the monthly numbers are revised twice after the initial report, as more survey respondents check in.  The September figures, for example, initially reported a loss of 159,000 government jobs (mostly teachers) and a gain of 64,000 in the private sector.  The final tally announced in the November report is a gain of 112,000 private sector positions and a loss of 136,000 in government.  That’s a net gain of 81,000 jobs.

The October report has also gained 21,000 jobs in its initial revision.

JOLTS

The Labor Department also produces a periodic Job Openings and Labor Turnover survey.  The next one comes out at 10am New York time today, a few hours after this is published.  The report will likely show that there are about 3 million unfilled job openings in the US, up by about 800,000 from the recession low.

No one really knows why these available jobs aren’t immediately filled.  The two leading causes posited are:  the jobs require technical skills that the currently unemployed generally don’t have; or the unemployed owe more in mortgages on their houses than the houses are worth, so people are unwilling/unable to move.

the real issue

It’s possible that the November jobs numbers will be revised up to approach the consensus forecasts in the upcoming December and January revisions.  And it is true that there are almost a million more Americans employed today than at the low point for employment in December 2009.

But about 100,000 new workers on average enter the labor force each month, mostly as they complete school or technical training.  In a sense, then the first 100,000 new jobs created in the economy each month go to absorb these new workers.

Let’s say that the economy is really generating about 200,000 new jobs a month–far above what the official figures say– right now, only we don’t know it yet.  How would that affect the unemployment rate or the roughly 8 million workers who lost their positions during the recession?

If so, that number would be enough to take care of all the new workers entering the labor force, plus reduce the number of unemployed by 100,000 a month.  That’s 1.2 million a year.

How many years at this level of job creation until the 8 million who lost their jobs are reabsorbed into the workforce?  Six years and eight months. In other words, at a very generous estimate of the way the economy is now expanding, we won’t have full employment until the second half of 2018.

That’s the real problem.

At first glance, this is purely a domestic political/social problem, not an investment one.  The work force is expanding.  Consumer confidence is rising.  Foreign tourism is on the rise.  And over half of Wall Street’s profits come from sources outside the US.  So S&P earnings will likely continue to rise at a healthy clip, even if unemployment declines at only a snail’s pace.

A key question for investors, however, is whether unemployment will remain an issue of secondary concern.  One could argue that the Fed is carrying out quantitative easing for purely social, not economic, reasons–even at the risk of negative economic effects.  It remains to be seen if this is the last action either the Fed, or Congress, decides to take.

Minutes of the June 22/23, 2010 Federal Open Market Committee

July 16, 2010 By in Current Market Thoughts, Discounting, economics, Portfolio management, Recent Market Action, securities markets, stock market, Strategy Tags: , , , , , , , , , , , , , Leave a comment

the June OMC meeting

The minutes of the Federal Reserve Open Market Committee meeting of June 22-23 were released on July 14th.

To my mind, the truly striking development in this report is not the economic numbers themselves.  It’s the fact that for the first time since world stock markets bottomed in March of last year, the forecasts of the country’s near-term economic prospects by the 17 members of the OMC (5 governors + the 12 presidents of the regional Federal Reserve banks) have stopped going up.  In fact, they’ve gone–at least temporarily–into reverse.

The Fed now thinks real GDP growth in 2010, at 3.3%, will be .25% less than it thought in April.  The unemployment rate is expected to remain about .2% higher than previously estimated, at 9.4% this year and 8.5% next.

What’s changed?

To be clear, the Fed believes that the US economy is in the process of a moderate, but self-sustaining economic recovery, where “inventory adjustments and fiscal stimulus were no longer the main factors supporting economic expansion.”  But it also thinks that several factors, most of them external, have recently emerged that put a firm upper limit on how fast the economy can advance.

They are:

–financial troubles in Europe

–the rise in the dollar, and

–weakness in stock prices (even with the recent rally from just about 1000 on the S&P 500, Wall Street remains 10% below the high water mark achieved earlier in the year).

They add to business and consumer uncertainties, real estate weakness and reluctance of banks to lend, as sources of the headwinds the domestic economy is facing.

The good news, then, is that the US is on an upward course.  The bad news is that what we see now is as good as it gets.

the US economy:  plusses and minuses

–industrial production gains are “strong and widespread,” with IT investment growing rapidly,

–but capacity utilization remains low enough that companies aren’t going to invest in plant and equipment for expansion (vs. replacement or upgrade) for some time to come.

–labor demand continues to firm,

–but the proportion of workers jobless for more than half a year, already unusually high, continues to rise.

–bank credit, “which had been contracting for some time, was showing some tentative signs of stabilizing,”

–but commercial real estate is weak, with no bottom in sight,

–and consumer credit keeps on contracting.

–inflation remains unusually low, with deflation a risk,

–but the current lack of inflation has not yet caused Americans to adjust their inflation expectations down, thus raising the deflation risk.

the bottom line

Economic growth will remain muted, and unemployment will therefore  remain unusually high for an extended period of time, with most OMC members expecting “the convergence process (to normal unemployment levels) to take no more than five to six years (emphasis added).”

In consequence, inflation will remain unusually low for a similar extended period, gradually rising to around 2%.

long-run projections

change in real GDP      2.4%-3.0%

unemployment rate     5.0%-6.3%

CPE inflation     1.5%-2.0%

investment implications

Wall Street has always been able to draw a clear distinction between sectors it thinks will perform well and those it thinks will perform badly.  And it has usually been able to separate that judgment from one about whether the overall market will go up or down.

Foreign stock markets have routinely been able to draw a similar kind of high-level distinction between the prospects for the home-country economy and those for international regions.  They have usually been able to vary their holdings between domestic- and foreign-oriented companies, and to disconnect that decision from one about whether the market will go up or down.

Right now, the US economy overall, and consumer-oriented sectors in particular, seem to me to be relegated to the laggard column for some time to come. It also seems to me that the overall market is cheap.  Or, as the Fed put it in its minutes, “The spread between the staff’s estimate of the expected real return on equities…and…the expected return on a 10-year Treasury note…increased from its already elevated level.”

American investors have clearly been able to make the inter-sector judgment without difficulty.  If the market can do the same for the foreign-domestic judgment–and that remains to be seen–IT and international-trade related firms should have smooth sailing in the year ahead.

two other thoughts

The notion that the economy won’t be back to normal for the next half-decade is shocking, but given the enormous amount of damage done by the financial crisis (the Washington-Wall Street complex) it’s not that surprising.  The realization of this fact is probably the cause of the large amount of public outrage directed at politicians and investment/commercial bankers.

Although the negative news about GDP growth and extended high unemployment have been widely reported, the Fed projections have barely made a ripple in the stock market.  Presumably, this means that investors have already discounted most of this n stock prices already.


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