Category: Fed Hiking Cycle

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The Wrong Signal

Brief Intro Note From Travis

While the Fed has 5-6 more interest rate hikes projected to get back to the projected neutral Fed Funds Rate according to the Fed’s Dot Plot, which is at the low end of historical neutral rates, the financial market is going to force the Fed to pause in their rate hiking campaign.

How?

The Fed is not going to invert the yield curve, and the market is going to force the Fed’s hand, providing a tailwind for an unexpected market development, which is the return of sustained inflationary pressures.

Thesis

The Fed will not invert the yield curve intentionally, and this reluctance will cause the Fed to settle at a lower Fed Funds Rate, at least temporarily, providing a continuation of historically accommodative monetary policy.

Setting The Stage – The Market Is Going To Force The Fed’s Hand

Right now, the market is pricing in a 99% chance of the Fed raising the Fed Funds Rate from a range of 1.75%-2.0% to 2%-2.25% at their September 2018 meeting.

Additionally, the financial markets are pricing in a 67% chance that the Fed will raise the Fed Funds Rate an additional quarter point at their December 2018 meeting to a range of 2.25%-2.50%.

So far, so good, according to market expectations.

However, looking out a year from now to September of 2019, there is only a 37% chance, according to the financial markets, that the Fed will raise rates one more time to the 2.50%-2.75% Fed Funds Rate target range.

Additionally, looking at the table above, there is a higher percentage chance, according to the financial markets, that the Fed will not raise rates one single time from December of 2018 all the way through September of 2019, versus the Fed raising rates twice.

Building on the narrative even further, the financial markets are pricing in a higher probability of a cut in the Fed Funds Rate in 2019, after the December 2018 Fed Funds Rate increase, than three Fed Funds rate hikes in 2019.

Market Expectations Do Not Square With The Dot Plot

While the financial markets are current predicting three more rate hikes in total through September of 2019, the Fed’s most recent Dot Plot showed four rate hikes in 2018 (two more to go) and an additional three rate hikes in 2019.

Clearly the market is much more pessimistic than the Fed’s own projections for their path of interest rates.

Why is this the case?

Yield Curve On The Cusp Of Inverting

The answer as to why the market’s expectations of future interest rates is more pessimistic than the Fed’s can be found in the yield curve.

Specifically, in the United States, 2-Year Treasury Yields have kept on rising, and remain near their recent highs.

However, 10-Year U.S. Treasury Yields have retreated from their recent highs, as the fears of higher long-term interest rates that were prevalent near the beginning of 2018, have receded.

With 2-Year Treasury Yields continuing to rise, and 10-Year Treasury Yields retreating, the yield curve has flattened significantly.

Putting it all together, market participants almost all know that an inverted yield curve has been a marker for a future recession, with a lead time of roughly 18 months.

Thus, we are in an investment landscape where most investors and speculators are casting a wary eye to the future, believing a recession is around the corner.

The Wrong Signal

The yield curve is flattening, and most investors and speculators are trying to make sense of this development.

This price action has obscured something remarkable.

Specifically, under a rules based approach, the Fed Funds Rate should be much higher.

More specifically, under the Taylor Rule, which is shown in the blue line in the above graph versus the actual Fed Funds Rate in depicted by the red line, the Fed Funds Rate under a rules based approach is targeted at 7.5%.

Before dismissing this analysis reflexively because of the level of the forecast, look how closely the Taylor Rule implied Fed Funds Rate tracked the actual Fed Funds Rate from 1980-2000.

Why is the Taylor Rule suggesting such a high Fed Funds Rate?

Two answers come to mind.

First, even though the current economic recovery dating to June of 2009 (for reference the U.S. stock market actually bottomed in March of 2009) has been anemic, averaging 2.2% Real GDP Growth, which is the second-worst growth rate for an economic expansion in the post-WWII era, the extraordinary length of the expansion has provided a cumulative economic growth that is greater than most market pundits, including myself, give the market credit for, and this cumulative growth has started to register on capacity restrained barometers.

Second, economic growth has picked up noticeably with the initial readings for Q2 2018 U.S. Real GDP Growth posting a 4.1% growth rate, noticeably above the Real GDP Growth Rate in this expansion.

Adding to the narrative, Real GDP Growth is picking up further, with the Atlanta Fed GDP Now Model back up a 4.6% Q3 2018 Real GDP Growth rate reading.

For all its criticisms, the Atlanta Fed GDP Now Model has been more accurate than the Blue Chip economists consensus forecast over the past six months, as the Atlanta Fed GDP Now Model, does not have the biases that human forecasters do, including myself, so if there as truly been a change in the growth paradigm, an unbiased model is likely to capture this change earlier.

Takeaway – Market Is Mispriced

The bond market, stock market, and commodities market are priced for pessimistic growth right now.

The Fed Funds Rate futures market does not even believe the Fed’s own forecasts right now about future interest rates or economic growth.

Historically, where the Fed has been more wrong than right with their forecasts, particularly at inflection points, we can understand the market’s hesitation.

Wait, but isn’t the U.S. stock market at record levels?

Yes.

However, the U.S. stock market has become a “safety trade” for global capital flows over the past decade.

Thus, stock markets outside the U.S. are painting a different picture of performance.

Additionally, below the surface of the U.S. stock market, economically sensitive equities, including many of our favorite targeted equities right now, have had abysmal relative, and absolute, performance over the past decade.

Why?

Economic growth has been disappointing in the United States, relative to past economic expansions over the past decade, and economic growth globally has been disappointing relative to expectations.

However, what if economic growth has finally reached a cumulative level of expansion after roughly a decade of GDP growth, that we are on the verge of triggering a traditional late-stage capital rotation?

Summarizing, for someone who nailed the potentially secular turning points in bonds and commodities in 2016, and who was rewarded for it handsomely, the last twenty months have been more difficult that almost any investing environment I have been through over the past 25 years, as there simply has not been uptake, or follow-through with regard to economically sensitive equities, particularly those value-oriented equities that should benefit the most from a turning point in economic growth expectations

The upside today is trades are more crowded than even 2016, as almost everyone believes in a uniform outcome in the financial markets, yet what if we are finally at the destination, after a very long journey, that demand is outstripping supply on a sustainable basis, and what if economic growth is actually accelerating, not rolling over?

Is the possibility of this scenario even priced in by the markets?

Even if the more modest projections of the Fed are more accurate than the markets current projections, what asset classes would benefit?

The more I think about it, the stage is set for the shunned equities of the past decade, notably commodity equities, international equities, and emerging market equities, to excel going forward.

The curve-ball of July and August of 2018, when liquidity conditions were supposed to permit a rally in risk assets, yet the safe-haven assets outperformed even further, was one of the market’s financial acts of deception, from my vantage point, eschewing investors from the very trades that are set to thrive.

To close, ironically the market is setting up a scenario where the market constrains the Fed, causing the Fed, at a minimum, to pause in their interest rate hikes, and more likely causing the Fed to settle at a terminal Fed Funds Rate in this this rate hiking cycle that is much easier, in-terms of monetary policy accommodation, that past Fed Funds neutral rates.

With the market potentially constraining the Fed, forcing an easier than normal monetary policy, the odds of higher economic growth actually increase, which would further benefit the downtrodden economically sensitive equities and inflation sensitive equities, both of which have been cast aside.

Interested to see if we can get a good discussion going on this,

Travis

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Is The Fed Behind The Curve?

This week I was writing an article for the esteemed members of our group at WTK The Contrarian and, in the article, which discussed past interest rate cycles, and Fed monetary policy, and the future consequences of this monetary policy, I used the following chart, depicting current interest rates and what interest rates would be under the Taylor Rule.

Ever since I wrote about it earlier this week, I cannot stop thinking about this chart above.

Specifically, the Fed has been extraordinarily easy in their application of monetary policy over the course of the current bull market compared to a rules based approach, becoming even easier over the past year, as the accelerated pace of interest rate increases in the Fed Funds Rate has lagged the improvements in economic growth and in inflationary readings.

Look at the chart above again.  

What would the Fed Funds Rate be under the Taylor Rule?

How about 7.5%.

For a variety of reasons, there is no way, I repeat “no way”, we are getting there, meaning to a 7.5% Fed Funds Rate.  Adding to the narrative, this holding down of interest rates is similar to the aftermath of the 2000-2002 downturn, where monetary policy was kept extraordinarily easy (see chart above again), and this policy planted the seeds for the extraordinary price action in 2007-2010 in the financial markets.

We know what the implications of easy monetary policy in the prior era, including a historic bubble in U.S. housing prices, with the benefit of hindsight.

More importantly, what are the implications of this extraordinarily easy monetary policy today, and over the course of the current bull market?

I have some ideas, including what has spurred the record level of the S&P 500 Index (SPY) today, whose positive price action, in my opinion, is largely in the rear-view mirror, and what assets are largely undervalued given the monetary policy backdrop.  The second point is what really matters going forward, and this is especially important given the challenging level of real returns going forward.

Interested in hearing what others in the SA community are thinking?

Hope everyone is enjoying the transition from the end of the Summer back to the school year.  With more children than I can keep track of, I certainly appreciate this time of year,

Travis

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Going To Bed Thinking About The Fed

Introduction Note From Travis

We have had a good discussion in The Contrarian lately regarding the Fed, specifically their pace of interest rate increases, and how close we are to the end of the current market cycle.

This has got me thinking, researching, and discussing, the end-game to this cycle over the past several days, and I wanted to put these thoughts on the proverbial paper.

Ultimately, I believe the Fed is behind the cycle, and the late-stage cycle investments are only at the beginning of their rally, with the first leg higher in these assets occurring in 2016, and the next leg higher set to commence, perhaps imminently.

Thesis

The Federal Reserve and the rest of the world’s central banks fear deflation, as 2007-2009 is still planted firmly in their minds, and thus monetary policy has stayed looser for longer, and will continue to do so, resulting in elongated investment cycles and a long runway for inflationary assets.

Fed Is Behind The Curve

On March 16th, 2017, I published an article for members of The Contrarian titled, “Market Historian – What Happens When The Fed Hikes Rates“, examining what happens to the markets in Fed tightening cycles.

Midway through the article, which looking back was very prescient (and I wish I would have followed my own rationale, reasoning, and logic better in 2017), I talked about the Taylor Rule, and posted a chart showing the differential in the Fed Funds Rate, and what the Fed Funds Rate would be projected to be under the Taylor Rule.

Back in March of 2017, the gap between the actual Fed Funds Rate and the Fed Funds Rate predicted by the Taylor Rule was pretty large, around 4%.

As economic growth in the United States has accelerated, and Fed Fund Rate increases have lagged past rate hiking cycles, that differential gap has widened further today.


With the Effective Federal Funds Rate hovering around 2%, and the Taylor Rule projecting the Federal Funds Rate should be 7.5% today (read that again and think about it) the gap between the projected Fed Funds Rate by the Taylor Rule, and the actual Fed Funds Rate has widened to 5.5%.

In summary, even though the Fed has accelerated their pace of tightening in 2018, they have actually allowed monetary policy to become looser relative to economic growth, and this easy monetary policy environment has the potential to spark an inflationary boom, which would be the best possible environment for inflationary equities, specifically commodity equities.

2004-2006 Tightening Cycle As A Comparison

The Fed has been predisposed to easier monetary policy for a long time.  The graph above would date this predisposition to around 1990, and as a market historian, I would say it began earlier, really with Fed Chairman Greenspan, particularly following the October 1987 U.S. stock market crash, where the Fed began easing interest rates immediately, after tightening them from February of 1987.

After the 2000-2002 U.S. stock market downturn, the Federal Reserve was noticeably slower to raise interest rates, waiting all the way until June of 2004 to lift rates from the 1% bottom.

Remember, 2003 was a very strong year for risk assets, so the Fed waited the entirety of 2003 and into 2004, and then they began raising rates at a steady pace.

How steady?

As I wrote in the member Market Historian article, the Fed raised rates 17 times from June of 2004 to June of 2006, which was a much faster rate hike cycle than we have seen in the current economic expansion and equity bull market.

Interestingly, the Fed stopped tightening in June of 2006, about a year-and-a-quarter before the U.S. stock market, as measured by the SPDR S&P 500 ETF (SPY), peaked late in 2007.

Adding to the narrative, commodity prices increased during the Fed tightening cycle in June of 2004 to June of 2006, adding to their advances from 2001 through June of 2004.

The price action of commodities in the chart above from 2004-2008 is of particular interest today, as I believe we are on the same path with regards to the economic cycle and financial markets today as were were back then.

Specifically, index funds dominated fund flows from 2003-2007, in a prelude to what we have seen during the current bull market, and volatility was muted, before an unwind.

It is my personal belief that the current U.S. equity bull market is sort of a hybrid between the 1990-2000 U.S. equity bull market, with growth assets dominating as I wrote about recently for members, and the 2003-2007 U.S. equity bull market, when passive flows became the go to investment vehicle for institutions on the traditional equity side.

Cycles Are Extended

With the Federal Reserve, and the world’s central banks sticking with a policy of negative real interest rates for longer than ever before, I believe investment cycles have lengthened.

From the Martin Pring graphic above, I think bonds have topped, with sovereign bonds making their secular highs (lows in yields) in 2016, so we are somewhere between Stage 4 and perhaps at the early part of Stage 5.

Keep in mind, the 4-5 year time-frame in the graphic above applied to U.S. markets historically, so again, I think investment cycles, especially on a global basis, have been elongated, so each stage of the cycle could be running 2x to 3x what is shown above.

For that reason, the current investment landscape, with large-cap growth outperforming has seemingly persisted forever.

This is the bad news.

The good news is that the other stages should be elongated too, so there should be an even longer runway for our favored late-stage asset plays today.

Investment Implications

The first thought that comes to mine is to buy iShares 20+Year Treasury Bond ETF (TLT) puts.

Why?

1.  The Fed is clearly way behind in their interest rate hiking cycle, and adding to this narrative, they may stop at a terminal rate that is significantly below what could be called for in a higher growth/higher inflation landscape.

2.  Sovereign interest rates have clearly bottomed in 2016, yet there is a reluctance to embrace this right now, and with 2007-2009 still fresh in most investor’s minds, the natural inclination is to buy bonds for a safety trade.

The second thought is that commodity equities, which have dominated the Top-Ten List, should be primed for their second leg higher.

The SPDR S&P Oil & Gas Exploration & Production ETF (XOP), which is already in the midst of its second leg higher, with the first leg occurring from the Spring of 2016 through the end of 2016, followed by a difficult pull-back for the majority of 2017, before embarking on the beginning of its second leg higher in the depths of despair in 2017, is a good leading indicator for the rest of the commodity complex today, in my opinion.

Thus, if XOP continues its uptrend of higher highs and higher lows, I think this will be a good sign for commodity equities in general, a few of which I have identified as particularly juicy opportunities, at least from my vantage point, in a recent member post titled Volatility Creating Opportunity.

The third thought that is on my mind is that the current equity bull market could go on longer than expected, as the late-stage cycle investments, have not really even gotten underway in what should be a longer than normal time-frame for late-stage cycle assets.

Having said that, projected real returns for the broader stock and bond markets are beyond abysmal today.

In summary, there really are only select pockets of value, and commodity equities are one of the sweet spots in my opinion.

Takeaway – Long Runway Still For Late Stage Assets

The Fed is farther behind in their rate hiking cycle than every before, and their glacial pace of interest rate increases in the current almost decade long equity bull market is a prime factor behind the price dislocations that we are seeing today.

Imagine for a second that monetary policy was normalized from 2009-2012.

Would we have the excesses and the imbalances that we have today?

Probably not.

However, you have to play the hand you are dealt.

Building on that narrative, the dislocations and dispersion in the financial markets the past decade is creating a Golden Age for active investors, as the supply/demand dynamics of many economically sensitive industries have been stretched to extremes, highlighting the importance of the capital cycle, and providing what I think are the investment opportunities of a lifetime.

Looking forward to what should be a dynamic rest of 2018,

Travis