Spot Exchanges Shorts: 3 Things to Know Ahead of Today’s FOMC Meeting

Inflation and the labor market are in focus for Janet Yellen in the November FOMC meeting. But it’s Jerome Powell who looms large over the meeting.

The Decade-High 2-Year Treasury Yield Is Not the End of the Bond Bull Market

The 30-year bond bull market has been predicted dead many times. Though 2-year Treasury yields hit a decade high, this time probably isn’t any different.

The 2-Year Treasury yield jumped above 1.60 percent today. That’s the highest level since the fall of 2008. The rising yield is taken as a bullish sign of near-term economic prospects – investors are dumping low-yielding debt to jump into the stock market which continues to hit all-time highs.

Onward and upward with long Treasury yields. Looks like we may have to run the “Is this the end of the 35-year bull market” piece again… pic.twitter.com/yRqsWbrDYM

— John Authers (@johnauthers) October 25, 2017

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The inimitable John Authers comes at this with a bit of tongue-in-cheek. But the rise in the yield might not the harbinger of an boom that many would expect. Looking at the 2-year in comparison to the 10-year yield, short-term rates are rising much faster than long-term yields.

A falling spread between the 2-year and 10-year yields indicates a flattening yield curve. That’s typically taken as a sign of trouble. Granted, the 10-year yield has continued to rise, which still indicates a risk-on environment. If the yield curve were flattening because investors were buying long-dated bonds, sending yields lower, that would be a pretty clear warning signal. But the fact that investors are holding dearer 10-year Treasuries shows a certain amount of worry in the system.

Still, the falling spread between short- and long-term debt is worth watching.

Consumer Credit at All-Time High: What Does This Mean for the Fed Chair Race?

Consumer credit as a percent of disposable income is at an all-time high. What could the policies of John Taylor and Jerome Powell mean for consumers?

Americans have been tapping into credit at levels we’ve never seen before. Some of the faster growing types of credit, like credit cards and student loans, float with interest rates. This means that more Federal Reserve rate hikes could make it harder for households to pay off debt. However, we might not see a wave of defaults that we’d expect in these circumstances.

That’s according to Wells Fargo’s Chief Economist John Sivlia and analyst Harry Pershing. In a weekly interest rate research note released on October 25th (link here), Silvia and Pershing note that consumer credit is at an all-time high compared to disposable income. That would normally bring about fears of a coming crisis, as a wave of defaults could push the U.S. economy right back into recession.

However, the authors argue that the Fed will raise interest rates slower than incomes will rise. That would mean consumers would pay more on debt, but it would be less of a burden compared to incomes.

Household debt delinquencies have mostly been falling since the Financial Crisis of 2008-09. Even though consumers are taking on more debt as a percent of income, they are still paying it down and not defaulting. Steady economic growth and a continuously improving labor market are certainly making consumers feel better about their debt burdens. The only way we’d see a spike in defaults is if rates rise much faster than expected.

What does this mean for the Federal Reserve Chair race?

Jerome Powell and John Taylor are the front-runners at this point. Powell would represent a continuation of current Fed policy, while Taylor is a bit more of a wild card.

Taylor’s famous Taylor Rule formulates the proper level of Fed base interest rates. It currently stands at about 3.0 percent. This is sharply higher than the current level of 1.25 percent. A move this big would be a huge shock to consumers holding floating rate debt.

Not everyone is convinced a Taylor Fed would raise interest rates this much, though. Taylor recently argued that the economy could withstand a 3 percent growth rate without too much inflation (specifically, if tax cuts lead to GDP growth). That would be a reason to leave rates lower.

Yellen, on the other hand, thinks inflation will tick upward if a massive tax package is passed. She would likely opt to raise rates in this scenario. Countering prevailing opinion, rates could be higher in a Yellen/Powell Fed than a Taylor Fed.

Consumers have benefited from a steady and predictable economy over the past decade. A massive shift in monetary policy could be the trigger that upends this consumer confidence, which makes this Fed horse race so intriguing.

Econ Vlog: Is Global Political Risk Creeping Up on Investors?

Spot Exchanges Shorts: The Apprentice: Federal Reserve Edition

What Do Trump Stock Market Tweets Mean for the Fed Chair Decision?

Another stock market record, another @realDonaldTrump tweet basking in it.

Yesterday’s example: After the Dow Jones Industrial Average hit 23,000, the president tweeted “WOW!” with an animated stock chart. Trump is certainly soaking in the sunshine of an index that has gained 25% since election day.

But this enthusiasm is headed for a crossroads. Trump likes to tweet about stock market milestones. But Trump also has a decision to make about who will lead the Federal Reserve. A hawkish pick for the Fed chief could increase the chances of a stock market correction.

Who is in the lead for the next Chair of the Federal Reserve?

How we got to 23,000; or life before before Trump stock market tweets

For years, many have argued that the low interest rate policies of the Bernanke and Yellen Feds have led to high asset prices, including in stocks.

Real interest rates – measured by the 10-year Yield minus CPI – turned negative in September for the first time since February. Overall, real yields are still well below the historical norm. In the 1990s, real yields were between 3 and 5 percent. The post-crisis, historically low rate environment is one of the key components for our currently lofty market valuations.

But if Trump picks a hawk on monetary policy – someone like John Taylor or Kevin Warsh – the Fed’s baseline interest rate could be hiked faster and higher than it would under a Janet Yellen or Gary Cohn regime (Though real interest rates have actually fallen as the Fed has increased interest rates over the past two years. See: The Janet Yellen Paradox: When Raising Rates Doesn’t Equal Tighter Financial Conditions).

Could we have a hawkish Fed and continued market record highs?

History shows that markets have performed well after a rate hike cycle. According to a Charles Schwab analysis,

As shown in the chart below, the S&P 500 Index returned an average of 9.0% and 5.5% before and after, respectively, the start of a Fed rate hike campaign. In all 11 of these instances, the S&P 500 Index generated positive returns for the six months before a rate hike. Additionally, market volatility rose around the time of each initial rate increase. In spite of this volatility, the S&P 500 Index generally resumed its upward climb after the rate hikes, generating positive returns in 8 of 11 instances.

Stock prices grew slower after a rate hike, but market more often than not continued to trend upward. But let’s take this bull case with a cautiously optimistic bent. First, 11 is an incredibly small sample size, so we need to understand what happens when rates rise. Second, we have to consider what could derail the bull market.

Stock Market Correction Ingredients

First, higher interest rates mean higher discount rates.

• Higher interest rates put downward pressure on price. All future expected earnings are discounted by the prevailing interest rate (plus a risk premium), so as rates rise, price tends to fall. In textbook finance, this is as true for bonds as it is for the broader market.

Second, higher rates could hurt earnings growth.

• To support the current stock market levels, earnings would have to grow even faster to offset that increase in interest rates. The question is whether or not the market can support faster earnings growth.

• Higher interest rates impact earnings in two ways. It increases the cost of capital for companies, so borrowing in the capital markets becomes more expensive. Higher rates also decrease the incentive to invest in new projects, because the return from sitting on cash is higher.

A standard market valuation is the Price-to-Earnings ratio. Higher expected earnings growth tends to lead to higher prices. Analysts are predicting double-digit earnings growth throughout 2018, according to a recent analysis by Factset. These expectations have led to the lofty market valuations – the S&P 500 Forward 12-month Price-to-Earnings ratio hit 18x earnings for the first time in 15 years.

If earnings growth falters on the back of higher rates, however, that could cause market valuations – and market prices – to tumble.

Which will win out, Twitter or Monetary Policy?

Since Trump likes Twitter, and likes to talk about how his administration’s policies are increasing stock market levels, would he really want to risk that by picking a hawk to lead the Fed?

The Fed is said to be the one who takes away the punchbowl after economic growth leads to inflation. So who does Trump choose? It is difficult to imagine that Trump would take away his own Twitter punchbowl with a hawkish choice to head the central bank.

Trump may say he loves John Taylor, but this could simply be a baseless statement to appease Republicans who distrusts the current Fed leadership. Trump is a “low-interest rate” guy who likes lofty valuations. The choice for the next chair of the Fed will probably reflect this.

(Update) Weekly Wrap: Inflation is the New Jobs Report

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Welcome to the 11th edition of the Weekly Wrap, where we love all economic data points equally, as if they were our own children.

Inflation: More Important than Jobs Data?

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Update: 9am ET

A weak CPI reading. Core CPI for September was released, and came in at 1.7 percent, 0.1 percent lower than expected. Traders are now predicting an 82 percent chance for a December rate hike, down from 86 percent earlier this morning.

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At 8:30 am (ET) this morning, we’ll get to see the updated Consumer Price Index (CPI) inflation number for September. The monthly jobs report has traditionally been the granddaddy of economic data. But this monthly inflation metric might be the new king of the heap.

• The Fed has a dual mandate: full employment and stable prices. Even with the hiccup in the September jobs report (-55,000 net jobs, the first monthly decline since 2010), the economy is pretty close to full employment.

• The stable prices mandate? That’s a different story. We’ve written about this several times recently (See: The Janet Yellen Paradox: When Raising Rates Doesn’t Equal Tighter Fiscal Conditions). Inflation has been persistently below the Fed’s 2 percent benchmark for years. Inflation, measured by CPI, has averaged 1.75 percent over the past 10 years.

• Low inflation has is the biggest source of disagreement within the central bank, according to the minutes from the September Fed meeting. Inflation was mentioned 90 times in the discussions. That’s more than 3x the number of mentions of “labor.”

Does this mean the Fed will hike rates in December?

According to the market, the answer is a resounding yes. Traders are pricing in an 86 percent chance of a rate hike in December. That’s up from about 70 percent on October 2 and 42 percent on August 18.

That’s in spite of the apprehensions of some Fed statements. Some members of the committee “noted that, in light of the uncertainty around their outlook for inflation, their decision on whether to take such a policy action would depend importantly on whether the economic data in coming months increased their confidence that inflation was moving up toward the Committee’s objective.”

Which brings us back to this morning’s CPI report. Would the Fed hold off on a December rate hike with low inflation readings? Probably not – low inflation hasn’t stopped the Fed from increasing rates before. But it is clear that monetary policymakers are keeping a much closer eye on the inflation side of the dual mandate.

What We Wrote This Week

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Other Links and Notes

Conor Sen argues in Bloomberg View that we should look past inflation – housing is the real crisis. (Don’t Worry About Inflation. Solve the Housing Shortage.;Conor Sen, Bloomberg View)

• “The more responsive approach would be to make it easier to build houses, to get public sector employers out of their recession-era mindsets to hire and pay more, and more generally, to ensure that millennial family needs are met by the public and private sector. The way to resolve a supply shortage in this case should mean creating more supply. Rather than hiking interest rates, the federal government should find ways to add construction workers, perhaps via worker training programs or immigration reform.”

Yanis Varoufakis, everyone’s favorite finance minister, argues that we shouldn’t let the Catalonia crisis go to waste. (Spain’s Crisis is Europe’s Opportunity; Yanis Varoufakis, Project Syndicate)

• “The Catalonia crisis is a strong hint from history that Europe needs to develop a new type of sovereignty, one that strengthens cities and regions, dissolves national particularism, and upholds democratic norms… But the longer-term beneficiary of this new type of sovereignty would be Europe as a whole. Imagining a pan-European democracy is the prerequisite for imagining a Europe worth saving.”

Workers quitting their jobs to seek out better ones. Could this be what’s holding back wage growth? (Record Job Openings Aren’t Enticing Workers to Quit; Eric Morath, Wall Street Journal Real-Time Economics)

• “The unwillingness to quit could be a factor holding back better wage growth, reflecting workers’ relative lack of bargaining power. It might also suggest other factors—such as the unwillingness to move for work, or satisfaction with work-life balance—is keeping workers in their jobs despite ample opportunities elsewhere.”

Cover photo: Brookings Institution (Flickr Commons)

Econ Vlog: 3 Takeaways From the IMF’s World Economic Outlook

The International Monetary Fund released its 2017 World Economic Outlook today. It gives a great overview of economic growth trends in both developing and developed countries, and is certainly worth browsing through.

Today, we discuss a few of the key points outlined in the IMF report, including:

• Global economic growth projections, which are slowing compared to estimates made in April by IMF analysts
• US growth projections, which are markedly lower than previous estimates. Analysts blame uncertainty in Washington for a lower medium-term outlook.
• Wage growth, which might be in the doldrums for several more years

The Janet Yellen Paradox: When Raising Rates Doesn’t Equal Tighter Financial Conditions

Janet Yellen has a decision of consequence to make. In December, the Federal Reserve is expected to raise its benchmark interest rate another quarter of a point. This would be the fifth rate hike since December 2015, when the Fed Funds rate sat at 0 percent.

First, let’s talk about the mechanics of the Fed’s interest rate policy

The Fed raises interest rates to respond to a booming economy. As unemployment falls, a virtuous cycle is sparked. With more jobs, people buy more homes and consume more goods and services. That means prices rise (well, this is supposed to happen, according to the Phillips Curve. More on that below.), which forces employers to give further raises. As it becomes more expensive to hire human labor, companies are incentivized to invest in new capital and machines to increase efficiency. This boom in wages and investment creates more inflationary pressure.

The backstop to this inflationary spiral? The Fed’s interest rate policy. Higher interest rates are supposed to quell inflation, as cash moves out of the economy and into safe assets like Treasuries. Suddenly the cost of borrowing to buy a home increases. Companies figure they can get a better return by investing their cash instead of expanding or investing in new machines. Inflation? Defeated.

The Janet Yellen Paradox

But something curious has happened over the past two years. As the Fed increases the baseline interest rate, the real (inflation-adjusted) yield on a 10-year Treasury has fallen.

The chart above shows the yield on a 10-year Treasury minus the Core Price Index, a measure of inflation.

It would be one thing if the real 10-year rate has fallen because high inflation was chopped down to size. But that’s not the case – inflation is low, and has remained low, for years. The driver of the recent trend? Investors continue to pack into Treasuries, even with falling real returns.

Think of it like this. If the idea in December 2015 was to make it more expensive to buy a home or borrow to expand a business, that goal has failed. Instead, it’s cheaper – the real interest rate is about 0.7 percent lower now than it was then.

So one of two things is happening. Either the Fed’s policy has worked too well, and we are at a point where the central bank should be loosening policy. Or the market is out of sync with the Fed’s policy maneuvers.

What does this mean for the December rate decision?

As of August 2017, the CPI showed that prices rose 1.9 percent over the past year. This is close to, but still below, the Fed’s 2 percent target. That 2 percent benchmark is also supposed to be an average.

However, inflation has been persistently below that level for years. This is where the the aforementioned Phillips Curve has broken down. Employment has been strong, but inflation remains muted. Inflation could pop up if the labor market trends in the same direction, but nobody knows if or when that will happen.

The Fed has been hawkish, and hasn’t waited around to see when the Phillips Curve reemerges. The central bank continues to raise rates, in spite of the non-inflationary indicators.

The markets are pricing in a 71 percent chance of a hike in December. On one hand, the Fed hasn’t met its target, and raising the Fed Funds rate will only put downward pressure on already low inflation. Many analysts argue that the Fed should instead hold pat and let inflation “run hot.”

But on the other hand, Janet Yellen isn’t likely to be at the Fed past February. According to PredictIt, bettors are giving Yellen a 20 percent chance of remaining the Chair of the Federal Reserve past February. Current Fed Governor Jerome Powell (29 percent) and former Fed Governor Kevin Warsh (25 percent) are currently in the lead.

The tenuousness of Yellen’s position could play into the decision. If she and the FOMC decide to hike rates, it’s easy to cut rates in the future if needed. Staying at the current level means the policy rate is closer to 0 percent, the zero-lower bound in Fed-speak.

Takeaway: By raising rates, the current Fed chair is giving a future Fed chair (maybe even her own future self) more optionality. That’s incredibly valuable in central banking. But if inflation is persistently below the target, and rate hikes aren’t pushing the market in the desired direction, might the Fed Funds rate be back where it is now anyway?

 

Cover photo: International Monetary Fund (Flickr Commons)

Weekly Wrap: A 1 in 1,095 Day Event for Econ Nerds

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Welcome to the 9th edition of the Weekly Wrap, where we had a great week scrolling through 1,262 pages of chart-tastic econ data.

The Federal Reserve’s Survey of Consumer Finances. The Greatest.

The Fed’s triennial report on the state of American household finances was released this week. This is one of the greatest gifts to people who enjoy spending weekends building charts. Or people who made bar bets about how many renters vs. buyers own equities (Answer at the end).

It will take years to run through and properly comment on all of this data. But here are three charts that immediately caught our attention.

Median income for those without a high school diploma has surged in the past few years

This was a particularly interesting finding, especially considering the narratives in the 2016 election. Median income for those without a high school diploma jumped 14.7 percent since 2013. For comparison, the median income for those with a college degree rose just 2.1 percent over the same period.

But can we dispel the argument that working-class America is not being left behind, at least in terms of income? Most certainly not.

Since 1989, the median wage has grown the most for the college-educated folks, and stagnated – if not fallen – for other groups:

[table id=3 /]

Another interesting trend is in the median income for families that fall into the college-educated category. While real incomes are up 5 percent since 1989, it is down 8 percent since the 2004 peak. The college wage premium is alive and well, though it might not be as big as it once was.

Incomes in the South and Midwest are Surging

Another finding that runs contrary to the 2016 election zeitgeist, the median income for families is rising fastest in the South and Midwest.

Incomes are still highest for families in the Northeast, but that region saw the slowest growth between 2013 and 2016.  

Again, can we dispel the narratives that Trump ran on in 2016 based on this data? Yet again, the answer is no. Incomes (adjusted for inflation) have actually fallen in three of the four regions since 2004. Only in the south is the median family better off than they were 13 years ago.

[table id=4 /]

Incomes for Families in Cities are Rising Much Faster than for Rural Families

Finally, we have a data point that validates the Trump narrative. Families of rural America saw income growth that was just one-fifth of the growth in cities.

This is the continuation of a long-term trend as well. The real (inflation-adjusted) median income for a family in a metropolitan area is 10 percent higher than it was in 1989. For rural families, it’s just 2.7 percent.

One caveat, if we’re going to look at this through the intersection of politics and economics: many suburban counties voted overwhelmingly for Trump. These counties are considered within the range of metropolitan statistical areas. Suburban Cincinnati is a good example. Trump won just 42 percent of votes in Hamilton County. But once you cross the county line, that number jumps into the 60s.

Takeaway: There are some fascinating insights to this report, and we will surely be dissecting it until the next dataset comes out in 2020.

What We Wrote This Week

Loftium Won’t Cause Another Housing Crash, But It Stirs Bad Memories (September 25): “Of course, this one company will never cause a meltdown of the entire nation’s housing market and economy. But it should still be considered from a micro level. If memory serves correct, things didn’t seem to work out too well for either the borrowers or the lenders in Vegas and Phoenix.”

5 Charts That Explain the State of American Manufacturing (September 27): “Manufacturing is not declining, it’s evolving. Productivity in American manufacturing has been the key story of the past few decades. It simply takes fewer workers to produce more goods than it once did. And the goods that are produced are higher quality and of higher value than before.”

The Trump Trade Is Back. Kinda. (September 28): If an entire swath of companies are going to rise and fall based on the latest legislative proposals, then investing in small caps is a bet on Congress getting their act together and passing meaningful legislation. But if we take the past nine months as any kind of indicator, that has some long odds.”

Other Links and Notes

We’re all pass-through entities now. Go incorporate yourself immediately. “It is an important asterisk to one of the core elements of the plan: a desire to tax income of “pass-through” businesses such as partnerships at a rate of only 25 percent. Currently, such income is taxed at the owners’ individual income tax rate, which is as high as 39.6 percent (and would fall to 35 percent in the Republican plan). The Republicans want the pass-through businesses to have a tax rate more in line with that of big, C-class corporations (which they are proposing to tax at 20 percent).” (Tax Plan Punts on a Loophole for the Wealthy; Neil Irwin, New York Times The Upshot)

We wrote about Toronto housing recently; UBS confirms it is bubbly. “Toronto and London are among the cities most at risk of a housing bubble as economic optimism and low borrowing costs push up property values in urban areas worldwide, according to UBS Group AG. The Canadian city, which entered the index of 20 locations for the first time this year, has the most overvalued housing market, while London was the third-riskiest in Europe after Stockholm and Munich, the Swiss bank said in a report published on Thursday.” (Toronto, London Among Riskiest Housing Bubble Cities, UBS Says; Jack Sidders, Bloomberg)

It’s not the fees that will kill you, it’s that you’re a terrible investor. “Those who bought in 2009 and held on until today would be pretty happy, but I get the impression that very few people did that. They either bought too late, sold too early, panicked and puked at the worst possible time, or chased a hot new trend. The result is that they inevitably underperformed a 60/40 mix of stocks and bonds 1  , which would have provided about a 10.4 percent return since the start of 2009.” (Fees Are Not the Enemy of Investors; Jared Dillian, Bloomberg View)

*Survey of Consumer Finances Trivia Question

The answer: 64.6 percent of homeowners and 29.6 percent of renters.

Cover photo: Federal Reserve (Flickr Commons)