A Change In Policy?

by: Alhambra Investment Partners

By Joseph Y. Calhoun

The Committee recognizes that low interest rates may provide incentives for some investors to "reach for yield," and those actions could increase vulnerabilities in the financial system to adverse events. While prices of real estate, equities, and corporate bonds have risen appreciably and valuation metrics have increased, they remain generally in line with historical norms. In some sectors, such as lower-rated corporate debt, valuations appear stretched and issuance has been brisk. Accordingly, we are closely monitoring developments in the leveraged loan market and are working to enhance the effectiveness of our supervisory guidance.

- Janet Yellen's prepared remarks before the Senate Banking Committee.

Equity valuations of smaller firms as well as social media and biotechnology firms appear to be stretched, with ratios of prices to forward earnings remaining high relative to historical norms.

- From the semi-annual report that accompanied Yellen's testimony.

Janet Yellen's comments last week in testimony before Congress generated a lot of commentary, much of it concentrated on the sectors she identified as having "stretched" valuations. It is very unusual for a Fed chair to comment on asset prices even in a general way. To point to specific sectors as potentially overvalued is unprecedented as far as I know. When Greenspan gave his irrational exuberance speech it was done in a way that left a lot to the imagination. Like many other market commentators, I am extremely uncomfortable with the Fed attempting to influence asset allocation decisions. I was already uncomfortable with their foray into credit allocation but this is way beyond some abstract objection to their purchase of mortgage backed securities. The degree to which the Fed has become the de facto central planner for the US economy is reaching levels that ought to make everyone uncomfortable.

I think though that lost in the rush to condemn her for speaking so plainly and transparently (another thing I think has gone too far) is that this may represent more than just Yellen responding to her critics. Yellen also said during her testimony that "if the labor market continues to improve more quickly than anticipated" by policymakers, "then increases in the federal funds rate target likely would occur sooner and be more rapid than currently envisioned." Combined with her comments on markets and comments from other Fed members, it appears the Fed is trying to talk down the market - or at least the portions they perceive as overvalued - in case this scenario becomes more than speculative. Is Yellen trying to tell us something?

While officially, Yellen is sticking to her belief that "macro-prudential" polices can be used to head off bubbles - contrary to all past evidence - she might even be starting to question that theory. The leveraged loan market to which she refers has already been the subject of some "macro-prudential" pushback from the OCC (Office of the Comptroller of the Currency) with a revision to their guidelines on these types of loans over a year ago. That Yellen is still concerned - more concerned - about that market 16 months after it was first identified as a problem area by regulators is evidence that her preferred method of addressing excesses is not working. I see her latest comments as a part of that macro-prudential effort but I can't help but wonder what she'll do next if this is as effective as the OCC memo (which is to say, not at all).

Despite her comments on some potentially overvalued asset classes, it is apparent from her testimony that Yellen is still looking to the economic data to guide policy, at least for now. She believes, as does Richard Fisher and several other FOMC voting members, that the economy is improving much more quickly than they anticipated. She did say that the outlook for the economy is still "very uncertain" but it seems that the Fed believes that the risks are now to the upside on inflation and growth. If they are right, as she pointed out in her testimony, rates may rise sooner and quicker than currently anticipated.

The incoming economic data does point to an acceleration in the second quarter. Last week's Empire State and Philly Fed surveys were much higher than expected and while retail sales were less than expected, last month's number was revised significantly higher. On the worse side, it is obvious the housing market is still having difficulties. Mortgage applications continue to fall and June housing starts were reported down 9.3% after a 7.3% drop in May. Permits also fell so the outlook doesn't appear to be getting any better. Industrial production was also less than expected although manufacturing production is up 6.7% annualized so far in the second quarter, a major improvement from the 1st quarter gain of 1.4%. So, yes GDP does look to improve in the second quarter.

Yellen also said that it would take a major change in the economic outlook for QE to be extended beyond the expected October end date. I see nothing in the data right now that would be sufficient for the Fed to justify not meeting their own deadline. As I've said before I do think that tapering by itself is a form of tightening even if rates are unchanged so in my mind they've already started tightening policy. Whether they take further actions immediately after QE ends is much more speculative. There are still major problems with the US and global economy and they aren't going to disappear by November.

Even assuming the Fed does start rate hikes sooner than expected, I'm not sure the market or the Fed will get what they think they will. There is still a consensus that with the Fed moving toward tighter policy that long-term Treasuries will feel the effects. The futures market, though, still shows a large short position in longer dated bonds. In the last tightening cycle, while the Fed funds rate rose 4.25% the 10 year Treasury yield only rose 1.5%. The longer end of the curve is less sensitive to tightening now than it has been in the past, primarily, I believe, because of the added debt in the economy. If that is true, I would not expect Treasury yields to rise much at all in this cycle. In fact, tightening may cause a rally in long Treasuries as the odds of recession rise with rate hikes.

Other bond markets may not be so lucky though. To the degree that monetary tightening raises fears of recession, the junk and corporate bond markets - and obviously stocks - are the ones that will likely feel the most pain. Unlike Treasuries, risky bonds perform poorly when growth is falling as it creates anxiety about their ability to pay. With credit spreads at or near all-time lows, a recession scare due to tightening would do a lot of damage.

For the markets and for the Fed's reputation, the greatest risk is that they take the second quarter acceleration as evidence that the economy is on stronger footing than it actually is. If this is just one of those growth bumps we've seen repeatedly over the last few years that fades quickly and the Fed gets too aggressive we could quickly find ourselves in recession. As the tapering tantrum seemed to show last year, this economy just can't handle higher rates. I've thought all year that the Treasury market is telling us something about the economy and it isn't good. We've now seen a minor selloff in the junk bond market - which might just be a reaction to Yellen's comments - and if it continues while Treasuries are stable or rallying, that will be a sign that we are closer to the end of the expansion part of the cycle than anyone currently believes. So, there may be a surprise in store for the markets and the Fed but perhaps not the one they are worried about.