Can We Be 'Reasonably Confident'?

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Includes: SPY, TLT, VXX
by: Christiaan van der Meer

Summary

FOMC is split in its mandate of full employment and inflation target which diverts policy from moderate long-term rates.

Loan demand is increasing, and credit environment supportive of economy.

Yet, we miss price pressure on many fronts, see low investments and company revenues come in below expectations.

An aggressive Federal Reserve is unlikely in today's world.

I have strong doubts about a rate hike in September and December.

As most readers know, the US Federal Reserve Board (Fed) conducts a monetary policy with a mandate to pursue maximum employment and stable prices. Maximum employment is estimated at a level of 5.0 to 5.2 percent while the Fed's inflation target is around 2 percent. However, the Fed's monetary policy also has an additional objective: moderate long-term interest rates. At this point, the labor market is very close to full employment: on Friday, market watchers expect to see an unemployment rate of 5.3%. The Federal Open Market Committee (FOMC) acknowledges that we're considerably below moderate long-term rates. Thus, a rate hike is on the table. The big question: is the FOMC Board "reasonably confident" about inflation rate to pull the trigger?

Favorable loan environment

The July 2015 Senior Loan Officer Opinion Survey on Bank Lending Practices, published on Monday, indicates that demand for loans is increasing. Especially in real estate, but also consumers show stronger demand for home-purchase loans, auto and credit card loans. The majority of banks said to have let lending standards basically unchanged, a small percentage reported to have eased standards "somewhat". So credit environment remains favorable in the second half of 2015. This is also the picture we got during the earnings announcements of listed financials during the last weeks.

Absence of price pressure

Despite a fertile ground of high employment and favorable lending standards, we have yet to see the occurrence of significant price pressure. This Monday's core PCE-inflation for June, widely regarded as the Fed's preferred inflation measure, came in at 1.3% YoY (non-core at 0.3%). That's well below the 2% target. There's no upward slope to be seen since the PCE price index excluding food and energy rose in June with the same percent as in May: 0.1%. In fact, if we look at the yearly change during the last six months, we basically witness a flat line.

Figure 1: PCE annual rate during the previous six months. Source: Bureau of Economic Analysis

Last Friday's employment cost index in Q2 showed a 0.2% increase, considerably below the expected 0.6%. This marks coming Friday's average hourly earnings monthly change as highly interesting. Stating in the Wall Street Journal:

Friday's numbers will tell us what direction we're going to take in the market in the next three weeks or so," said Kent Engelke, chief economic strategist at Capitol Securities Management, adding that wage inflation is the gauge he is most eager to see.

"It's going to be very tantamount to how aggressive the Fed is actually going to be," he said.

Economy not on full speed

Obviously, thus far there's no sign of an economy on full steam. Q2 first estimate came in at a disappointing 2.3% while 2.5% was expected. Although durable goods were promising with a better-than-expected rise of 1.1% MoM (excluding transportation and defense), but the numbers are still down 3.0% YoY. According to Deutsche Bank Market Research, of the S&P 500 companies which reported their earnings announcements until yesterday (370 companies), 74% have beaten EPS but only 50% have beaten revenue forecasts. Q2 expectations were relatively mild due to a strong US Dollar. A strong US Dollar is likely to persist during the coming quarters, causing US companies to be less competitive compared to its foreign counterparties. In addition, a strong US Dollar dampens price pressure due to cheaper imports.

Fed's guidance

Many market commentators thoroughly screened the FOMC's latest monetary decision. The addition of the word "SOME"...

The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.

...is regarded by a number of commentators as a clear sign a rate hike for September is a sensible possibility. I think that's grossly exaggerated. During many press conferences and speeches, Chairwoman Yellen and her fellow Board members made clear they want to guide the market to a first Fed rate hike. To me, that means we need to get more assurance the Fed is indeed "reasonably confident" about inflation to pick up. Up to now, we didn't get that message.

This Tuesday, Board member Powell (voting member) addressed an interesting point on Treasury markets during a speech at The Brookings Institution, Washington D.C.:

I take the concerns about a decline in market liquidity seriously. Hard evidence on the level of liquidity in secondary Treasury markets is mixed, with some measures at or above pre-crisis levels and some suggesting a reduced ability to buy or sell large positions without material price effect - a reasonable definition of liquidity. It is also possible that liquidity may be more prone to disappearing at times of stress. On October 15, for example, market depth declined sharply, and we saw a sudden spike in prices that was without precedent for a period with little relevant news. Other events - such as the 2013 "taper tantrum," the "bund tantrum" last spring, and the sharp moves on March 18 in the euro-dollar exchange rate - all broadly show the same pattern: rapidly diminishing liquidity, and large price moves for a given quantum of news. But the causes and implications of these events are unclear. Is this the new normal? We don't know. Current macroeconomic and market conditions are unprecedented in many respects. For now, what we have is a small number of broadly similar events that bear careful consideration.

This is a clear indication that the Fed will be cautious in guiding a first rate hike in order to prevent market turmoil. The reference to the Bunds move earlier this year is probably telling. Powell also referred to the fact that "the Federal Reserve and foreign owners (about half of which are foreign central banks) have increased their ownership to over two-thirds of outstanding Treasuries". This doesn't sound like a board member who is looking to act aggressively.

Bonds over stocks

So what does that mean for investors? First, data regarding employment, wages and price pressure will be very closely watched by the market. As a result, in particular this Friday's NFP figures may be accompanied by significant price action, with even more action at September's figures. The closer we get to the Fed September meeting, the more nervousness i.e. market volatility may arise. Barring short-lived moments of increased market tension, adding the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) to your portfolio was a losing strategy, and I would not recommend doing so in order to hedge market turmoil at this point in time. A more subdued development of share prices is likely, until the Fed provides a strong signal of an imminent rate hike, for instance by dropping "reasonably" from its next statement or by indicating more confidence about rising inflation during speeches of its members.

Until then, I prefer the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT) over the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) due to its higher yield and a monthly distribution of dividends (SPY: quarterly distribution). TLT currently yields 2.80% compared to SPY's 1.96% (source: Yahoo Finance). For more drastic adjustments in allocation, we need signals that are far more clearer than the addition of words such as "SOME". A lift off in Fed interest rates should be supported by strong numbers in employment and inflation. At this point, we cannot be "reasonably confident" that this is the case.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in TLT over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.