Every year around this time, I try to get a sense of where interest rates are headed for the year. On 9 February 2015, I wrote a forecast for 2015 in which I concluded:
My own thinking is that there probably will be some small rate hikes beginning at some point late in 2015, and probably only one tentative rate hike in 2015.
That is exactly what transpired. The Fed raised rates once, at its December meeting, and it wasn't completely sure about doing that, either. I made that forecast despite the fact that market sentiment when I wrote that article projected a rate hike no later than June 2015, and was pricing in three rate hikes by this point (early 2016). I do not follow the herd, I follow the data.
I am not looking to take any bows for my 2015 forecast. Despite its accuracy, the Fed so stoked rate-hike jitters throughout the year with its endless hints at coming massive rate hikes that it managed to crush yield-sensitive instruments such as REITs. For REIT investors (and many others, as the overall markets were mixed to down), 2015 was an excruciatingly painful year. In my opinion, the source of the pain rested primarily at the Fed's doorstep. I most definitely did not forecast that REITs would become the fall guy to the Fed's hostage-taker.
In my view, the Fed should not have raised rates in 2015 at all. I felt that when I wrote that February 2015 article, and nothing since has happened to change my mind. However, one must feel the pulse of the market and not just one's own wrist to work the markets successfully. Thus, rather than rely on a "feeling," it is important to look at the data.
Let's see what we can make of the rate landscape in 2016, which is distinctly murkier than in 2015.
It is a New Year with Old Problems
The absolute carnage in the high yield category in recent weeks, most noticeably in the mortgage REIT sector, has created steep discounts to book value. Or, rather, let me amend that: it has created steeper discounts to book value. Does this make them a bargain at current levels? I think so.
A truism in investing is that when prices plummet, most investors aren't inclined to buy. Despite all the fancy slogans about buying low and selling high and being a contrarian, that is an absolute truth that cannot be denied. Prices drop because investors lose confidence, and they lose confidence for a reason.
A quick glance at coverage of the mREIT sector illustrates the depth of angst and outright fear. "Is the mortgage REIT business going out of business?," shouts one headline that pretty much sums up the feelings of many mREIT investors these days.
I don't think so.
As I have discussed elsewhere recently, the main problem with these types of investments such as REITs is not fundamental. They still make money, and they have survived worse economic climates than this. Rather, the issue is primarily psychological, though it does have roots in the data which is affecting that psychology.
The Yield Curve Has Flattened
The yield curve isn't the sexiest indicator out there, but it certainly is one of the most important if you want to forecast the economy and, by extension, the stock and bond markets.
The above chart from the US Department of the Treasury shows that all rates are higher than a year ago. However, the long end of the curve (to the right) has not moved up as much proportionately as the short end (the left) has, meaning the curve has flattened. Real rates have risen over the past year because inflation is quiescent, and inflation expectations (shown in the graph below) are lower than a year ago.
When the curve flattens too much, that signals problems. It does not happen very often, but when it does, it is important to take notice. In fact, one part of the yield actually inverted on 2 February 2016 for a brief period of time.
Any inversion is troublesome, because it suggests something is not normal. That was just a brief, tantalizing glimpse of the possible damage that the Fed has wrought.
The reason to keep a close eye on the yield curve is because it is one of the best signals of coming economic contractions. Inverted yield curves involving the difference between the 10-year treasury rate and the 3-month yield have been an excellent harbinger of recessions.
As the above chart shows (shaded areas are recessions), we are not currently in an inverted yield curve environment by the traditional method of calculating it. However, if the Fed persists in raising rates against the collective wisdom of the market, it wouldn't take too much to invert it. The 10-year rate is refusing to stay above 2% despite widespread belief for years that it "must' go up, and despite the fact that the Fed already has started raising rates.
In fact, the 10-year yield recently hit its lowest levels in nine months.
The 10-year yield broke all sorts of technical levels when it slid below the August and October lows. According to technical analysis theory, the 1.90% mark now should become overhead resistance, though 2% is probably a more important psychological barrier.
What Does All This Mean for the Fed and Rates?
What is frustrating to many market watchers is that, while the Fed blandly toots its pipe and marches forward to the tune of higher rates, the economy is not following along. In fact, as the above charts suggest, the market sees no reason to send rates higher. It is incongruous that rates were about to fall just as the Fed was grandly announcing its rate hike in December 2015.
The Fed has a dual mandate of stable prices and full employment. According to the Fed, its inflation target is 2%, and the Fed itself does not forecast that level being reached until about 2018.
Employment, meanwhile, has reached the Fed's target zone of "full employment" at 5.0%. It is right about where the unemployment rate bottomed in the late 1980s, though is still a bit above the troughs hit right before the 2000 and 2009 recessions.
Interestingly, if you were to plot a trend line through the 2000 and 2008 unemployment lows, that line would continue onward right around to where the Civilian Unemployment Rate is today, if not a bit higher. The current expansion is getting very long in the tooth.
US economic growth has been mediocre for years.
US GDP Growth Per Annum
|Year||US GDP Growth|
Source: The World Bank.
While the Fed is supposed to only mind its statutory mandate, economic growth matters. The most recent government data suggests that the economy advanced at only a 0.7% rate for the 4th quarter of 2015. If that figure holds through the revisions, the economy grew at about the same mediocre 2.4% in 2015 as it did in 2014.
Weak economic growth and low inflation suggests that rates should be lowered or kept where they are. A healthy jobs market would suggest that rates should be hiked. For some reason, the Fed has been focused solely on the jobs side of its dual mandate as it marches toward rate hikes.
However, there are reasons to believe that the low unemployment rate itself may be suspect.
The Labor Force Participation Rate has been the fly in the ointment of the economy for the past decade. Currently, it is 62.6%. It is easy to dismiss this statistic because, long ago, the Participation Rate was even lower than it is now. However, it was at 67.3% only sixteen years ago. A drop of 5% in this indicator suggests that employment is far from full. The economy may need more stimulus, not less via a rate hike, in order to get more people back to work.
The shaky Participation rate greatly undermines the conclusion that the economy is anywhere near true full employment, despite what some other statistics suggest. The fact that inflation, which normally would accelerate in a tight job market due to wage pressure, has been so quiet adds further weight to the argument that the jobs market remains a lot weaker than the Civilian Unemployment Rate would suggest. There remain many unemployed people who would like to work but can't find good jobs. Fairly decent jobs growth is sopping up some, but hardly all, of that excess labor.
The Fed appears flummoxed by the current economic situation - "Fed Waves White Flag" was own personal favorite recent headline. Investors apparently have decided that if the Fed doesn't know what is going on, how can they? So, in the teeth of uncertainty, they sold off rate-sensitive bond equivalents.
The Bottom Line
The Fed waited too long to start raising interest rates. Not only is inflation nowhere near its target, but the Civilian Unemployment Rate is reaching levels where it normally bounces and then heads higher again. While there are reasons to question the actual meaning the Civilian Unemployment Rate, the historical record is too clear on that point to ignore.
The yield curve has flattened because the market is pricing in Fed hikes at the short end of the curve, but much less so at the long end. If the Fed follows through with its plans to raise rates throughout 2016, there is no reason to expect the yield curve to act any differently than it has over the past year. In other words, it is likely to flatten further. That is not a sign of economic health, and in fact is usually a precursor to recessions.
The World Bank has cautioned the Fed against engaging in intemperate rate hikes. Japan recently cut its interest rates below zero. Raising rates in the US when the rest of the world is ratcheting them down as fast as possible is either the mark of genius or madness, and the jury is very much still out on that.
The recent GDP report showed that higher US rates than in the rest of the world, which drives a higher US dollar, already is hurting US exports and driving more imports, which is a net negative for the US economy. The Fed thus is actively hurting the jobs picture when it raises rates without any real corresponding benefit, given that inflation is not an issue and the economy is not overheating.
The World Economic Forum recently concluded that increasing automation will force interest rates lower over time, not higher. In fact, that trend has been in place for decades already.
The bottom line is that the Fed is fighting history and current world trends if it tries to engage in a traditional rate hike cycle. The last attempt, in 2004-2006, led to an inverted yield curve and the recession of 2008-2009. There is no reason to forecast any different outcome if the Fed engages another imprudent rate hike cycle.
All that said, the Fed can and will do whatever it feels prudent based on whatever factors it considers important, however misguided in hindsight. What they say should be taken with a huge grain of salt. Anyone who follows the endless stream of speeches by Fed Governors and the like is just going to get dizzy from all the dissonance. One day a Governor say that rates should be higher for this or that reason, the next another one says the economy looks shaky and thus rate increases should be restrained. If often seems as if they are just reacting to market fluctuations rather than actual underlying economic reality.
The proper way to handle Fed-speak is to focus on the data. Don't listen to the ever-changing chirping of unofficial pronouncements of people "in the know." That will just cause confusion.
For all above reasons, unless there is a drastic change in the economic situation, I do not expect the Fed to raise rates more than once in 2016. Even that, in my view, would be a classic mistake, but the Fed already made one such mistake in December, so there is no reason to think it will not repeat the error. The more prudent course would be no rate hikes at all in 2016, and I see that as more likely than two or more rate hikes. However, my confidence in the Fed's wisdom is not very high right now.
Rate-Sensitive Instruments are Good Values
I like to use Annaly Capital Management, Inc.(NYSE:NLY) as a proxy for rate-sensitive instruments. It is very rate-sensitive and has been around for decades, surviving the vagaries of Fed policy. Below is its long-term price chart.
Annaly is trading around its lowest levels of the century. The major break in its price came when the Fed began its current tightening phase in May 2013, and it has been unable to get out of its own way since. Because the Fed has dragged out the process, first by gradually reducing its Quantitative Easing and then spending the better part of two years threatening to raise rates without doing it, NLY stock has been depressed to levels not seen since 2000, and this is indicative of the negative sentiment surrounding bond equivalents. History suggests that NLY will bounce back again as Fed policy finally takes on actual, as opposed to merely rhetorical, contours. That, at least, is what it has done in the past.
As the market catches on that the economy simply will not support higher rates, interest-sensitive instruments that took such a walloping in 2015 should stabilize and ultimately recover over the next few years. Their discounts to book value should shrink, as investors regain confidence that those values are real and not on the verge of being wiped out by an overly aggressive Fed rate hike plan. As the Fed back off, the yield curve also hopefully will become steeper again, making it easier for mortgage REITs to make money and raise/support their dividends.
REITs likely will bottom out in 2016 - if they haven't already - and stabilize until the economic picture becomes clearer. The Fed, however, must accept the economic reality that higher rates are not a good idea in the current economic climate. If the Fed goes against the grain and does ratchet rates higher, it will do tremendous damage not just to NLY, but to all similar instruments.
The economic data available suggests that the economy will not support higher interest rates, and that there is no need for them. Real interest rates already are higher than a year ago, and forcing them higher still would serve no purpose. The economy is approaching a recession, though nobody can say exactly when it will start. Higher rates could be the catalyst that pushes the economy over the edge, with great danger of an inverted yield curve if the Fed pushes forward aggressively as it has indicated recently with multiple rate hikes.
For these reasons, the Fed likely will turn increasingly dovish as the year progresses. The most likely outcome is that the Fed may hike rates once in 2016 as it tinkers recklessly with a fragile economy, and even that is uncertain.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.