The Federal Reserve recently released their meeting minutes for 04/26/2016 to 04/27/2016. The results didn't have a huge impact on the S&P 500 but it sent the market for fixed income securities and other yield securities into a bit of a frenzy. When I talk about "other yield securities," I am including triple net lease REITs like Realty Income Corporation (NYSE:O) and National Retail Properties (NYSE:NNN). Most REITs could be included, but the ones with lower yields and very durable revenues were taking some of the worst beatings. The mortgage REIT sector also got hit pretty hard with Annaly Capital Management (NYSE:NLY) down over 2%.
The Federal Reserve is talking about raising short-term rates and they are in a bad situation. It would be substantially more useful if they could talk about selling off part of their bond portfolio but that would really send the bond markets wild. The problem the Federal Reserve faces now is that they are essentially dealing with macroeconomic situations, while having only one major policy tool. That tool is the short-term interest rates. The Federal Reserve sets the level of interest to be paid on excess reserves and it creates a bit of a floor on the rates that investors would expect to see in the market. It isn't a hard floor since there are several entities that are not eligible to earn interest on excess reserves. You might have a savings account that receives a terribly small amount of interest.
The following chart by CME Group demonstrates the implied probability of a rate hike at the June meeting:
The first thing investors will see is that the implied probability suggests about a 44% chance for an increase. However, if you look at the numbers in the top right corner you'll notice that on the previous day the implied probability of a hike was 15% and a month ago the implied probability (still talking about the June meeting) was a mere 1.2%.
What They Said
There are two sections from the release I want to highlight so I can provide a simplified version.
"Federal Reserve communications following the March FOMC meeting were interpreted by market participants as more accommodative than expected. In particular, investors were attentive to the larger-than-expected downward revisions to the projections of the federal funds rate in the FOMC's Summary of Economic Projections as well as to references in the March FOMC statement and the Chair's prepared remarks at the press conference to risks to the U.S. economic outlook stemming from global economic and financial developments. Meanwhile, domestic data releases were mixed and elicited only modest market reactions. On net, financial market quotes implied that the federal funds rate path expected by investors flattened notably, and that their estimated probability of a rate hike by the June FOMC meeting declined significantly. In the Survey of Market Participants, the median investor's modal path for the federal funds rate also moved down substantially, while in the Survey of Primary Dealers, the median dealer's modal path was little changed."
They also said:
"Over the intermeeting period, broad U.S. equity price indexes moved up, on net, likely because of investors' views that monetary policy would be more accommodative than previously expected along with an improvement in risk sentiment. Stock prices increased broadly across industries, including the energy sector. One-month-ahead implied volatility on the S&P 500 index--the VIX--moved down and ended the period below its historical median. Spreads on 10-year corporate bond yields over yields on comparable-maturity Treasury securities for both triple-B-rated and speculative-grade issuers declined, on balance, but remained at levels near the high end of their ranges since 2012, as the outlook for corporate earnings deteriorated somewhat over the period. In light of available earnings reports of some companies in the S&P 500 index along with equity analysts' forecasts for companies that had not yet issued reports, corporate earnings in the first quarter appeared to have decreased markedly relative to the previous quarter."
The Federal Reserve is telling investors that they noticed the S&P 500 is getting expensive despite weak future earnings, and the signals for market volatility are moving down despite the valuation being on the high end. They also pointed out that after their last minutes were announced the market became more comfortable with the idea that further hikes were not in the near future. They don't want the market to be that relaxed because it is driving a flat yield curve (which typically precedes a recession) and it is driving up share prices, which increases the potential for a significant fall.
The Federal Reserve is working to get into a position where they can convince investors that short-term rates will be increased so that they can do it without shocking the market. In theory, if they can raise short-term rates, it would give them some room to provide easing when the next recession hits. Realistically, there is a substantial problem facing the economy. While the job reports were improving significantly, unemployment was still effectively understated because the unemployment rate does not create adjustments for a decline in the percentage of the population that is actively seeking work. The low oil prices also create the potential for temporary disruptions, as layoffs in the sector will lead to people needing other jobs. While cheap oil prices fuel other consumption that eventually leads to other jobs, the transition is far from immediate.
If the Federal Reserve were simply managing two mandates - full employment and 2% inflation - the simple answer would be that there is no case for raising rates in the short term. The longer answer is more complicated. If the Federal Reserve really wants to prevent another recession, then they want to avoid seeing the yield curve inverted or the S&P 500 reach such lofty valuations that it can deliver the kind of dive seen at the start of the century. In effect, the Federal Reserve's mandates are starting to extend to managing the shape of the yield curve and the level of the S&P 500 because those factors can lead to recessions, which would in turn weaken employment.
If the bond yields are pushed higher and the triple net lease REIT sector continues to sell off (due to correlation across asset classes), I may add to my position in NNN or acquire some O.
Disclosure: I am/we are long NNN.
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