The Federal Reserve Demurs

Jun. 17, 2016 7:09 AM ETTU, NTT, WPC, PBT, T:CA4 Comments
Douglas Adams profile picture
Douglas Adams
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Summary

  • The probability of an increase in the federal funds rate in 2016 is about 28%. Currently six of 17 FOMC voting members project just one rate hike for the year.
  • Foreign events will continue to heavily influence Fed decisions given the outsized dominance of the US dollar in global financial transactions.
  • Low probability of a federal funds rate in 2016 augments dividend plays in the greater market.

The Federal Reserve evoked little market surprise by voting to keep the federal funds rate unchanged at its June FOMC rate setting meeting. Fed Chair Janet Yellen presented a mixed economic report at her press conference announcing the decision:

  • Total industrial production fell in April by 0.4% month over month, largely wiping out the 0.6% gain in March. Manufacturing and utilities both fell during the month while mining managed to eke out a 0.2% gain for the period. Year-over-year mining, which includes the oil and gas sector, plummeted 11.1%, while manufacturing fell 0.1% and utilities fell 0.8%.
  • Consumer spending remained robust, increasing 1% in April after no change in March. Disposable income also gained 0.4% for the month.
  • Export prices rose by 1.1% in May while import prices increased by 1.4% as the dollar has fallen almost 5% from its year-to-date peak in late January. Increasing export prices should add to GDP growth in the 2nd quarter. Then again, a series of recent polls have breathed new life in a Brexit scenario which has raised investor angst across both Europe and the globe.
  • Corporate capital investment remains anemic, falling in the past two consecutive quarters. The last time that happened was in the 3rd and 4th quarters of 2009. Further bad news came with the announcement of a report by Wood Mackenzie that oil and gas investment will drop $1 trillion from planned spending due to the slump in oil prices worldwide. Oil and gas investment in the US is expected to fall about $125 billion through 2020.
  • While the national unemployment rate fell to 4.7% (for the wrong reasons) and wage growth remained at 2.5% year over year during May, job growth surprised to the downside, creating a miserly 38,000 positions - the lowest total since September 2010. The Labor Market Conditions Index (LMCI), a 19-measure compilation of labor market indicators plummeted 4.8% for the month, its steepest slide since May 2009. The LMCI has now fallen in every month of 2016, a consecutive string exceeded only during the period from May 2007 through June 2009.

Even the Federal Reserve Bank of Kansas City President Ester L. George, a long-time interest rate hawk who dissented in both the March and April FOMC meetings, made the vote to keep rates unchanged unanimous.

Figure 1: Supplementary Economic Projections (SEP): The Median Federal Funds Rate Projections

2015

2016

2017

2018

Longer

June 2016

0.9

1.6

2.4

3.0

March 2016

0.9

1.9

3.0

3.3

Dec. 2015

0.4

1.4

2.4

3.3

3.5

Sept. 2015

0.4

1.4

2.6

3.4

3.5

June 2015

0.6

1.6

2.9

-

3.8

What is interesting about the evolution of FOMC thinking in regard to the federal funds rate is how the compilation of projections has fallen over the course of the past year. The projection through the end of 2016 dropped dramatically from 1.6% in June of 2015 to 0.9% a year later. Similarly, projections for 2017 have fallen from the 2.9% projections in June 2015 to 1.6% at Wednesday FOMC meeting (see Figure 1, above). Six FOMC voting members now project just one increase in the federal funds rate this year, contrasting sharply with March's SEP where no one projected such an outcome. The language Chair Yellen used to characterize such an increase degraded significantly from her speech before the World Affairs Council in Philadelphia earlier in the month to Wednesday's press conference. A rate increase "…in the coming months" indeed differs in both style and content a rate increase characterized as "…not impossible."

Meanwhile, the 30-day Federal Funds Futures quotes on the Chicago Mercantile Exchange this morning (16 June) place the probability of a rate increase at the July meeting at below zero while an increase at the September meeting carries a 10% probability. An increase by the December FOMC meeting is just 28%. While the volatile nature of the measure is duly noted, once again, the Federal Reserve appears well out ahead of market expectations.

Is there a market play at current levels of uncertainty? Given the high levels of market distortion in the bond markets and with the increasingly low probability of the Federal Reserve pulling the trigger in all of 2016, dividend stocks will continue to outperform. Telecommunication positions like Canada's Telus (NYSE:TU) and Japan's Nippon Telegraph (NYSE:NTT) provides international exposure, strong earnings and solid dividend streams to yield hungry investors. NTT will continue to benefit from copious levels of liquidity being pumped into the Japanese financial system by the Bank of Japan.

In commercial real estate, W.P. Carey (NYSE:WPC) continues to be an outsized player with strong earnings in both the traded and non-traded space. WPC's current yield of 5.7% yield pales against the 1.51% yield of the US 10-year Treasury.

For the more adventurous investors, Permian Basin Royalty Trust (NYSE:PBT) combines outsized appreciation with strong dividend yields. The Permian basin straddles the Texas and New Mexico border and is one of the largest oil and gas plays with one of the lowest cost structures in the country.

May's job report is more likely than not a one-off event. The margin of error used by Bureau of Labor Statistics in gathering the data for the report carries a 90% confidence factor. This means May's job tally creates a range of ±115,000 jobs. With such a wide dispersion, revisions are almost guaranteed as more employment information comes to the fore. One month does not a trend make - but such an outsized diversion from consensus forecasts certainly commands attention. The Verizon (VZ) strike during the collection period caused upward of 35,000 workers nationwide to fall out of the labor force, workers that will be reinstated in June's count. Job growth is a noisy series and the Verizon strike explains at least part of the bad news. On six different occasions since the beginning of 2011, monthly hiring gains have dipped below 100,000 only to bounce back above that threshold in the course of a month's time. While international events continue to hamper economic growth, pronouncements on the end of the recovery process in the US are likely exaggerated. That said, international events will continue to factor heavily in Fed decisions on the federal funds rate for the foreseeable future. The dollar retains its outsized presence in the global financial system - 87% of all currency transactions, 60% of all central bank reserves and 62% of all international debt, according to data compiled by Morgan Stanley. The Federal Reserve's jurisdiction extends well beyond the borders of the US.

This article was written by

Douglas Adams profile picture
1.58K Followers
Douglas Adams specializes in macro-economic research and turning theory into practical portfolio applications for clients over the past seventeen years. Mr. Adams recently formed Charybdis Investments International based in High Falls, New York where he is the managing director of a fee-only investment advisory practice with clients throughout the United States. As an author, Mr. Adams has commented widely on a diverse array of topics from Brexit to monetary policy to forex to labor productivity and wage growth. He holds an undergraduate degree from the University of California, a master’s degree from the University of Washington and an MBA in finance from Syracuse University.
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Disclosure: I am/we are long PBT, NTT. 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.

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