The Clash Of Expectations

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Douglas Adams


  • Market expectations on expanded economic growth in the New Year appear to clash with the rising strength of the US dollar and the Fed's ability to increase short-term interest rates.
  • While markets project enhanced economic growth for the New Year, the increase in the federal funds rate increases debt service costs for consumers and mortgage rates for home buyers.
  • Economic growth from anticipated tax cuts, deregulation and infrastructural spending will assuredly be offset by Fed increases in short-term interest rates.
  • Meanwhile, the BOJ, the BOE and the ECB will pump over $500 billion into their respective economies through the end of the year; EM space strains under a strong dollar.

Since well before the official end of the Great Recession of 2007, the baseline rate for all borrowing throughout the developed world has been largely defined by a zero lower bound rate of interest maintained throughout the period by the Federal Reserve. From household savers and borrowers to sovereign debt issues by governments, to institutional investors to home mortgage borrowers to corporate borrowers to shareholder enhancement programs to investors searching the world for yield-zero rates of interest have defined investor and borrower behavior in the debt markets for the duration.

It has been a year almost to the day since the Federal Reserve last raised the federal funds rate at its December 2015 meeting. After penciling four additional increases for 2016, the Committee finally raised the rate again last week for only the second time since 2006, as time and again during the course of the year weaker than expected economic conditions both in the US and abroad disrupted the Fed's clockwork-like time table. As if on cue, the dollar soared on the expected announcement. While economic conditions here in the US have improved, structural constraints remain-particularly weak productivity caused mainly by an ever aging labor force combining with a low growth rate in the work-aged population due in part to the impact of equally low national birth rate. Wage growth remains below trend as middle income factory work and goods production continues to be replaced by lower income service jobs. These conditions will likely continue into the New Year and beyond, exerting downward pressure on overall growth in the New Year and beyond. At the same time, economic conditions throughout the developed world and emerging market space remain tenuous. The central banks of Japan, Europe and England will combine to spend well over $500 billion in the 4th quarter on sovereign and corporate debt-the largest sum of asset purchases since the early days of the Fed's own program first launched in 2008-09 during the heat of the financial crisis. While the Fed has penciled in three increases in short-term rates for 2017, weak economic conditions and perhaps other events in the political realm could thrust to the fore and thwart such expectations yet again.

Of course expectations could change on a dime: It was only this past July when the yield on a 10-year Treasury note hit a record post-WWII low of 1.36%, did interest rates finally sketched out a trough and reversed course, soaring to Friday's market close (16 December) of 2.59%-its highest post since September 2014. During the so-called "taper tantrum" in May of 2013, when then Fed chair Ben Bernanke hinted at winding down the US large-scale asset purchase program at the time, the yield on the 10-year benchmark similarly soared from 1.6% at the start of May hitting 3% by September before falling steadily through much of 2014 and eventually falling below 2% by January of 2015. This go around, the combination of a defining national election and the second 25-basis point uptick in the federal funds rate since 2006 has sent market expectations soaring. The US dollar hit a 13-year high against a basket of world currencies, pressuring currency pegs to the dollar throughout the emerging market space. Currency pegs in the Nigeria, Kazakhstan, and Azerbaijan have already unraveled sending local currencies valuations spiraling downward while interest rates and inflation streaked skyward under the onslaught. The recent agreement by Kazakhstan and Azerbaijan with OPEC to limit oil production will be severely tested in the New Year in the face of wildly fluctuating local prices, interest rates and currency valuations that will beckon loudly to produce-and sell-as much oil as possible on world markets to ease their local economic plight. Both Libya's and Nigeria's production was exempted by the Vienna agreement due precisely to both countries' severe, strife-riven economic conditions. Nigeria's currency is down more than a third since abandoning its dollar peg in June while the twin ills of soaring inflation and interest rates continue to grind economic growth to a standstill. Other more established currency pegs to the US dollar in such diverse places such as Turkey, South Africa and Brazil are also experiencing strong gyrations in interest rates and currency valuations that continue to rock their respective economies. OPEC member states Saudi, Kuwait, Qatar and the UAE have spent billions in foreign exchange reserves propping up their respective currencies from the twin evils of falling crude prices since June of 2014-and more recently against a rampaging dollar. That crude oil prices are denominated in dollars merely serves to add a third layer of economic pain.

The euro, the yen and the pound have not escaped the dollar's reach. The euro peaked for the year at $1.1535 against the dollar in the first few days of May has fallen fairly steadily to a market close of $1.0451 (16 December)-its lowest post since the end of 2002. Similarly, the yen was at its strongest against the dollar as recently as July at $100.55-the yen's strongest post since November 2013. By mid-December, the yen had fallen to $117.92 against the dollar-a move of over 17% in the space of less than five months. Of course the pummeling of the pound in the wake of the Brexit vote on the 23rd of June offers a special case study in the annals of forex but nevertheless the pound still trades against the dollar at levels last seen when Margaret Thatcher resided at 10 Downing Street.

Nor has the renminbi fared much better: Pegged at Rnb6.9593 at Friday's market close (16 December), the renminbi is at its lowest level since 2010 and stands poised to break through the psychologically important Rmb7.00 threshold as the dollar continues to strengthen. The renminbi is down 6.7% on the year-and will continue to fall well into the New Year and beyond. The country happens to have one of the world's most leveraged corporate sectors, a wildly volatile housing sector and the world's highest debt-to-GDP ratio making China particularly sensitive to global interest rate moves. The dollar's strength has already forced the PBOC to spend down an estimated $47 billion in foreign currency reserves through the end of October. That figure rose to $69 billion in November, the fifth consecutive monthly decline. The PBOC has also recently tightened short-term borrowing access to further curb investors' speculative appetite for placing bets against the renminbi. Further moves against capital flight include the State Council recently issuing a decree tightening the regulations around overseas investments by Chinese firms outside their core business operations. Further slippage in the renminbi-dollar exchange rate moving forward is a foregone conclusion as China's economy continues to slow while at the same time as US monetary policy continues to tighten. Exports eked out a 0.1% gain in November year-over-year-the first such gain since March on the back of a 7.3% decline in October.

Currency pegs throughout the emerging market space as well as new lows for the euro, the yen and the pound will continue to be tested throughout 2017 as the divergence between the economic fortunes of the US and much of the rest of the world become all the more defined in the New Year with the highly anticipated rollout of fiscal policy initiatives by the incoming Trump administration. Market expectations since the election are clearly signaling an uptick in growth and inflation which has pushed bond yields up and bond prices down. The national unemployment rate, currently at 4.6% and a nine year low, could fall even further. The rollout of fiscal policy, rising markets, increasing yields and an uptick of inflation will unquestionably elicit a response from the Fed and for the first time in years, the Fed's forward projections on the federal funds rate for 2017 appear realistic-three increases in short-term interest rates with a median ending rate of 1.4% by the close of 2017-up from 1.1% median value and two projected increases in the federal funds rate from September's SEP projections.

The clash of expectations continues: Contrary to market forecasts, the Fed's median SEP projections see GDP growth for the New Year at 2.1%. While SEP forecasts fall a full point below the 3.2% final growth number for the 3rd quarter, one-off export gains during the quarter heavily skewed the final number and is not expected to be repeated in the 4th quarter or beyond. The SEP is likely a more sustainable growth trend that better mirrors the less than 0.5% growth of the country's working age population or the lower productivity levels that go hand-in-hand with an aging workforce, lower birth rates and the long exhausted productivity gains from women entering the workforce en masse for the first time. The median Fed headline inflation as measured by personal consumption expectations (PCE) projects out at 1.9% through the end of 2017, still below the Fed's 2% inflation target. At the core level, which excludes the volatile energy and food sectors of the measure, the median projection comes to 1.8%, also below the Fed's 2% inflation target.

The equity markets continue to discount the Fed's ability to increase short-term interest rates as well as the path of the dollar which continues to strengthen in world currency markets. While US exports make up a small portion of overall GDP growth, the strength of the dollar will clearly create headwinds for corporate earnings, not to mention emerging markets growth as a strong dollar squeezes local currency values and economic growth while sending inflation and interest rates skyward. In the rest of the developed world, central banks continue to actively fund their large scale asset purchase programs attempting to coax both an uptick in inflation and growth by lowering overall borrowing costs in the greater economy. Still, borrowing costs in the European peripheral states of Italy, Spain and Portugal are on the rise as spreads between peripheral countries and Germany continue to widen. Here in the US stocks have been buoyant since the election, yet increasingly those gains appear to be coming on the back of fixed income investors as rising inflation expectations continue to erode the gains of long-dated debt-a typical trade to offset the uptick in short-term borrowing costs. On the price side, the increase in yield wreaks havoc on bond positions purchased at a premium as capital gains quickly turn to outsized capital losses. The yield on the 10-year Treasury note has leaped almost 40% or three quarters of a percentage point since the election. The yield premium investors are demanding to hold a 10-year relative to a 2-year note is now 1.33 percentage points through Friday's market close (16 December). This is the highest spread since December 2015. About half of the gain is due to rising inflation expectations.

In spite of the difficulties fixed income investors continue to encounter as yields rise and prices fall in US markets, foreign fixed income investors continue to pour capital into the US Treasury market. A degree in rocket science is not necessary here: the spread between the 10-year Treasury note which closed at yield of 2.591% and the comparable German Bund at 0.317% through Friday's market close (16 December) is a whopping 2.27 percentage points-the highest spread since the fall of the Berlin Wall. An even higher spread can be had in relation to the Japanese 10-year note which closes at 0.082% for a spread of 2.51 percentage points. Japan is the second largest purchaser of US Treasury notes behind China with around 60% to 70% of Japanese international bond purchases directed toward US shores. The spread between the US 10-year note and the 10-year British gilt is less of a shock: at a yield of 1.294% through Friday's close the resulting spread is a more "reasonable" 1.297 percentage points. Dollar based assets will continue to attract foreign capital flows like a magnet for the foreseeable future. Further, the yield differential between US Treasury notes and those of the rest of the traditional "safe harbor" plays in the developed world will likely place cap US yields on the upside for the foreseeable future.

As the yield curve steepens the earnings potential of bank stocks large and small, particularly for small-, mid-sized and regional banks as borrowing on the short-end and lending at the long-end of the yield curve, becomes more profitable. That said, short-term borrowing costs for the nonfinancial sector are rising fast, hitting levels not seen in the past eight years as 3-month LIBOR rates cleared 0.96%. The 3-month LIBOR was 0.53% this time last year. The increase is an important gauge for the ability of companies to grow faster than the rate of increase in borrowing costs to finance ongoing operations. While the increases in LIBOR are mostly regulatory related, if growth expectations actually lag operational financing costs overall growth in the economy comes under pressure further depressing earnings moving forward. Current market expectations could crash.

On the long end of the yield curve, borrowing costs for companies at the lower and lowest rungs of the investment grade ladder are fast approaching 5%-the highest post since early spring. Borrowing costs for Baa-rated companies had fallen to as low as 4.15% as late as July when the total amount of negative yielding bonds, mainly concentrated in Japan and Europe, peaked at $14 trillion. Corporate bond yields have been rising in lock-step with the sell-off of sovereign debt in the wake of the Trump's surprise Electoral College win. The market shift from bonds to equities has specifically favored-rightly or wrongly-financial, infrastructural, defense as well as mid- and small-cap stocks. Long-duration bonds remain under pressure due to the Treasury debt that will need to be issued if Trump's fiscal spending programs on infrastructural actually pass muster with Congressional deficits hawks that presumably lay in wait.

And then there are those 92 million consumers who have outstanding loan balances on variable rate credit cards, according to TransUnion data. With the Fed's 25-basis point increase in the federal funds rate, the prime rate has followed suit, rising from 3.50% to 3.75% as debt services costs tighten. Ditto with the housing market as the 30-year fixed rate has soared to 4.16% through the week ending 15 December, up from 3.54% before the election.

Market expectations are clearly signaling higher levels of economic growth from the incoming Trump administration. Yet tighter financial conditions at both ends of the yield curve in the US point in a rather different direction-one characterized by slower not faster growth. A strong dollar tightens growth in emerging markets by fanning inflation and interest rates while depressing valuations on local currencies. Commodity exporting countries are doubly disadvantaged by having their main source of exchange denominated in US dollars.

With everything said thus far, the Fed appeared to go out of its way with its silence on whether the surprise Trump victory in the Electoral College materially changed the Fed's economic outlook moving forward. December's SEP projections saw no change in inflation at either the headline or core levels from its pre-election September SEP valuations of prices in the greater economy. Overall GDP growth notched up slightly in December to 2.1% from 2.0% in September, while the unemployment rate inched down to a national rate of 4.5% from September's 4.6% forecast. The biggest change between the two projections was with the federal funds rate where December's plot priced in a third increase in short term rates ending 2017 with a 1.4% over September's two increases for the year with an ending rate of 1.1%. The Fed's statement reiterated its view that the Committee expected "…that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate… ."

For the first time since the American Recovery and Reinvestment Act (2009), there is a real chance for the incoming Trump administration to launch a fiscal stimulus response to the Fed's monetary policy of old. The Republicans control all branches of government and infrastructural spending, tax cuts and economic growth were all topics of conversation during the course of the Trump campaign. Few details on such policy initiatives have yet been committed to paper. Still, the fact has not stopped market expectations from running rampant in anticipation. The binary nature of the bond markets have clearly signaled an uptick in inflation as yields on debt issues have surged since the election. So have equity markets. The dollar has surged in world currency markets.

In the Fed's view faster economic growth could trigger higher inflation, an event to which the Fed would likely respond; the greater the stimulus the faster the pace of offsetting increases in the short term interest rates. At the moment, the potential of faster economic growth appears to fit well into the Fed's forward economic outlook: A faster rate of increases in the federal funds rate gives the Fed more of a monetary cushion against future economic downturns. In the meantime, the Fed appears content with a wait-and-see approach to potential stimulus flows from the fiscal side of the aisle-which explains much of the lack of change in the Fed's December forecast. Current market expectations regarding future Trump fiscal policy initiatives are clearly ahead of FOMC thinking. Yet it is always important to remember the fact that major policy changes take time to formulate and the dance of legislation twists and turns in unpredictable directions over equally unpredictable periods of time before policy statements become the law of the land--let alone when the first shovel breaks ground. Janet Yellen was given ample opportunity during her press conference to comment on the merits of the Trump initiatives to date and carefully refrained from doing so. Market expectations to date have been much less restrained. Any pending clash between fiscal and monetary policy could stretch years into the future.

The economy continues to make progress with growth likely at the new normal of roughly 2% annualized. The unemployment rate is at a nine year low while inflation remains largely quiescent-signaling more slack is likely present that could be squeezed out of the labor market. The Fed's December increase in the federal funds rate was "a vote of confidence in the economy, a characterization used in a response to a question during Yellen's press conference following the meeting." The Fed can still afford to be patient.

This article was written by

Douglas Adams profile picture
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.

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.

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