Reflation's Dead Cat Bounce

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Douglas Adams


  • Financial stocks spiked above 50-day moving averages in the wake of the Federal Reserve's move on short-term interest rates, only to fall back quickly amidst broadly-based profit taking.
  • The move was curious as the yield curve was moving in the opposite direction. The 2-year Treasury note hit its highest post in more than three years.
  • An even bigger move in yields came in the wake of falling inflation, declining retail sales and plummeting oil prices signaling the demise of the reflation trade.
  • Fed intentions of beginning the long process of winding down its balance sheet added further layers of monetary tightening that markets have yet to price out.

Financial stocks took rather kindly to the Fed's 25-basis point (b/p) hike of the federal funds rate at its June meeting. The two financial sector proxies, the SPDR Financial Select Sector ETF (XLF) and the PowerShares KBW Regional Banking Portfolio ETF (KBWR), definitively broke loose from their respective 2-month stints below their 50-day moving averages for their highest market post since March. Uncertainty quickly reasserted its chokehold on investor psyche and profit-taking ensued. KBWR is now below its 50-day average while XLF is headed in that direction, on its way to completing its dead cat cycle (see Figure 1, below).

The financial sector has soared on the reflation wave since the November election, with trade volumes in excess of 250 million in the first week of December. Fanned by the drumbeat of rising interest rates and the oft-promised decoupling of the financial sector from the uber-regulatory clutches of Dodd-Frank, both chalked up a 25% market uptick by the first week of March.

As is often the case with runaway expectations, fulfillment and reality came up all too short. By mid-March, the sector had fallen below its 50-day moving average, trading sideways for the better part of two months as markets began discounting the ability of Republicans to deliver on tax reform - especially in the wake of the failed Affordable Care Act (ACA) repeal effort that capped the month.

The House bill that finally did pass two months later and did so on a strictly party-line vote remains highly controversial. Expectations were further dashed with the administration's one-page tax reform blueprint in April, which carried revenue loss estimates of anywhere from $3 trillion to $7 trillion over 10 years depending on the path of forthcoming details.

Still, shorn of tax savings from the repeal of ACA and the revenue heft of border adjustment taxes, a permanent tax proposal that envisions both a 15%-20% corporate rate and achieving revenue neutrality with the same stroke of the pen is now simply a fool's errand. With legislative enactments still sparse to date, the reflation trade succumbed to the numbing din of political distractions emanating from the executive end of Pennsylvania Avenue.

Figure 1: PowerShares KBW Regional Banking Portfolio ETF

The yield curve is a key metric for bank profitability. Bank stocks typically do well when the yield curve steepens since profitable loan growth is a function of borrowing at the short end and lending at the long end of the yield curve. Flat yield curves turn the profit proposition for banks upside down, which, in turn, typically flatlines economic growth at the local level. Curiously, financial stocks rallied in the midst of a yield curve that is moving in the wrong direction.

The 2-year Treasury note hit 1.360% intra-day (21 June), its highest level in more than three years with a resulting 2-year 10-year Treasury spread of 0.79 percentage points - the lowest spread since August 2016. At face value, the yield on the 2-year Treasury note, which is currently above the federal funds rate, implies that the Fed is done with its rate hike cycle for at least the next two years. Much money has been made by fixed income traders betting against the Fed's projections on the federal funds rate - moves the Fed had telegraphed to market players that just didn't happen.

Such betting has slowed considerably over the past several months. The Jefferies Group's, a closely held investment bank owed by Leucadia National Corporation (LUK), fixed income revenue slowed almost 29% through the end of May in comparison with 1st quarter results through the end of February. Since Jefferies reports on a fiscal year ending in November, it precedes the calendar reporting of Goldman Sachs and Morgan Stanley and is seen by investors as a bellwether for revenue growth in the sector.

Fixed income trading declines could be as much as 10% to 15% across the sector in coming weeks as earnings season start anew. Meanwhile, equity revenue at Jefferies soared $114.8 million for the quarter, a net gain of 73% on the quarter and 21% on May 2016 as the dichotomy between the equity and bond markets continues apace. One caveat of note here: Jefferies booked a $94 million market-to-market gain on its April purchase of a 24% position in KCG Holdings, a high-speed trading platform owned by Virtu Financial (VIRT). Excluding the one-off gain, equity revenue would have posted a more modest 12% gain for the 2nd quarter.

The biggest fall in US bond yields came the morning of the Fed's announcement with the release of inflation data from the Bureau of Labor Statistics and retail sales results for the month of May from the US Census Bureau. Headline inflation fell to 1.9% in May, down from 2.29% in April YOY for the lowest post since November. Core CPI fell to 1.7% for the month. Headline PCE inflation had fallen to 1.7% while core PCE had fallen to 1.5% through April YOY.

Retail sales fell 0.3%. Wage growth through the end of May came in at 2.5%, which meant wages were staying ahead of the rate of inflation, but certainly not at a level where the expectations of a boom in consumption was deemed imminent. The assumption here is that if wages do not follow the inflation target higher, the result will likely entail a reduction in living standards and a further shift in resources from labor to capital.

Translation: The haves get more and the have-nots less of the total economic pie. Furthermore, world oil prices continued their downward descent as excess supply relentlessly pressured prices from all directions. OPEC production actually rose 1% during the month according to in-house OPEC market data, as Libyan output improbably hit 885,000 barrels/day last week. The output was triple what the country brought to market only last year amidst widespread civil strife throughout much of the country.

Because of that strife, Libya and Nigeria and sanction-weakened Iran were granted free passes from OPEC production cuts. Brent pricing has fallen almost 16% since OPEC's May extension of production cuts that will now run through March 2018. On the year, Brent and West Texas Intermediate (WTI) crude are both in bear territory, down 21.42% and 23.30% respectively through yesterday's close (22 June). The exempted countries' growing output - not to mention the output of the US - is an obvious headwind on the cartel's ability to control, let alone reduce, current world crude supplies.

All told, the reflation trade is clearly history. Falling prices now registers more of a concern to policy makers and investors alike as the impact of plummeting energy once again migrates through the economy. In the meantime, the yield curve continues to flatten.

The myriad causes now enveloping forward growth are many - from vastly diverging central bank policies across the developed world to investor carry-trade activity from low- to high-interest rate environments to regulatory requirements that claim ever greater proportions of available high-grade paper to falling inflation to the exorbitant cost of tuition and healthcare inhibiting consumption to flat wage growth and worker productivity measures to the souring fixed-investor sentiment on growth.

In other words, pinpointing the specific cause of falling long-term yields remains fiendishly problematic. Nevertheless, investors poured just over $1.4 billion into the financial sector according to news reports on the eve of the Fed's June rate setting meeting, producing a sharp market move in both financial proxies that sent the financial sector up almost 5% for the month to date (see Figure 1, above). Investors are curiously locked between the push of fiscal expansion and the pull of monetary tightening - as the economy continues its slow but methodical path forward.

Monetary policy, like it or not, is the only real game in town. That said, the market remains skeptical of the Fed's ability to complete its troika of rate hikes slated for 2017, assigning a tellingly low 25% probability of such a happening through the end of the year. Meanwhile, the Fed has another vise-like tool up its sleeve that it hopes to employ by year's end. The Fed has a $4.5 trillion balance sheet that needs to unwind, and the supplementary notes on the subject were released for public consumption at the June meeting.

The Fed's balance sheet will most likely not return to pre-Great Recession of 2007 levels that were about $800 billion. The demand for cash has almost doubled in the ensuing decade from about $800 billion in May of 2007 to $1.5 trillion through the end of last month. At the economy's current growth rate of about 2%, the demand for cash will approach $3 trillion by 2027, according to Fed estimates. This means the Fed's balance sheet will likely not fall below the $2.5 trillion to $3 trillion level at the end of the long road of unwinding its balance sheet.

The unwind is as follows: The Fed will shed $10 billion a month from its portfolio of securities for three months split 60:40 between Treasury notes and mortgage-backed securities (MBS). After successfully completing this first phase of the wind-down, the Fed will increase the pace by another $10 billion over the next three-month interval at the same proportional split between Treasuries and MBS.

Payments of principal the Fed receives on maturing Treasury securities will be capped at $6 billion per month with proceeds over the cap being reinvested. The cap will increase in increments of $6 billion over three-month intervals over 12 months until the cap reaches $30 billion/month. For MBS, the cap will be set at $4 billion over the same period of time until the cap reaches $20 billion/month.

The current projection to completion of both tasks is about 3-5 years with the balance sheet shrinking by about half from current levels. Market optimists see the Fed's plan as a smooth transition to a more balanced portfolio given the Fed's transparency and patience in following the program through to its logical conclusion. Market pessimists see nothing but trouble: The Fed's various renditions of large-scale asset purchase programs have left bond markets deeply distorted and no matter how transparent, patient and methodical the Fed unwind program proves to be, market shocks are inevitable. The reality of the unwind remain daunting and roadmaps simply do not exist.

  • The Fed owns about 25% of all MBS in the market not already owned by Fannie (OTCQB:FNMA) or Freddie (OTCQB:FMCC). To date, there is no private sector player with the financial heft to replace the Fed in the MBS market as either buyer or seller. The Fed's presence in the MBS market has kept a tight lid on mortgage rates, which forms the keystone of the US housing market. A steady stream of MBS into the market could easily send mortgage rates skyward, placing a chokehold on would-be homebuyers forced to enter the credit markets to finance their purchase.
  • On the Treasury side, the Fed now owns more securities on the long side of the yield curve than on the short end of the curve. Letting these securities mature may further flatten a growingly curve-less yield curve by lowering long-term yields relative to short-term yields, which will continue to rise with each incremental 25-basis point bump in the federal funds rate. Since the maturities of long-term Treasuries retire at more distant time frames, the curve-less yield curve could endure well into the future.
  • And then there is the issue of whether the Fed's unwinding of the balance sheet will run simultaneously with increasing the federal funds rate. Market-based inflation expectations have fallen in response to declines in April and May headline and core inflation measures while consumption remains weak. The combination offers up strengthening headwinds against an aggressive tightening regime that currently has not been priced in by the greater market. Investor sentiment at any juncture along the way could fall off triggered by myriad events, least of which the lack of policy progress and endless political distractions emanating from Washington. Sharply rising mortgage rates at the start of the mid-term 2018 electoral cycle carry obvious political risks.

While the Fed's future path on both interest rate hikes and the unwinding of its outsized balance sheet are slowly coming to light, forward economic data most certainly carries the potential of upending the Fed's carefully choreographed plans of mice and men. Still, markets across the globe remain awash in calm. The VIX has been trading at roughly half its average of 19.54 on data back to January 1990 since the election with an average reading over the period of 11.90.

Large swings in Asian and European markets have largely disappeared according to news reports, the result of central bank activity, improving market conditions, positive corporate earnings - and perhaps more than a dollop of investor complacency. Investors reaching for more speculative market opportunities have turned to such non-market sectors like art, wine, collectibles and pseudo-currency trading in bitcoin.

The cyclical return of falling prices could change volatility measures. The average reading on the VIX from January 2016 through election eve was 16.32. With the demise of the reflation trade, the VIX could be on the cusp of returning to more historic levels. Stay tuned.

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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