Oct 6, 2017 - Older people's income and wealth gains outpace the rest of us, but they ... Most members of the FOMC adher
Why TitleThis Hiking Cycle Might be Different October 06, 2017 By David Ader, Chief Macro Strategist for Informa Financial Intelligence
Ader’s Musings… • When do we stop listening to Yellen? • Big question for me is how 2018 FOMC holds to hiking – via the Funds rate or Balance Sheet? -- Warsh might use balance sheet, which would tend to steepen the curve. Taylor has his rule which would put Funds over 3%. • Base effects give Fed room for hikes in H1, then revert. -- but do note real disposable income continues to disappoint. • Older people’s income and wealth gains outpace the rest of us, but they are savers, not spenders. • The media looks at potential Fed chairmen, challenges tax cuts as a growth impetus, cautions that deficit boosting tax cuts are a bad idea. When do we stop listening to Yellen? This is, of course, a reference to the impending potential change in her career. Bear in mind we will likely be listening to her even if she’s out of the Fed – brains, insight and experience do count for something – but her relevance will, like other ex-Fed officials, tend to diminish with time. For now, she’s got at least one hike to go in the FOMC meetings she has left to chair. (Her term expires Jan 31 which is also the last date of a two-day FOMC meeting. I presume she’ll let her successor take the reins if not reappointed and, having hiked in December, both will find little to do. That alone may be another reason to hike in December come to think of it.) So, in answer to the first question, don’t stop listening yet. The context of that comes with the current odds of a Dec hike, about 75%, and her recent dismissal of low inflation as due to various transient factors. In any event, low inflation heretofore has not changed the Fed’s bias, indeed they seem a bit more adamant, and so that extracts the main inhibition to keeping a hike priced in. After that, bets are off. The tax code and changes to it are first and foremost. The current mindset of the Fed would, I think, greet that with a somewhat more aggressive policy since they are already worried about the level of unemployment, expecting higher inflation, and talking about asset prices being warily high. The newer Fed members in theory will be closer to Trump’s mindset (oh jeez) at least in terms of economics and so perhaps be more patient with seeing how tax and other policies play out. Are they then more bullish for the bond market? The Fed has two monetary policies at work; the Funds rate and related instruments at the front end and the balance sheet further out. The traditional camp is likely to go slow initially in playing with the balance sheet, meaning sticking to the current trajectory barring a recession. No one knows how that will unfold and to the extent building it boosted stocks and risk assets, unwinding it may hurt especially if 2% (plus or minus) GDP is here to stay. And there will soon be more issuance for everyone to buy, all things being equal, and underwritten by a Treasury-dealing community that ain’t what it used to be.
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Title Traditionally, a hiking cycle flattens the curve. A slow hiking policy against balance sheet reduction, perhaps accelerated if Trump chooses a Warsh or another ‘outsider’ of the Fed, may inhibit that tradition. I’m not sure how easing up on bank regulations might impact the curve, but to the extent banks like a steeper curve and incoming Fed officials favor deregulation, then I’d say fewer hikes and more push for the balance sheet reduction, thus creating the risk of a hiking cycle have less of a flattening curve inclination. For the umpteenth time, I will say that increased Treasury coupon issuance may encourage that as well. CHARTS AND THEMATICS: To relay that at 1.4% YoY PCE inflation has been disappointing to bondmarket bears is hardly noteworthy. Most members of the FOMC adhere to their view that inflation will rise, eventually, to their 2% YoY target and have used that view as a part, a large part, of their rationale for hiking thus far. Stop me if you’ve heard this one before. Well, they’re not quite getting there though are sticking to their guns that it will appear eventually. That remains to be seen, of course, but I will offer up a scenario that lends itself to at least an excuse for more hikes by the middle of next year. This is simply the base effect meaning that a ‘low’ rate of inflation in a given period can generate a ‘high’ rate of inflation in the corresponding period a year later even if the overall rate of inflation really is just steady or, at least in mathematical terms, smaller. It doesn’t mean inflation is really accelerating; rather it means that it was optically lower the year before and so the YoY gain appears high.
Legitimate economists will cringe at the chart above as any sort of a model or predictive formula but then I suspect few would characterize me as a legitimate economist so I can get away with things. To wit, over the last 17 years (more actually) the base effect does anticipate itself. In other words, that we are coming off some low inflation reads this year suggests higher YoY inflation reads in Q1 and Q2. This, I offer, as a potential slant for a couple of Fed hikes by the middle of next year. It’s not rocket science and I’m not saying it’s so. What I am saying is that the reverse also holds true; if we see an uptick inflation presumably the base effect will make it appear relatively softer a year later.
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Title Blend that with tax breaks to come, balance sheet reduction adding to the float, larger Treasury auctions due to a bigger deficit and you have more of the current fears to produce a spike in rates for a while. The latter would correspond with bearish seasonals in the first half of a given year as well.
On the topic of inflation, I stole an idea from Lou Crandall of Wrightson ICAP looking at several measures of inflation: “It is one thing for the Fed to look past the low level of the YOY growth rate resulting from the string of soft readings earlier in the year; it is quite another to ignore a continued decline in the YOY inflation rate heading into the autumn.” This does not detract from the inclination the Fed has to hike. Lou also notes that in her recent speech on the topic Yellen talked about….yawn….seasonality of inflation as a factor keeping it down into the end of the year. The details are too dreary to review in detail, but suffice it to say that the Fed has ample excuses for the moment to continue to look past some low inflation reads and stick to their hiking impetus.
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Oh, but for all the good news on low inflation it would be nice for wages to outperform better. At the end of September, with the release of August Personal Income data, we learned that Real Disposable Income fell 0.1% MoM, the weakest of the year, and is only up 1.2% YoY, which perhaps helps explain the pretty light spending habits of late. Did you catch the blog from the St Louis titled “Long-term Household Income and Wealth Favor Older Americans”? (https://goo.gl/K5Efsp). It’s a rare bit of good new on aging demographics which shows older fogies’ median household wealth and inflation-adjusted incomes outperforming everyone else. Among some of the other items, it shows that nearly all folks over 65 are covered by Medicare (we’ll see how long that lasts) and that their share of poverty is the lowest in the population, which surprised me. But it’s the income and net worth angle that got me because, I think, they have implications for investment and spending. First, on the income side, an index shows gains for 65+ have been stellar relative to the rest of the population. This doesn’t mean they’re rich; in constant prices, they earn about $39k vs. $59k overall. What is tells you is that everyone else has simply gained less in relative terms. What it doesn’t mean is that older people will spend a lot in their dotage; they don’t have that much to spend. The point reinforces the view that older demographics means slower consumption gains.
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Now consider median Net Worth. It’s $97.3k for all families, but $224k for 65-74 and $265k for 75+. Again, here we see gains for older people outpacing in real terms gain for younger people. This really isn’t that surprising as they’ve spent their lives earning and don’t have all the expenses from the household formation years that preceded. Do you think these older people are likely to invest aggressively? No. Given their slimmer incomes, and thin returns on fixed-income investments, these growing cohorts will be inclined to save more entering their golden years and invest more conservatively because they can’t afford to take risk with wealth. This is all simply a variation on the theme of how demographics might influence the economy and investing habits in the years to come.
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IN OTHER NEWS: Well it’s not really in ‘other news’, as the impending choice of a new Fed chairman, and prognostications for monetary policy as a result, is being well speculated about here and elsewhere. Greg Ip inevitably handles it particularly well in a Thursday piece, “Trump’s Fed Choice: Continuity or Disruption” (https://goo.gl/vQjMPR). Temperament-wise, I suppose he’ll favor the disrupters, which doesn’t make them unqualified. Yellen naturally would provide the most continuity with my note that she’s a bit more hawkish than she was, say, a year ago. She also likes regulation. Powell, not an economist, was an Obama appointment but also served in Treasury under Bush. He is a Republican and would likely be quite mainstream in the continuity sense. Warsh is the odds favorite and is a conservative with experience on the Fed. Most notable for me is that he opposed QE which begs the question if he’d lead monetary policy via a balance-sheet reduction emphasis. Ip notes he has critiqued the Fed for being too sensitive to data and models and too insensitive to market signals. I interpret that to mean he’d seeing high asset prices as a cause to tighten. Taylor has been an opponent of QE and zero rates, saying the latter creates too much uncertainty and inhibits growth. I imagine he’s an advocate of the Taylor rule. I’ll let the Atlanta Fed tell you about that; The Taylor rule is an equation John Taylor introduced in a 1993 paper that prescribes a value for the federal funds rate—the short-term interest rate targeted by the Federal Open Market Committee (FOMC)—based on the values of inflation and economic slack such as the output gap or unemployment gap. Since 1993, alternative versions of Taylor's original equation have been used and called "simple (monetary) policy rules."
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Title The takeaway is that he is more ‘rules-based.’ Below is what the Taylor rule’s prescription is now (created for me by the folks at Macrobond, the system behind most of my charts).
There doesn’t seem to be much disagreement in Washington that some form of tax reduction is in the works though what that looks like remains a huge unknown. Which is why three pieces on the topic caught my attention. One in the New York Times headlined, “Tax Cuts May Be Stimulus, for Inequality.” This went over the Laffer Curve (suggesting that the higher something is taxed, the less of it you’ll get) then went on to, basically, say times have changed since it was first brought up (top tax rate was 70% and the top 1% earned 10% of the income while today it’s 20%) and, anyway, we never got better growth when the rates were dropped. The upshot is an argument against lower taxes for the rich. (As an aside, an article just above that one leads, “Some Health Care Rates May Rise Over 50% in Tumultuous Market,” which I point out for no particular reason other than to mention my eyes rolling back into my head.) Two other WSJ pieces caught my attention. One was from The Outlook with the headline “Tax Cuts’ Link to Growth is Tenuous.” (https://goo.gl/hhvtCM) . It goes over a lot but makes its point; the link is simply not clear, at least in the long run. Kate Davidson, the author, notes that in the 80s there was a tax cut but also the aftermath of two recessions in the early part of the decade, a massive fall in interest rates, and then a productivity surge in the 90s. The 90s also saw the Federal budget deficit disappearing and reduced Treasury issuance providing, I suppose, crowding in of private investment. Do I need to relay we have pretty much the opposite of all that now?
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Title Finally, there was an Opinion piece – “The US Can No Longer Afford Deficit-Increasing Tax Cuts” by Jason Furman, a professor of ‘practice’ at Harvard. He’s urging to the business community to speak out about the deficit-boosting tax plan that’s been put forward. He points out that Federal Revenue as a % of GDP has declined since the last two big tax reforms, but that the deficit as a % of GDP has ballooned. He cites the work of various non-partisan economists who say that growth associated with tax cuts will offset but 20-30% of those cuts. So, the $1.5 trillion in tax cuts would generate a $1 trillion addition to the deficit. Where are the hawks when we need them? P.S. he refers to the Simpson-Bowles commission which I recall fondly and think was one of the grand missed opportunities of the last regime.
NEAR-TERM MARKET THOUGHTS: This is almost easy. Well, not easy, but in the wake of a partially disastrous NFP report and the market’s ready dismissal of the weak components I have to veer to the downside for the market. Simply, we know that NFP was adversely impacted by the storms and you can hardly blame forecasters for the big miss – a 40k decline vs. expected 75k gain – when they hold their finger up to the strong winds of the hurricanes. Sorry for that analogy. Still, the report has some bearish influences though those, too, must be a bit suspect. Average Hourly Earnings were strong, participation rose (making the fall in the Unemployment Rate all the more impressive) even as the Household Survey shows a 547K drop in the pool of available labor but a 906k gain in employment. Wow. Still, be careful on those wages; the big drop was in poor paying jobs (Leisure/Hospitality down 111k. That surely skewed wage gains to better-paid jobs.). For some perspective, there’s a chart at the end of those not at work due to bad weather. I’m not sure if you can see this but usually the spikes are in the winter months; 1.49 mn is second highest in over 40 years.
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Title The key takeaway is that the market has been under pressure, duh, and there’s nothing in the data of the last week, or Fedspeak, to suggest that the pressure is misplaced. In other words, the December hike is on justifying the now 80.2% odds of such an event. I won’t argue with that. I’m ‘letting’ the selloff go further. I am a bit surprised that the curve is steepening into such an event. Technically that makes sense, but, again, it’s into anticipation of a Fed hike. Some of the curve valuations are getting stretched, meaning near oversold conditions, but then that may be a function of positions; speculators are short the front end and long the backend per the Commitment of Traders data. Of course, tax reform did start the process and that remains a key factor, probably more important than the CoT data. Where to? 10s have recent highs near 2.42% which is hardly a reach and not much support over that until 2.50-54%. Something of a bear flag/pennant is going on that, too, suggests an approach of that 2.50%. I’ll admit it’s not so perfect a pattern to give me a more specific level, but it’s bearish enough to anticipate a break of 2.42%. 5s have a bit of support up near 2.05%, and show a divergence favoring lower yields. I’m suspect, to be sure, but keeping an eye on the. Against 2s/10s they are looking decidedly oversold – watch recent support near 10 bp on the fly. (Oh, and for the sake of space I’m not adding charts of all these, but feel free to ask and I’ll send them off.) 2s have trendline support at 1.54% and, like 5s, show oversold momentum measures and a divergence that tempts me to buy the dip. Note at the very end here is a chart of Informa’s EPFR fund flows that show impressive buying over the last week. It’s all due to flows into corporate bonds. Short and intermediate government bond funds saw a bit of selling, not much really, but rather sharper selling in long government funds.
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Bringing 30 years of investment strategy experience to his role at Informa Financial Intelligence, David Ader has held senior positions at major investment banks and financial information firms as well as serving on investment policy committees and management teams. Most recently Partner, Head of Government Bond Strategy for CRT Capital, he headed the team voted #1 in U.S. Rates Strategy for 11 years and #1 in Technical Analysis for five years in Institutional Investor’s annual survey.
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David Ader is Chief Macro Strategist for Informa Financial Intelligence. For further information on our products and services, please see: https://financialintelligence.informa.com/
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