The Fed has spoken. When one reads the FOMC rate decision statement, the Fed’s comments appear fairly balanced, even innocuous. The FOMC statement led off with:
Information received since the Federal Open Market Committee met in April indicates that growth in economic activity has rebounded in recent months. Labor market indicators generally showed further improvement. The unemployment rate, though lower, remains elevated. Household spending appears to be rising moderately and business fixed investment resumed its advance, while the recovery in the housing sector remained slow. Fiscal policy is restraining economic growth, although the extent of restraint is diminishing. Inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.
No surprises here except for an unconcerned view of inflation. The Fed’s outlook for the economy seems to be consistent with the data indicating moderate economic growth:
The Committee sees the risks to the outlook for the economy and the labor market as nearly balanced. The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.
To see a list of high yielding CDs go here.
The FOMC saw improvement in the labor market, stating:
The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions.
As a result the Fed reduced the amount of monthly asset purchases by $10 billion and plans to continue gradually reducing asset purchases. Although the Fed sees economic improvement, it has no plans to raise the Fed Funds Rate in the near future.
The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.
The Dot Dash (deciphering Fed Code)
OK, we have heard all of this before. So why did both stock and bond prices rally late yesterday? To answer that, we must review the so-called “dots” and Ms. Yellen’s press conference.
o The Fed revised lower its 2014 U.S. GDP estimate to a range of 2.1% to 2.3% versus an estimate of 2.8% to 3.1% given back in March. Considering that Q1 GDP printed at -1.0% in Q1, the economy would have to average over 3.0% for the balance of 2014 for the economy to match the Fed’s target. This outcome is far from certain.
o The Fed lowered its guidance for what might constitute a neutral Fed Funds Rate to 3.75% from 4.00%.
o The median Fed Funds Rate for year-end 2015 was raised to 1.13% from 1.00%. The year-end 2016 Fed Funds Rate forecast was increased 2.5% from 2.25%.
o The Unemployment Rate is expected to fall slowly. The Fed’s consensus forecast calls for a year-end 2014 Unemployment Rate of between 6.0% and 6.1%. Although this was better than the initial forecast of 6.2% to 6.3%, the forecast was accompanied by a concern that the faster than expected Unemployment Rate decline is due to workers falling out of the labor market.
o 2015 PCE inflation is expected to average between 1.5% and 2.0% and 2016 PCE inflation is expected to run between 1.7% and 2.0%.
o The Housing sector remains slow.
The “dots” would seem to add up to a situation in which the Fed would be raising the Fed Funds Rate in 2015 even as GDP and job growth increase at a moderate pace. Honestly, the “dots” and the FOMC statement were fairly neutral. So what pushed asset prices higher? It was Ms. Yellen’s comments.
During her press conference, Fed Chair Yellen stated:
• Taper and Fed policy is not preset.
• Fed Funds Rate policy will depend on a variety of indicators, including: inflation, employment and financial developments.
• The Fed could keep the Fed Funds Rate below the historical neutral for some time and remain lower, longer.
• Stronger economic data could hasten Fed tightening.
• The Fed hopes to unveil its plan for rate hikes later this year.
• The Labor Market has broadly improved.
• The Fed will maintain a large balance sheet for an extended period (no selling of bond holdings in the near future).
• Wage growth seems “very well contained.”
What the market appeared to really like were her comments on asset values. She stated:
• Equity values are not outside historic norms.
• Ms. Yellen does not see broad trends posing too much risk.
• Ms. Yellen does not see broad use of leverage.
When taken with lowered growth and rate expectations, as well as fairly dovish comments on policy during her press conference, Ms. Yellen’s apparent lack of concern with asset valuations was a green light for both risk assets and U.S. Treasuries.
However, the markets appear to have ignored comments stating that leveraged lending is “very much part” of Fed supervision. Little has been mentioned regarding Ms. Yellen’s warning to market participants that they should “prepare for uncertainty.” She expressed some concern with a reach for yield, in terms of both duration and credit risk. Most notably, market participants took Ms. Yellen’s comments that the Fed focus is not on asset prices as a sign the Fed will allow the risk party to continue.
We have been Fed watchers and interpreters for more than two decades. The way we interpreted Ms. Yellen’s comments on the Fed’s approach to asset valuations is:
Investors had better not assume that the Fed will adjust policy, in either direction, based on asset valuations. If it is in the best interest of the economy and meeting the Fed’s dual mandates of full employment and price stability, the Fed could adjust monetary policy in either direction regardless of the impact on asset prices.
Ms. Yellen stated that she does not believe that broad equity prices are in bubble territory. We agree, but equities were never a major concern of ours. Our concerns lie in the nether regions and opaque corners of the fixed income markets. In spite of her reluctance to comment on asset prices, Ms. Yellen reiterated concerns regarding leveraged loans (marketed as “bank loans” to investors) and junk bonds.
Ms. Yellen stated that leveraged lending is “very much part of supervision.” Remember, the Fed is the main banking regulator. If the Fed determines that leveraged lending is presenting systemic risk for the financial system, the Fed could act via its regulatory powers rather than through monetary policies. Accommodative Fed policies and dovish comments could push junk bonds and leveraged loan prices a bit higher, but if we were comparing the junk debt market to a baseball game, we would say it is in the bottom of the eighth inning. (1)
We spent some time in the Mudville nine watching it from our desk
This leaves some investors with a dilemma: Do they stay until the game ends or to they leave early to beat the traffic? Since we are fairly certain of the eventual outcome, we would suggest hitting the road. An exception would be BB-rated credits out to about seven years. It is among these corporations that businesses can be found which have improved their balance sheets and have prospects of servicing their debt out to and including maturity.
We believe the risk asset markets are guilty of selective hearing. They heard Ms. Yellen allude that the Fed would not necessarily tighten monetary policy in response to elevated asset prices. They ignored the fact that she said the opposite was true. The Fed could tighten policy even if it resulted in a sharp correction in risk asset valuation.
The markets heard that the Fed would leave the Fed Funds Rate low for a considerable time after conditions reach Fed comfort levels, but disregarded her statement that policies (and Fed bias) could change if the Fed became concerned with inflation.
The markets heard Ms. Yellen state that it is not the Fed’s place to use monetary policy to address market conditions which could result in systemic risks, but ignored her comments that the Fed’s regulatory authority could be used to prevent potential systemically-negative events.
This last point is very important because Fed officials are debating whether or not investment companies are systemically important. We understand the Fed’s concerns. Firms in this space have been encouraging investors and advisors to take more risk, often by understating risk present in junk bonds and leveraged loans. If the junk space becomes more overheated (a scary thought) and the Fed implements capital requirements of companies which offer shares of junk bonds and loan vehicles, conditions in low-rated debt could unravel. Investment companies would be forced to decide whether or not it was worth tying up potentially large amounts of capital to conduct this business.
We believe the Fed’s statement and commentary could lend support to risk asset prices until the September 2014 meeting (we doubt that the Fed would say anything at its July 30th meeting unless economic conditions change significantly between now and then). However, hanging on to outsized long positions in risk assets to the very end is market timing. Market timing involves as much luck as it does skill and intelligence (if not more). Anyone who cares to consider junk debt yields, debt indentures and corporate balance sheets (as we do) can tell you that there is trouble brewing in the bottom of the credit markets.
However, investors and advisors seem content in selectively tuning out some voices and tuning into those which say what they want to hear. This is like ignoring you doctor when he tells you to cut back on junk food and drink less beer and instead listening to the convenience store clerk who is more than happy to ring up your purchase of beer and pretzels.
Instead of buying along with the yield hogs, we are using the reach for yield as an opportunity to pare risk and even gain negative exposure in some risk assets as a way to hedge our core bond positions. Just as we were buying into last year’s panic selling of municipal debt investments by retail, this year, we are taking the other side of retail’s trade in which they are acquiring more risk.
Let us be clear: We are not abandoning high yield debt in portfolios for which below investment grade assets are appropriate. However, whereas we were willing to dip down into the single-B area during the past few years, we are becoming more concentrated in the BB area of high yield. We are eschewing CCC credits as opportunities are few and far between on a risk vs. reward basis and are inappropriate for the majority of our clients. (1)
Our theme is to move the bottom of our risk exposure higher, but the top of our risk exposure remains unchanged with a preferred top of A (except where higher-rated debt is consistent with goals, objectives and risk tolerances). We have also been bringing in our average portfolio duration (just a bit). We are looking to keep our longest maturities inside 15 years (except when opportunities present themselves in the 20-year area). We prefer to start our bond ladders in 2016 (to be able to begin reinvesting matured assets after the Fed might have raised short-term rates a few times).
Earlier this year, Fed Chair Yellen advised market participants to ignore the “dots” and focus on the FOMC statement. That might be OK in the near term. However, the “dots” provide a good indication of where Fed officials believe conditions are heading. We would sum it up this way:
Paying attention to Ms. Yellen’s comments is like driving by looking out your windshield. Paying attention to only the FOMC statement is like driving with only your rearview and side view mirrors. Paying attention to the Fed’s “dots” is like looking ahead via radar. Our advice is to use all three tools when assessing potential future monetary policy conditions.
By Thomas Byrne – Director of Fixed Income – Investment Consultant
Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.
- November 2012 – Present, Wealth Strategies & Management LLC, Stroudsburg PA
- December 2011 – November 2012 – Bond Squad, Kunkletown, PA
- April 1988 – December 2011, Citigroup and predecessor firms, New York, NY
- June 1986 – March 1988 – E.F. Hutton, New York, NY