The FOMC disappointed the markets again. In spite of improving U.S. economic conditions, the Fed left the Fed Funds Rate in a range of 0.00% to 0.25%. As economist David Malpass described, it was like Lucy pulling away the football as Charlie Brown tried to kick it.
The Peanuts Gallery (wah, wah?)
In my 9/17/15 report (written hours before the FOMC rate decision) I wrote:
Given my knowledge of Ms. Yellen, her ideology and thought processes, I would guess that she would stay put to see how Q3 (usually one of the stronger quarters of the year) and international situations play out. However, she might have her conscience, in this case Jiminy Fischer, tapping on her shoulder. My intuition says that the Fed stays put and does a year-end hike (much as what it did with tapering, last year), but the very influential (and talented) Stanley Fischer might pull her over to the hawkish camp.
Although I believed that the Fed should have tightened and there was at least a 50% chance that it would tighten, my senses were tingling. Something was not sitting right with me. I too have expressed concerns about a spillover effect from China into the global economy. Last minute pleas from the IMF and World Bank (IBRD) sounded desperate. It made me think: Could the situation in China/EM be worse than even I believe? This might be the case. It was, apparently, fear of global contagion which was the main, but not the only, factor in keeping the Fed on hold. The Fed statement and Ms. Yellen’s speech shed much light on what has changed at the Fed.
The Fed stated:
- It does not see inflation (presumably as measured by Core PCE) rising to 2.0% until early 2018.
- The Fed stated that global economic conditions “may constrain” U.S. economic activity.
- The Fed lowered its end of 2016 Fed Funds Rate forecast, now seeing the Fed Funds Rate around 1.478% versus a forecast 1.75% stated at the June Meeting. Note: Fed Funds Futures are pricing in a 0.73% Fed Funds Rate for December 2016.
- The FOMC lowered its 2016 GDP forecast to a range of 2.1% to 2.8% from a prior range 2.3% to 3.0%.
- Ms. Yellen stated that inflation should remain low in the coming months.
- Ms. Yellen noted that financial conditions have tightened significantly since the June meeting. Read tighter corporate borrowing conditions.
- Ms. Yellen commented that it is unlikely inflation pressures increase in the near future, even if the labor markets tighten further.
- Three FOMC members see the first Fed Funds Rate hike in 2016. One member sees the first Fed Funds Rate hike coming in 2017.
- When the Fed does tighten, Ms. Yellen believes it should be on a long and shallow path.
By now, you have probably have read these highlights in other publications, but how do they relate to investment strategy? This is my take.
In my opinion, it all comes down to inflation. Until the Fed is confident that inflation is moving toward 2.0% it might not tighten or tighten appreciably. The following chart illustrates the Fed’s problem:
Core PCE since 2009 (Source: Bloomberg):
Since reaching a post-recession peak of (a whopping) 2.10% in March 2012, inflation has come steadily downward. This is spite of QE∞ which was launched in September 2012. What this states clearly, at least to me, is that the Fed may be powerless to create inflation in the current global economic environment.
This should not be surprising. Monetary policy accommodation generally causes inflation by lowering rates to encourage borrowing to boost consumption and/or by devaluing the currency. By now it should be clear that consumers are less likely or less able to borrow and spend as they have in the past. It should also be clear that it is very difficult for the U.S. dollar to weaken versus major foreign currencies when major foreign economies are sputtering and many central banks are weakening their currencies. Also, some troubled economies (China, Brazil, etc.) are experiencing currency devaluation via market forces (capital flight).
The TIPS of the Iceberg
When the Fed decided not to tighten, the bullish TIPs crowd shouted (again): Buy TIPS now because the Fed will reflate the economy.
Really? Einstein defined insanity as doing the same thing over and over again and expecting different results. Why in the world should we expect accommodative Fed policy to boost inflation until global economic conditions improve? The answer, in my opinion, is: We shouldn’t. Thus, inflation pressures should remain low until structural conditions improve around the world. The time needed to fix structural problems could take years. If Japan can be used as an example, it could take decades (and still counting). My opinion is that we are in a period of secularly-low inflation. This is the direct opposite of the 1970s when we saw secularly-high inflation. Then as now, structural economic reforms (both abroad and, to a lesser extent, in the U.S.) will probably be required to break secular trends.
In my view, the breakeven spread between TIPS and cash U.S. Treasuries should remain fairly narrow. If this scenario plays out, TIPS could be a good hedge as inflation has a low hurdle to clear to make them potentially attractive hedging instruments. However, even a low hurdle might be too high for TIPS to outperform for the next several years. Thus, I am not in the camp that TIPS are a “buy” for total return purposes.
Make no mistake, inflation is the main impetus for the moves seen in the bond market since the FOMC Rate decision. Many pundits have stated that “bonds” rallied because the Fed did not tighten. This was true of the short end of the curve, as U.S. Treasuries with maturities two years and in are directly affected by Fed policy. However, the long end of the UST curve responds to inflation/inflation expectations. It was the Fed’s lower inflation forecast which drove long-term rates lower. Thus, it was not the lack of tightening, but the reason (low inflation and tightening financial conditions) for the lack of tightening which drove down long-term rates.
Walking a Tightrope
This brings us to “tightening financial conditions.” In her press conference, Ms. Yellen stated that one reason the Fed did not tighten was because financial conditions have tightened since the June 2015 meeting. This is to what Ms. Yellen was referring:
What are the charts telling us? They are telling us that while UST yields have trended in a narrow range (mainly trending lower), yields of junk-rated debt moved in the other direction. In the case of CCC-rated and lower U.S. corporate debt, borrowing costs rose about 400 basis points since this time last year and about 200 basis points since the June 2015 FOMC meeting (the last “major” FOMC meeting). This means that in spite of falling U.S. Treasury yields, junk-rated companies received pretty hefty rate hikes I.E. credit widening. B-rated companies saw about a one full point rise in borrowing costs. Market pundits were all flustered by a potential 25 basis point Fed Funds Rate increase. What they should have been watching were deteriorating credit conditions in the corporate bond market. I was and have written about it several times.
What happened in the investment grade market? See for yourself:
In one year, credit spreads have widened about 65 basis points and 30 basis points since June. This is not much more than the amount U.S. Treasury yields have fallen. Thus, investment grade companies saw little change in borrowing conditions. What has happened during the past year is credit conditions have deteriorated the most for corporate borrowers which can least afford it.
Back in Q2 of 2014, as high yield credit spreads reached their tightest levels since the housing bubble, I opined that I preferred taking moderately more duration risk than increased credit risk (where client suitable). This has worked out well. Following the Fed’s decisions not to tighten, some pundits and investment strategists suggested that investors might wish to revisit high yield bonds now that the Fed is likely to remain dovish for a while longer. However, look at the above high yield charts. Spreads began widening again following last Thursday’s FOMC decision.
Why would high yield credit spreads begin widening after the Fed decided to not begin removing accommodation? Probably for the same reason the Fed decided to remain extremely accommodative; the global economy is slowing. No matter how low the Fed keeps benchmark rates, the ability of corporations to repay debt depends on their ability to generate revenue and profit. As earnings prospects appear to diminish, credit spreads tend to widen. As such, I am concerned that very-low-rated corporations could continue to come under significant financial pressure from higher borrowing costs, even if the Fed ends up not tightening for an extended period of time.
Investors should approach corporate issuers with high levels of balance sheet leverage with caution. Highly leveraged companies could find financing/refinancing costs higher than they anticipated. This could mean higher interest costs and lower profitability. It could also force some companies to issue equity in lieu of taking on more debt or paying off maturing debt via new debt issuance. After years of share repurchases, we could see some companies re-issue shares bought back during the past five years.
Bond investors should also be wary of mergers and acquisitions. Some mergers or takeovers are facilitated via leveraged buyout. In this case, the acquiring company heaps debt on the balance sheet of the acquired company. Capital structures are left independent and the credit rating of the acquired company can be downgraded. Even before a credit ratings downgrade takes place, the bonds of the more highly-leveraged company can plunge in value. This is precisely what happened last week with Cablevision bonds after the merger with Altice was announced. LBOs are often a potential negative for bond investors.
A Rose is a Rose (What’s in a Name?)
In my conversations with readers, I am getting the sense of reluctance to mix taxable munis with corporate bonds in dedicated taxable fixed income portfolios. This is apparently due to the views of some that bond portfolio strategies should not mix assets classes. Mixing taxable municipal bonds and corporate bonds is consistent with a taxable income strategy, in my opinion. Why should clients be forced to accept a potentially less advantageous portfolio, for the sake of the name of an asset class?
At the present time, I believe taxable municipals can offer attractive alternatives to corporate bonds for some investors (where suitable). The following chart supports my view:
The data indicate that one can pick up about 60 basis points of yield in taxable munis versus corporates on the 10-year area of the curve. On all points of the curve, A-rated taxable munis appear to offer better values risk versus reward basis. There is yet another positive here. Because of more stringent ratings methodologies, A-rated municipal bonds tend to subject investors to less credit risk than do A-rated corporate bonds. Of course this is credit specific and one must do their credit homework, but I believe that taxable municipal bonds are worthy of consideration when constructing taxable bond portfolios.
Panic at the Disco
The markets were clearly unnerved by Ms. Yellen’s comments and the Fed’s official statement. For years, Fed forecasts have proved overly optimistic. The Fed has consistently lowered its so-called “dots” (economic forecasts). However, when a group of policymakers which has been overly optimistic takes what appears to be a more bearish view of EM, China and the global economy than the Street, one must ask: Is the Fed wrong again, just in the other direction or is the Fed’s dour view of foreign economies still too optimistic?
To be honest, I do not know which it is. However, I believe that the problems vexing many foreign economies are more structural in nature than they are cyclical. Thus, my forecasts are:
- Core PCE to remain below 1.5% for at least the next six months.
- The U.S. dollar to remain strong, if not strengthen, even if the Fed does not tighten.
- High yield bond defaults could continue to increase, in spite of accommodative Fed policies.
- Global financial conditions are unlikely to improve much between now and the October or December FOMC meetings. If the Fed is going to tighten, it will probably have to do so without a rosier outlook form overseas.
- I expect the 10-year UST note yield to be range bound between 2.10% and 2.40%, unless we see an unexpected improvement or deterioration in global economic conditions.
- Look for the potential for more QE from the ECB and more aggressive monetary stimulus from the Bank of Japan. In the EM world, look for more currency defending to prevent capital flight and to combat inflation pressures.
- My core strategy is to lower portfolio risk on market spikes and move up in quality on market dips. The degree that this is done depends on client goals, objectives and risk tolerance (aka: suitability).
- Where suitable, I find municipal bonds (taxable and tax-free) attractive versus similarly rated corporate bonds.
- High yield bond investors should be prepared for more volatility and possible further credit spread widening.
- At present, I assign no more than a 60% probability for a Fed liftoff by year end. I just don’t foresee a dramatic improvement in global economic conditions in that timeframe.
- I do believe the U.S. economy should maintain its resilience versus global headwinds. A 2.0% to 2.5% economy seems to be baked in at the present time. As such. U.S. and U.S.-focused international corporations remain attractive, in my opinion.
- As has been the case for more than a year, my modus operandi has been to be tactically defensive, but strategically offensive. By this I mean (where suitable): We are not materially increasing cash positions, but being risk smart. By risk smart, I refer to fully considering risk as much as potential reward.
About Thomas Byrne
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.