ADER’S MUSINGS – COUNTERVAILING FORCES KEEPING RATES IN RANGE

Aug 31, 2018 

* Trump warms to Mexico with deal, China talks cool, Canada out in the cold? -- WSJ opines, “We’re glad to see Mr. Trump step back from the suicide of NAFTA withdrawal, but on the public evidence so far his new deal is worse.” --- Don't think tariff stress is over. * Mnuchin says yield curve shape isn’t a worry sign for economy. * SF Fed report gets attention; focuses on 3mo/10s.  -- Conclusion 1, “Comfortable distance from yield curve inversion.” -- Conclusion 2, This time is NOT different in judging yield curve inversions vs. recession. * Q2 GDP revised up, July Trade Deficit widens -- begs the question of the front-loading of exports (soybeans) ahead of tariffs, -- Good news is rise non-residential investment, mostly intellectual property, -- Corporate Profits soar at the expense of tax receipts -- corp. tax receipts down 35% YoY, ex taxes corporate profits up a rather more tame 0.2% YoY.

I’m not sure what one really can make of the last week of summer, though I’m inclined to put emphasis on the calendar more than the surrounding inputs I think. We have, for instance, the aftershocks of a Jackson Hole meeting and set of FOMC Minutes that while largely touted as dovish, wasn’t so dovish for the market as to stop Dec Fed Funds from hitting a new, albeit marginal, high at 2.23+% putting odds of a hike that month at near 65%.  

Nor were there many aftershocks from the Cohen/Manafort ‘thing’ even as the accountant Weisselberg enters the fray. Not much new came out over Turkey, though no news wasn’t quite good news even if Germany lends a hand. We find some sort of a deal with Mexico and we’re yet to hear how Canada fits in. Then the trade talks with China cool off, but maybe with a Mexico win to Tweet Trump feels less concerned about doing a deal with China. Or maybe the bloom coming off the rose of a Nobel-prize deal with North Korea is just a negotiating strategy. Whatever, the markets didn’t seem to react very much so maybe it is about summer’s end.

Which may be why a couple of Fed pieces telling us little we didn’t already know about the yield curve (but doing so with style) garnered so much attention. One was a SF Fed’s Economic Letter about “Information in the Yield Curve about Future Recessions.” The paper talks about the 3-mo/10-yr spread as being the most reliable and concludes it’s still a comforting distance away from a recessionary-warning inversion.  They don’t dismiss the more popular 2s/10s, by the way, and as the chart below shows they track each other very well. The St. Louis Fed also agreed that an inversion was a good recession signal and included a trough in the Unemployment Rate as another good signal, preceding a recession by on average nine months. Is that a surprise? The challenge is determining that trough though an inversion typically precedes it. In short, watch the curve.

Before I talk about this a little bit more, let me just say that both curves are flattening sharply, and that that simple behavior is enough to warrant caution about the economic outlook they provide. Further they cite the 3mo-10s spread at ‘slightly below 1%’ and hence a cause of some comfort, i.e. not inverted. Well, that spread is about 20 bp narrower now vs. when they cited their level.

Something the authors state and about the yield curve more generally is that it’s important to make the distinction between cause and correlation. Curve inversion correlates with recessions, but correlations don’t identify cause and effect complicating interpretation. They address some of that by looking at term premium vs. outright longer yields, but found that approach was less accurate than simple curve observations.

They took on the impact of QE, the idea being that QE depressed long yields more than they otherwise would be and so the curve is flatter than it might otherwise be. They get over that saying that the impact of QE is a big ‘if’ since the assumptions are based on assumptions. Further, the comment that lower-term premiums have contributed to problems in the past (overheating) with no evidence that this time is different

I talk a lot about the curve and want to emphasize how much attention it’s been getting from the Fed, pundits like me, the public, and recently Mnuchin. Look up ‘flat yield curve’ on Google and you’ll see over 21 million results though that may be skewed, according to Trump, by an effort to see the flat curve as a harbinger of bad things like a recession.

The idea that ‘this time is different’ came up a lot so let’s address that. First, assuming that QE did have an influence it’s pretty clear that influence was small given that QE is running off, supply increasing, and the curve still flattening.  

Second, let’s try to handicap the influence and I’ll make up a number. Say there had been no QE, where would yields be? Before we get there, just consider what no QE may have meant for risk assets; presumably not as strong and so something of a dampener on rates. Leaving that aside, I’ll toss out that without QE 10s would be 65 bp higher, a pure guess. Assuming all other things being equal, that would make the current 2s/10s spread about 65 bp, or 40 bp steeper.  Why not more? Don’t forget that QE also involved selling short Treasuries.

The curve would still have flattened, albeit less so. That would not change the curve’s direction or anticipation for Fed hike leaving us, today, with a pretty secure anticipation for four more hikes, 100 bp, by the middle of 2019. So here we’d be with 10s at, roughly, 3.55%, for a real yield of 1%, presumably a firmer dollar and all the more allure against the stock market. Which is to say, that next set of hikes would certainly get us to inversion soon enough to anticipate a recession by the 2020 election.

 Steve Blitz, chief US economist over at TS Lombard, showed me this fascinating chart below which looks at the RATIO of 2s/10s, not the spread, on a log scale. The goal with that is to emphasize how ‘wide’ the ratio has had to go and for longer periods in order to restore the economy to a normal expansion. And this one has taken an exceptionally long period to get the curve back to normal. Looking at Steve’s chart (and stealing his analysis) it seems reasonable to anticipate more flattening on the back of more Fed.

 CHARTS AND THEMATICS:  I want to touch on two things. The first is more a teaser than anything else, but it’s a reminder of why, perhaps, Powell’s recent comments on inflation were quite benign. First, there is the chance of base effects coming into play meaning simply that the higher MoM gains in H2 last year may give the incoming figures a bit of relief, i.e. not accelerating. I’m not handicapping the tariff impact and will, of course, be looking for that, but I hope this first chart gives you a sense of the potential to see moderated inflation in the coming months. I’ll read that as a benign thing for the bond market but not so benign as to lose more hikes this year.

 Related to that is the broader sense of inflation from rather more common elements. Two of those are the CRB and the dollar, which I don’t need to tell you hint at moderating inflation pressures. The CRB has slipped to late 2016 levels, as has the Raw Materials Index, and the dollar is at its strongest level in over a year.

Meanwhile, there’s wide agreement from the likes of the TIPS market where BEIRs have been flat for most of this year (2/3s of which is behind us, FYI), the Fed’s 5-yr 5-yr forward rate, which has followed that sideways pattern.

The second thing I want to discuss is the softer tone in the housing market, though I’m not sure what words can add to the charts on display. Between higher prices and rates, the Housing Affordability Index produced by the National Association of Realtors has been plummeting, reaching a level last seen in the summer of 2008. (The index measures whether a typical family has enough income to qualify for a mortgage on a typical home.) I think the lowest level in 10 years warrants mention since other signals like Home Builders Future Sales, Existing and New Home Sales are clearly weakening -- Existing Home Sales have been negative for the last four months while New Home Sales have been down in three of the last four months and likewise for Pending Home Sales.

While new homes clearly are the economic contributor to GDP and inspire homebuilder stocks, bear in mind it often takes a sale of an old one to buy a new one and even with existing homes there’s the economic addition of new appliances, renovations, decorating; the whole bit. This hardly bears a resemblance to what provoked the last recession in terms of debt and overexposure, but I’ll chalk it up to a negative signal.

A recent piece in Forbes (https://goo.gl/kZxKvi) caught some of the issue that goes beyond supply and mortgage rates. The headline asks the question, “Are Millennials Killing The U.S. Housing Market?” and the body seeks to answer it, “A slowdown in the growth rate of the adult population is one factor. The less obvious trend is behavioral: Today’s young adults are no longer rushing to set out on their own—and their parents are no longer yearning for an empty nest. Barring a drastic reversal in this trend, the housing market will have to cope with sustained slow growth for years to come.”

IN OTHER NEWS:  Both the New York Times and FT hit upon the topic of student loans where recent data shows the outstanding amount of student debt just crossed $1.5 trillion. I also have ‘conflicting’ data that suggest the figure is a more tame $1.4 trillion, but let’s not quibble over a $100 bn there or $100 bn here. Suffice it to say that having just dropped my son off at the University of Vermont I’ll bet a good chunk of that debt could be paid down if the kids simply returned cans and bottles for the deposit, but that’s just a father’s observation.

Anyway, the story mounts along with the debt. In terms of GDP, those sorts of figures are between 6.9% and 7.5%, with the lower figure having been just 2.1% in 2003. Granted these figures pale against mortgage debt at 44%, but in terms of over indebtedness it ranks. And student debt has been the fastest growing category of Consumer Credit since the grand recession.  Student debt constitutes 30.5% of Consumer Credit from just about 5% 10 years ago.

A report by S&P flagged by the FT, notes that while loan origination has declined since 2011, the overall level of debt has gone up. Why? Apparently, there have been payment adjustments to offer lower payments in the near term but adding to the long-term debt level. This keeps borrowers current on their loan payments but means they owe more for longer which makes the notes and calls that, for example, my other son, just graduated in May, is getting for alumni donations rather insensitive.

This is a problem from many angles and has implications for slower consumption for young people in general. I’ve emphasized this as a drain on Household Formation and spending in general by an age group that traditionally has been a huge consumer relative to incomes and savings. The story with Household Formation has other social elements like people marrying later, having children later, staying urban or opting for alternative lifestyles more broadly but the high debt has a lot to do with it.

Such indebtedness also is an obvious inhibition to getting a loan for starting a business, buying a car, or getting a mortgage with all the implications that has for the economy.  

This brings up another problem that goes with any sort of borrowing. That is, you have young people going into more debt earlier, before they even start careers, which means more bankruptcies early on. The good news is that at least delinquencies are down thanks to the job market (and maybe parents dropping their kids off, helping clean their rooms and collecting all those bottles and cans for the deposit). Delinquencies are down to 8.8% from a peak of 11.8% in 2013, though longer-term delinquencies (over 90 days) haven’t improved very much at all.

A NYT piece (an OpEd by Ben Miller, https://goo.gl/538fK2) put more emphasis on the negatives commandeered by the headline, “Student Debt: It’s Worse Than We Imagined.”  Citing national education statistics from the appropriately named National Center for Education Statistics, it seems the typical borrower will graduate with a diploma (assuming he or she or ze --UVM remember? -- hands in their cap and gown) and a $22,000 loan balance to start repaying. Miller’s piece gripes that government data puts the default rate at just about 10%, but stops looking at it three years post-graduation. Beyond that he discovered the default rate rises to 16% over the next two years for a total of 841,000 recent grads in default. Another 1.3 mn were at least severely delinquent.

It’s worse for for-profit schools than non-profit schools and notice I didn’t mention Trump University there. Forty-four percent of borrowers at such schools were in ‘some form of loan distress’ five years after they started to repay. Too, he cites that deferment issue the FT brought up noting that schools with especially high default rates has later defaults because of this option, but defaults nonetheless. 

Meanwhile, Seth Frotman, the so-called student loan ombudsman at the Consumer Financial Protection Bureau resigned in rather dramatic form. In his resignation letter to CFPB head Mulvaney he wrote, “it has become clear that consumers no longer have a strong, independent Consumer Bureau on their side…Unfortunately, under your leadership, the Bureau has abandoned the very consumers it is tasked by Congress with protecting…Instead, you have used the Bureau to serve the wishes of the most powerful financial companies in America."

This is all to say that the problem doesn’t appear to be going away anytime soon.

NEAR-TERM MARKET THOUGHTS:  The minor retreat in yields and steepening of the curve is in my view totally a function of illiquid-summer trading meeting oversold technicals into supply. I can skew that action by trying to portray the Fed as somehow more dovish than it was a couple of weeks ago, or how the trade stuff with Mexico and maybe Canada represents risk off or the relatively quieter tone to emerging markets. I mean, I could attempt to say the market moved because of X, but just as readily offer a counterbalancing Y. I think it’s all noise.

That doesn’t mean I’m oblivious to, potentially, the dollar boosting issue from, you name it, Turkey/Italy/Argentina/Venezuela or the relief that accompanies an arm-twisted force of some version of a new NAFTA. Problem is with all that is headlines could change at any moment, and the China trade work remains out there. Did I mention a Brexit deal? There is a lot out there that seems to outweigh US fundamentals (which I think are rather steady, meaning a balance that isn’t providing much rate direction) and I don’t see that changing. I expect rate will trade sideways, more or less, into the FOMC. Corrective technical steepening or rate retreat is just that; I wouldn’t attach it to a given headline.

I think the market will remain very much in the range confines of the last couple of weeks.  2s look rather bullish in terms of a rally with somewhat oversold stochastics and what some are calling a double top. I don’t see it so clearly, the double top, but could draw you a compelling chart which I’ve done below. Maybe that’s enough to take 2s to the 40-day at 2.62% or approach very recent lows near 2.58%? I doubt the latter, not this close to the FOMC hike. A second chart of 2s, with more perspective, should held keep bullish temperament sedated. I think this channel dominates into the FOMC and I really can’t see much of a rally beforehand.

I suspect the curve can steepen a wee bit, but that’s totally technical as well. Maybe the dollar’s recent retreat -- though not against the EM Currency Index -- will encourage that to a small degree, say 2s/10s to the 21- or 40-day MAs near 25-26 bp.  The same influences over the longer term are in place, i.e. the Fed, EM stress (Argentina hikes to 60%!) and those are not going away. Too, and it pains me to acknowledge this, but the NAFTA ‘progress’ does extract a risk element to risk markets. That won’t make me bullish stocks, but it’s not a reason to be bullish bonds, let alone the front end, either.

Oh, oh, oh…did you see Personal Income and Spending? Totally as expected so a big yawn to start Q3, but I would like to point out the price data was rather benign as well; PCE up 0.1% MoM, core up 0.2% but a ‘low’ one at 0.156%. I think we’re about to see a bit of calming in these sorts of inflation figures and talk about the contrast with CPI (which was up 2.9% in July and 2.4% at the core level). That the market didn’t move on PCE is relevant. I’ll note that 10s vs. the YoY PCE figures (last chart) looks rather okay. I mean that 10s are the cheapest they’ve been to the figures in about seven years. Historically the spread has been much wider, so this can be a case of the glass being half full since at wider times YoY PCE figures weren’t much different than they are today. I’ll weigh in on the ‘double bottom’ potential implying a wider spread and would be content to see that spread nearer 150 bp at the headline level, implying a 50 bp widening, at some point. Maybe that added 50 bp is part of the impact of QE that I discussed above?

David Ader, Chief Macro Strategist for Informa Financial Intelligence

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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