ADER’S MUSINGS – MUCH ADO ABOUT FOMC MINUTES

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Aug 24, 2018 

* Trump complains Powell not ‘cheap money’ enough, -- September 2016, Trump tells CNBC the Fed is doing what Obama wants by keeping interest rates low. “Yellen and central bank policymakers are very political, and Yellen should be "ashamed" of what she's doing to the country.” Also, Trump said, Fed is not even close to being independent. By keeping interest rates low, the Fed has created a "false stock market." * Atlanta Fed’s Bostic, “I pledge to you I will not vote for anything that will knowingly invert the curve.” * Dallas Fed’s Kaplan, 3-4 more hikes to neutral, then…” step back and assess the outlook for the economy and look at a range of other factors—including the levels and shape of the Treasury yield curve—before deciding what further actions, if any, might be appropriate.” * FOMC Minutes as in time or Minutes as in small potatoes? * Existing and New Home Sales slip again.

One should hardly be surprised by Trump’s admonitions of the Fed, specifically his pick for Chairman, given his tendencies towards people who don’t do exactly what he wants. I’m not sure what Trump’s issue is given the generic state of the stock market and economy overall. If he were a thinking man on the topic, surely, he’d be satisfied with the tax and spending plans he has at his back and wouldn’t quibble about the Fed hiking.  

The irony or self-serving cynicism of his critiquing Yellen for keeping rates too low merely to boost Obama’s legacy comes to mind. Oh, and he did say that. This is from CNBC just before the election; Trump said rates are being kept lower to bolster Obama's legacy. "Any increase at all will be a very, very small increase because they want to keep the market up so Obama goes out and let the new guy ... raise interest rates ... and watch what happens in the stock market." Then again, maybe he’s talking position.

To those who say the implications of a flattening yield curve is different this time around, I offer up Atlanta Fed’s Bostic on the subject. He said that an inverted curve is indeed a concern and something he’d vote against if he saw policy going that way. Pay attention to this. A number of Fed officials are giving due respect to the curve’s predictive capability including Powell and Bullard among others. You may not agree with their concern, but to the extent it translates to policy you have no other choice in the matter.

Those who say this time is different rely on two major themes. One is that the Fed’s use of the balance sheet has made long rates lower than they otherwise would be and that has been exacerbated by foreign central banks doing their own version of QE. The second is that because of monetary policies, US rates are that much more attractive drawing in foreign money.  I don’t disagree that those are major influences, but they ignore the Fed’s hiking and its ‘targets’ (inflation, dot plots) putting upward pressure on short rates even more.  

Too, the balance sheet story has an expiration date. I’m being cute here, but first the reduction is well under way without observable market consequences that I can identify.  There’s a growing chorus out there suggesting the balance sheet reduction won’t last too much longer due to liquidity needs. Further, if we agree that the balance sheet will be larger than pre-crisis due to various factors (money in circulation, for example) and that the portfolio will largely be made up of Treasuries, then there’s a good case for the current level of Treasury holdings not have much further to go; I can imagine the reduction in Treasuries ending by 2020 and sooner if global liquidity needs concern the Fed.

What we don’t know is the maturity breakdown goal, but I suspect it will largely be in bills (again the liquidity thing) though in a recession would likely move out the curve. Again.

Specs are short. I used to pay more attention to the Commitment of Traders data, and I know a lot of smart people do still. Increasingly I’m hearing from a lot of less-than-smart people about deep shorts in the whole construct which I think is visually very interesting but fundamentally hard to understand. Let me explain.

First, this report represents speculators who don’t have an offsetting position in the cash market, i.e. Treasuries. It doesn’t mean the short is not a hedge against something else. The CFTC says so; A trader may be classified as a commercial trader in some commodities and as a non-commercial trader in other commodities. I believe that means the deep short in TY isn’t necessarily a pure naked short that risks a brisk covering rally, but a position against something else. If I’m wrong, you should be bullish.

I’ll observe some things that don’t mesh with that view. First, the Daily Sentiment Index is very neutral and remains my favorite contrarian proxy. That seems about right. Second, I was talking with Ian Lyngen, top rates strategist at BMO, on the topic and he noted that there’s been covering in the front end in the same data so maybe the market is thinking the Fed is closer to ‘done’ and that’s reflected in the shorts further out the curve, though not entirely. Bond specs are a little short having run off a long that lasted from last May to this one, but hardly ‘deep’ and specs have been short fives for over three years, and deeply so now. I can make up stories, but it seems fixating on this would require more creative speculation than insight.

The easy thing is to ignore it unless you really have some grasp of what’s going and, instead, consider the price action (sideways) in light of the DSIs. Nor, by the way, is there much evidence in the repo market of a short base. I hope that’s not too much of a copout. Per comments in recent days by, my ‘focus’ is on these Fed folks talking more and more about the yield curve, specifically inversion, as a cause for concern. To the idea of naked shorts in TY or ultras, just bear in mind that such commentary still allows for a good three or four more hikes by which time, surely, the yield curve will be well inverted.

CHARTS AND THEMATICS:  I got a note from a friend who is also a manager at a rather huge public pension fund about last week’s Musings where I made note of a NYT Op-Ed piece on “The Big, Dangerous Bubble in Corporate Debt.” My point about the piece was that concerns with the IG bond market were filtering out to the public from our, err umm, ‘professional’ realm. Well, a director at said manager’s fund had seen the piece and expressed concern proving it’s getting out to the public. Oh, and some action was being taken accordingly.

Undoubtedly inspired by constant charts and musings on the matter, Barron’s Vito Racanelli wrote “Where Bonds’ Next Big Firestorm Could Begin.” Guess where?  

Racanelli discusses the sharp rise in triple-B bonds over the last 10 years which has had the effective effect of weakening the overall credit of a given IG index.  BBB bonds, for example, stand at $3 trillion vs. just $700 bn in 2008. That a bulge in the market, outpacing issuance of other credits, and so taking the broader indexes down a notch in credit quality as you might expect. Triple-B bonds are cuspy credits, too, such that with downgrading in the next recession these are the most vulnerable and would have to be sold if they fall from IG standing.  

Consider that in a Pimco “Viewpoint” from earlier this year, relayed that triple-B was 48% of the IG market in 2017, nearly double the level of the 1990s. The same piece also made note that 18% of such companies were downgraded below investment grade, a function of the fall in commodity prices. Such activity underscores the fallen angel risk inherent in an IG index. At the same time, net leverage has increased sharply. The chart below came from a Q1 article in the FT.

The red flags all this raise is about what happens when the inevitable comes to fruition, which is to say the business cycle is not dead.

Still, the spread to Treasuries is arguably rich for all that, a point that all the articles done on a Google search seem to be making. Too, the articles offer the warning that investors don’t realize just how large a share of the IG market triple-B makes up. I’m forced to reason in a similar oddity with the S&P 500 I’ve been on (and on) about which is that that index is much less defensive today than it was before 2008. Then 40% of the S&P 500 was made up of defensive shares. Today it’s 16.7%. This is all to say that broad market indexes, stocks and bonds, are riskier today as we edge toward the long end of this particular cycle than at anytime in past 20 years. Do I need to add, “and will behave accordingly”?  

In the grand scheme of things, it’s not only about triple-B becoming such a force in IG but the state of corporate bonds in general.  Corporate debt as a % of GDP at 45.2% is pretty much at the historic highs, and rather reminiscent of a similar development in, oh, 2000 and 2008.  Which is to say, we’ve been here, right here, before. This doesn’t tell us a recession is around the corner (that’s why we have the yield curve!!), but it does suggest why we might slip easily into the next big firestorm to use Racanelli’s words. 

Oh, and this chart below. This is a view of Treasuries relative to THE bond market with my projections for where the weightings are going based on budget deficit projections and recent trends (hardly genius). I bring this up in the context of reallocating to Treasuries in the coming year or so based on my concerns about 1) corporate debt as just discussed, 2) a generic conclusion to this cycle, 3) curve action and Fed hikes and 4) the last chart in this section more about which in a moment. The point is that investors will need more Treasuries in their portfolio merely to keep pace with Treasuries’ weighting in the bond market.  Add in the potential for longer maturity issuance in a flat yield curve environment. 

I discussed that last week, but very few of you were around if my ‘out of office’ messages indicate anything so I’m using it again. It shows the Milliman 100 Pension Funding Index. Focus on the Funding Ratio. What this 93.4% tells you is that pension funds have reached their highest funding ratio (assets vs. liabilities) since 2008. Surely, such an achievement, and one with a good deal of gratitude owed to risk assets, warrants some derisking given the sorts of exposure and valuations I just outline. To paraphrase my friend, ‘we still have more to do.’

IN OTHER NEWS:  Well, ahem, there is a lot of news out there. I’ll point to the front page of Wednesday’s Wall Street Journal which offers up the conundrum surely on everyone’s mind which on the one hand led with the headline “Former Trump Advisers Guilty” and right under that, with charts and tables for emphasis, is “Bull Market Set to Become the Longest.” I think that captures a degree of the bipolarity that helps to keep the bond market in a stable if not bullish sort of range.

What I mean is the discomforting uncertainties connected with the Trump Administration -- from trade policies, to tax stimulus, to ranting Tweets and, now, the intensification of legal problems -- to the behavior of the stock market. The latter has, surely, been boosted by the fiscal inputs and perhaps sheer momentum to say nothing of tax-plan advantaged earnings and the general state of the economy.  And all that has pushed valuations to rich levels which should be a concern. After all, the YTD performance in stocks has been good, although I’ll point out that the S&P 500 6.3% YTD return isn’t so hefty when excluding FAANG and Microsoft at 2.7%.

 The former, the Trump Administration, has got me. I think the tumult will take a toll and surprised it hasn’t already. Is it the wait for mid-term elections? To see if more legal rankles come to the fore?  Are we just giving Trump such a pass on all this? Or is it 1999 again, and we’re simply using equity prices as a leading indicator of equity prices?

Which brings up other things in the news. Here I refer to the Fed. Let me pull rank and note that I’ve been at this for over 30 years and I’ve never seen just a focus on things like the FOMC Minutes, Beige Book and Jackson bloody Hole Symposium as I do now. One must bear in mind the Fed has become so very transparent in recent years, that that particular trio reveals little that various forms of Fedspeak hasn’t done beforehand. We fixate on the dots, but there’s ample divergence with, say, Fed Fund futures to suggest the market’s got a mind of its own.

Maybe it’s an otherwise slow news week when it comes to the fundamentals, or simply the tight trading range forces people to make mountains out of molehills. I grant that the Fed is in the middle of a rather steady hiking policy and so how the removal of accommodation goes is important. But the Fed doesn’t know either other than to make it ‘steady as she goes’ precisely not to roil markets. They don’t have a specific level of Funds which would be deemed neutral, more a range and that can shift, they don’t know if rates need to be restrictive (especially given the real wage story), they don’t know a final level for the balance sheet. These are wonderful talking points, but don’t expect targets you can position for.

More interesting is the criticism of Trump of Powell, i.e. I’m not thrilled. This is bothersome on several fronts. First, who is Trump to now criticize the Fed for hiking after bitching that Yellen kept rates too low for political reasons. Second, the Fed is supposed to be independent, so words like “I should be given some help” don’t resonate. Third, guess who will get blame if the economy stumbles? I’m not sure if Trump fully understands how exchange rates play into trade negotiations, but suffice it to say if he’s touting the strong economy that boosting the dollar then the level of interest rates clearly is not a problem. Then again, if he needs props like the tax plan and an easy Fed maybe the underlying economy isn’t so strong on its own merits.

Anyway, the Fed will not kowtow to Trump’s complaints, I’m confident of that. If they slow the pace of hikes next year, it’ll be for sound reasons, maybe like the yield curve, or inflation threats have subsided. If they get more aggressive, it’ll be for economic reasons. And if Trump tweets vitriol, they’ll roll their eyes and carry on. 

Phew, I got that off my chest. Of all the Fed stuff, I’m most interested in the balance sheet right now; how large it will be, and where on the curve they want to focus their holdings. 

Totally unrelated to all that was another WSJ piece, this one titled “Fewer Workers Are Willing to Relocate for New Jobs.” But, dear reader, you knew that already. The reasons are many but come down to family ties and costly relocations, especially discouraging to the aging workforce.  Then there’s stuff like shared custody, aging parents, dual income families that don’t want to move for the sake of one job, and one I didn’t know is that relocation packages have gotten skimpier. There are many factors, but my input has been that a diminished willingness or ability to move puts dampening pressure on wages. Anyway, did Fed Fund futures do anything on the back of all this? No, they did not.

NEAR-TERM MARKET THOUGHTS:  The curve flattened a bit more to new cycle narrows as longer yields made marginal but distinct gains; 10s are back into the channel that dominated the later part of June and much of July, while 30s are lagging by a very few bp. You have to come away with a bullish-y read though what the specific dynamics were that make this action different from the general tone of August. If I had to say what added to the cause it wouldn’t be particularly useful, but that never stopped me. 

First, I’ll dismiss the FOMC Minutes (try saying that with a long ‘I’ and the stress on the second syllable for a long ‘u’) and the supposed short base in TY. The Minutes told us nothing we couldn’t have figured out from Fedspeak and a bit of one’s own logic; trade policy might hurt the economy even if it gives a temporary nudge to inflation, fiscal headwinds eventually run out and EM stress is on the radar along with a softer tone in housing. I guess Fed officials read the same papers we do. That doesn’t stop them from hiking a few more times which is what a 21 bp 2s/10s curve needs to focus on. I’ve already discussed the TY story so won’t belabor that.

And with the Funds rate headed toward 2.5% in the next few quarters, basically even to a tad ahead of inflation, of course rates are losing a sense of being accommodative. Do we need the Minutes to tell us that?  A lot of words were spoken in the market about what might be discussed at Jackson Hole with pundits sort of implying that our own agenda would be part of it. I don’t think that tells you much either other than that we think it would be nice to have some Balance Sheet insights.

This is all to conclude that I don’t think the market has moved very much and that the headlines those things garnered are not so much mission-critical but filler in an otherwise slow news week.

Of course, this ignores the political realm which I have to believe is on the market’s mind though less sure of its influence. I mean if the Manafort and Cohen stuff somehow supports bonds with their implications for uncertainty in the coming elections to say nothing of the future of Trump, shouldn’t it be detrimental to stocks and maybe the dollar, too? Watch this space; at some stage I think these events will impact markets. Whether that’s positive, i.e. relief, or negative, remains to be seen.

So, what do we know? As we get into September we know the Fed will hike. That’s largely priced in leaving little room for further accommodation. There are some chinks it the proverbial armor of economic data as witnessed by the Citi Surprise Index at -20.20, the lowest level since last summer. There is good news against that, the behavior in stocks for instance, but then with the further weakness in various housing sets, the ongoing poor performance of real wages, I think there’s little room for more than a modest retreat in rate or steepening other than as a corrective thing.

And then there’s the wait. It’s awful to a strategist’s role to be so patient, but I don’t know how to handicap the situation with Turkey, the impending China trade talks, Trump’s legal travails and his distracting temperamental tweets. Man, what would the media have to talk about if he just acted more like, well, more like a President?

To bore you a bit further it’s like this, I see the broad range holding 10s from 2.75-3.0% for much of the month and WELCOME you telling me why and where I’m wrong. Bear in (see chart) 30s have traded in a 15 bp channel for most of this year; I’ll stick to that theme and sell forays towards 2.90% and buy against 3.10%. 10s aren’t singing much of a different tune, though the charts tell me 10s/30s can flatten. 5s look rich, see final chart below.

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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