(Click on image to enlarge)

(Click on image to enlarge)

(Click on image to enlarge)

It Came Upon a Fed Day Clear

It finally happened. The Fed exited ZIRP exactly seven years to the day after it began. The Fed raised the Fed Funds Rate range to 0.25%-0.50%. As a result the bond market did… very little. Bond market participants were well prepared for liftoff and have learned to largely ignore the Fed’s so-called “dots” (interest rate projections). Let’s discuss.

• The Fed hiked the range of the Fed Funds Rate to 0.25% to 0.50%.

• The Fed sees the Fed Funds Rate rising only gradually.

• The Fed’s “dot plot” forecast calls for a 1.375% Fed Funds Rate at year-end 2016.

• The “dot plot” indicates that the Fed does not see the Fed Funds Rate above 3.0% until beyond 2018.

• The Fed sees low inflation as transitory and that building wage pressures and rising oil prices should push inflation (Core PCE) to its 2.0% target.

• Although the Fed is optimistic about the economy, it sees the need for only gradual rate hikes.

• Additional rate hikes are not expected to be “mechanical” or “evenly-spaced.”

• The Fed said it does not expect to stop reinvesting balance sheet proceeds until well into the tightening process.

• Fed Chair Yellen stated that she believes long-term borrowing costs should not “move much.”

What was the Bond market’s reaction? Following some volatility immediately after the FOMC Rate Decision and Ms. Yellen’s press conference, prices of long-dated U.S. Treasuries rallied, pushing long-term yields lower. The yield of the benchmark 10-year UST note ended that day at 2.27%. At the time of this writing, the price of the 10-year UST note was up 16/32s to yield 2.24%. The yield of the 30-year U.S. Government bond stood at 2.93% with its price up 1-12/32s.

The bond market is clearly in disagreement with the Fed’s outlook. Bond market participants have looked around the globe and within the U.S. economy, and have decided that the Fed’s transitory and cyclical phenomena are probably more structural and longer-lasting in nature. If I had to bet on who will be proved right, I would put my money on the bond market. After all, it is the bond market which really sets interest rates. The Fed knows this full well. This is why it tried to jawbone sunshine in yesterday’s commentary. It is also why the Fed is sweating over whether it can effectively raise the Fed Funds Rate in the open market.

Remember, pushing the Fed Funds Rate higher doesn’t happen via Fed edict. The Fed has to remove money from the financial system. Traditionally, the Fed would sell short-term Treasuries via open market operations. However, since the Twist of 2011 and long-term asset purchases (QE Infinity) of 2012, the Fed holds very few short-term U.S. Treasuries. The bulk of the Fed’s balance sheet is in the 3 to 5 year maturity range. The Fed’s course of rate hike action could be to repo out U.S. Treasuries on the so-called belly of the curve. Thus, we could see the most rate volatility materialize in the 5-year UST.

Won’t Get Fooled

The bond market is downplaying Fed rate hikes because, when it looks at the economy and sees job growth which was slower in 2015 than it was in 2014 and 2013, slowing global growth trouble among commodities producers and a plunging manufacturing sector, bond market participants are not expecting rising inflation. When you add in the fact that Fed tightening is typically anti-inflationary, there was little reason for long rates to rise yesterday.

Then there is the divergence of monetary policy between the Fed and most sovereign central banks. Whether or not this divergence can push the USD to parity with the EUR is debatable, but there is little doubt as to the U.S. dollar remaining strong, or strengthening, versus many major foreign currencies. The USD continues to strengthen against most foreign economies, including the yuan. That the USD is rising versus the yuan is significant as Treasury department data indicate that net foreign sales of Treasury bonds and notes were $55.1 billion during October. That compares with net purchases of $17.4 billion in September and the previous record net sales of $55 billion in January. Treasury data also indicated that China, the biggest foreign holder of U.S. government debt, had $1.25 trillion in bonds, notes and bills in October, down $3.2 billion versus September. Japan, the largest holder after China, reduced its holdings by $27.9 billion to $1.15 trillion, the lowest level since August 2013.

This is significant for in spite of near-record selling of U.S. Treasures, the 10-year U.S. Treasury note (a favorite holding of central banks) remains in the 2.20%s. This means that either there is very strong demand for long-dated U.S. Treasuries from investors other than central banks or foreign central banks are mainly selling shorter-term U.S. Treasuries. Recent Treasury auction data indicate that indirect bidders (which includes foreign central banks) demand was strong. In fact, indirect bidder demand at last week’s 30-year U.S. government bond auction was the third strongest ever.

Bond Squad’s outlook for the path of the Fed Funds Rate is that we could see two or maybe three, rate increases in 2016. I believe that inflation pressures should trend below Fed expectations and that job growth could step down (moderately) again in 2016. Oil prices should stabilize and push headline inflation higher, but rather than stabilizing oil pushing core inflation higher as well, I believe we should see a convergence of Core and Headline CPI in the high -.0% area and a convergence of Core and Headline PCE in the mid-1.0% area. The Fed is counting on rising wages to drive inflation as well. This is based on the Phillips Curve, which assumes that wage growth translates directly to inflation pressures. The problem is that the Phillips Curve hasn’t worked since about the time I was born. Although the Fed continues to use the Phillips Curve as a forecasting tool, it is now largely discredited among economists. I believe that we should see the Fed “dots” lowered throughout 2016.

The Bond market shares my views. According for Fed Funds Futures, the Fed Funds Rate is not expected to top 1.0% until April 2017. This is dramatically different than the Fed’s forecast of 1.375% at year-end 2016. Again, I would expect the bond market will be proved more accurate.

In Spite of All the Dangers

In spite of all the evidence stacking up to the contrary, the Fed believes it will get back to a more normal Fed Funds Rate of 3.50%-plus in about 2019. Fed Chair Yellen intimated that economic conditions could warrant a neutral Fed Funds rate lower than the traditional neutral rate for the next several years, but conditions should renormalize in the next three or four years. What strikes me is that the Fed thinks that after six years of economic expansion, the economic and credit cycle will continue unabated, pretty much saying that trees will grow to the sky. Although it might be true that expansions do not die of old age, they usually do not run uninterrupted forever. There are signs in the economic data that consumer confidence, growth and hiring might be past peak. The economy might continue to expand during the next three or four years, but at a slower pace.

I think the Fed is underestimating the disinflationary forces emanating from overseas. Few economists argue with the idea that slow growth and low inflation forces in Europe, Japan and EM are far more structural than cyclical. Thus, anti-growth and anti-inflation headwinds from overseas could persist for an extended period of time. This is what the bond market sees. Why doesn’t the Fed see this? It might be because it chooses to rely on models rather than what is really happening. Another possibility is that the Fed does see what is happening, but is reluctant to admit that it is largely powerless to reverse structural economic trends.

I believe the latter to be the case. If the Fed came out and said, growth will probably be modest and inflation low and we are almost powerless to change it, the lack of confidence could disrupt the markets and lead to a lack of confidence in the economy.

NIM Skulls

Following the FOMC rate decision, a number of banks raised their prime rate 25 basis points to 3.50% from 3.25%. However, at the time of this writing, no bank raised its deposit rate. Banks effectively widened their net interest margins. Remember, banks cannot be forced to raise ofrcut lending and borrowing rates. In this scenario, banks could make more money per loan, but a higher prime rate could curb loan demand. Granted a 25 basis point rise of the prime rate might not do much to curb loan demand, but several moves in 2016 could.

Dazed and Confused

Following the FOMC rate decision, utility and REIT stocks rallied. This perplexed Bond Squad readers, who largely believed that these interest rate-sensitive equities would decline following a Fed rate hike. What is not well-understood in the wealth management industry is that dividend-paying long duration/perpetual equities tend to track closely with long-term interest rates rather than short-term interest rates. Thus, as long as long-term UST yields remain contained, prices of utilities and REIT stocks should receive market support. The lack of understanding of the yield curve can lead investors and advisors to make poor decisions with regard to interest rate sensitive instruments.