Last year, the cry in the markets was to replace Janet Yellen as Fed chair before inflation got of hand. Today, the capital markets, particularly the equity and high yield debt markets, fret that President Trump will appoint a Fed Chair who is too hawkish and will combat any and all inflation created by fiscal and tax policy reforms. Thus, what said market participants want is another Janet Yellen, if not the lady herself. This tells me that they believe that inflation is structurally more moderate than any time since World War II.

With this I agree. With what I do not agree is the idea that higher inflation corresponds with stronger growth. Ever hear of stagflation? Although strong growth can cause inflation pressures to rise, this is not always true. There are times, such as the 1920s (when economic growth was driven by technological innovation), when economic growth was robust, but inflation pressure were scant. I believe today’s economy rhymes with the 1920s U.S. economy, but with technological efficiencies occurring on the downstream/distribution side of the economy rather than the upstream/production side of the economy. As most productivity gauges measure upstream, they are missing the efficiencies gained in the downstream side of the economy. In my opinion, efforts to boost inflation with the idea that economic growth will follow has a reasonably good chance of creating stagflation.

Presently, there are four known candidates for Fed Chair. From most dovish to most hawkish they are:

·        Jerome Powell (Fed governor)

·        Janet Yellen (current Fed Chair)

·        Kevin Warsh (former Fed governor)

·        John Taylor (noted economist and creator of the “Taylor Rule” used to calculate “correct” monetary policy

I listed John Taylor as most hawkish as he is rules based and, at present, the Taylor Rule suggests a Fed Funds Rate of about 3.74%. 

The Taylor Rule is based on three factors:

1)   Targeted versus actual inflation levels

2)    Full employment versus actual employment levels

3)   The short-term interest rate appropriately consistent with full employment.

           The Taylor Rules does not take into account QE. In theory a large Fed balance sheet has a similar effect as a lower Fed Funds Rate.

Where I think the Taylor Rule comes up short is that it assumes targeted inflation rates which may be too high for today’s economy and a full employment unemployment rate which may be out of step with the composition of today’s labor force. If Mr. Taylor would take a strict rules based approach, the Fed Funds Rate would be above 3.75%, according to the Taylor Rule. Even if those who believe that somewhat higher interest rates could increase consumption among savers and retirees, jacking the Fed Funds Rate to nearly 4.00% would probably invert the curve and send the economy into recession. As such, Mr. Taylor might not be as rules based as some believe should he be named Fed Chair.

Of the four known Fed Chair candidates, the most flexible is Kevin Warsh, in my opinion. Not only is he not rules based, he is not wedded to traditional inflation targets and full employment rates. Mr. Warsh was appointed Fed Governor in 2006, at age 35, making him the youngest Fed Governor in history. Currently age 47, he is by far the youngest of the four known candidates. As a free thinker and not an adherent to any particular dogma, the appointment of Mr. Warsh as Fed Chair could cause uncertainty among market participants. As we all know, markets abhor uncertainty.

           Ms. Yellen is a known quantity, a pragmatist who can lean dovish in times of economic malaise. Mr. Powell is arguably more dovish than Ms. Yellen. He is seen as the most likely to continue the Fed’s path established by Fed Chair Yellen. In fact, he might push to renormalize at a slower pace than that preferred by Fed Chair Yellen. This, along with the fact that he is a Republican, is probably why Jerome Powell is the preferred candidate of Treasury Secretary Steven Mnuchin. There is some irony in having Mr. Powell as a favored candidate.

Since her taking office, Ms. Yellen has been criticized by Republicans (including then presidential candidate, Donald Trump) for keeping monetary policy too low for too long, perhaps for political purposes (which I think is a ridiculous assertion). Now, President Trump is considering both Ms. Yellen and Mr. Powell for Fed Chair. In my opinion, Mr. Powell is the front runner, followed by Ms. Yellen and Mr. Warsh, with John Taylor bringing up the rear. With moderate tax cuts a more likely occurrence than true tax (and healthcare) reform, low interest rates would be necessary to make debt-fueled tax cuts anything resembling affordable.

What Mr. Trump might not be figuring on is; regardless of which candidate he chooses as Fed Chair, that person is likely to follow the Fed’s dual mandate of price stability and full employment. Thus, as long as the U3 Unemployment Rate is sub-5.00%, the Fed (regardless of who is Chair) is likely to combat inflation, should it heat up. In my opinion, the idea of allowing the economy to run hot, in terms of inflation, with the intent of spurring economic growth is a flawed strategy. In my view, that would result in a U.S. economy which more resembles (rhymes with) the 1970s than it would the 1980s. Thus, regardless of who is named Fed Chair, I foresee a bear flattening of the U.S. Treasury yield curve. How quickly it flattens and how high UST yields are when the curve does go flat depends on who is named Fed Chair (the more dovish the higher rates could be when the curve goes flat). However, regardless of who is named Fed Chair, I doubt we see the 10-year UST note yield touch 3.00% for the balance of the current interest rate/economic cycle. In my opinion, when the curve goes flat and eventually inverts, I believe that all UST yields will be below 3.00%, at those times. (5) (6) (7)

Credit When Credit is due

           What might that scenario mean for the economy and the bond market? A flatter yield curve would likely mean that banks become more selective, in terms of creditworthiness, about to whom they lend. In a bear flattening (where all interest rates rise, but short-term yields rise more than long-term yields) not only are net interest margins squeezed, but mortgage interest rates would rise. There is a misconception among investors and consumers that bank rates must move almost in lock step with the Fed Funds Rate and/or UST yields. This is not necessarily the case. Banks could raise deposit rates as little as they can without losing deposits while raising mortgage rates somewhat more than benchmark UST yields in an effort to maintain as profitable net interest margins as they can. Thus, the 10-year UST note yield (the benchmark for 30-year fixed-rate mortgages) could rise 25 to 50 basis points, but 30-year mortgage rates rise 50 to 75 basis points. Yes, mortgage rates would still be low in the eyes of us old-timers, but for borrowers under the age of 35, mortgage rates could be considered fairly high.

           A bear flattening could have negative impacts on the corporate credit markets. The lower on the credit spectrum, the more negative the impacts could be. As the yield curve flattens, bank lending to corporations could become more restrictive, as they could among mortgage borrowers. As banks choose to focus on more creditworthy corporate borrowers, junk rated corporations could find borrowing expensive, if not impossible (for some). I shared my thoughts with Barron’s Abby Schultz, which she featured in the Income Investing blog. Also featured was a contrary view stating that corporate balance sheets are strengthening and corporate debt issuance could decrease. That might be true of the investment grade bond market. In the junk debt market, the situation is less sanguine.

According to BAML data, the size of the global high yield bond market has grown from just over $800 billion in 2007 to more than $2 trillion by 2015.

Size of Global HY Bond Market since 1998 (BAML):

Even when we consider that the percentage of U.S. high yield debt versus the global market declined to 62.6% from 87.1%, the actual size of the U.S. high yield bond market has grown from about $700 billion in 2007 to nearly $1.4 trillion in 2015 and it has only grown since then. Goldman Sachs research shows that corporate balance sheet leverage, as measured by aggregate net debt versus EBITDA.

The data do include investment grade companies as well, but considering that many investment grade corporations on sitting on piles of cash, the majority of balance sheet leverage growth has occurred in the high yield debt market. As such, arguments that balance sheets among high yield companies are healthy and becoming healthier ring hollow with me. What also rings hollow is the argument that investors are pouring capital into corporate debt, including junk bonds, because they are confident in corporate balance sheets. This is not what we are experiencing at Wealth Strategies and Management LLC and it is not what I am hearing from readers.

I don’t expect the high yield market to unravel in the next several months, but by the end of 2018, we could see cracks begin to form. When considering investing in high yield bonds, my advice is to do your credit homework and stay inside three years on the yield curve. (1) (5) (6) (7).

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(1) High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.

(2) International and emerging market investment involves special risks, such as currency fluctuation and political instability and may not be suitable for all investors.

(3) Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values may decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Many Municipal bonds are federally tax-free but other state and local taxes may apply.

(4) Mortgage backed securities are subject to credit, default, prepayment, extension, market and interest rate risk.

(5) The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

(6)The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. 

(7) All indices are unmanaged and may not be invested into directly.