November Economic Read

• Early indications are that October was another month of slow but positive growth in the U.S. and abroad. The monthly nonfarm payroll number for October was the strongest of the year, suggesting that weakness in August and September’s numbers was just noise. Emerging markets continue to be a small drag on the U.S. economy, but there are no signs of a crisis at this point. On the monetary policy view, the Fed continues to prepare the markets for tightening, perhaps at the December meeting.
• At 271,000 new jobs, the month-to-month change in nonfarm payrolls released in last Friday’s employment report was the strongest of the year. In addition, the year-over-year change in wages was as strong as it has been since the crisis, up 2.5% year-over-year. We can hope that wage gains hint at more of the economy’s gains accruing to average Americans to build a firmer foundation for a sustainable recovery. It is worth noting that as the expansion ages we can expect monthly employment gains to moderate and to see strength in the labor market represented as additional wage growth.
• On the international scene my view continues to be fairly strong growth in the developed world and faltering growth in the emerging world. Below, I plot the Purchasing Managers’ Indexes for the major international economies. For China (the epicenter of current concern) the PMIs stopped falling in October, though only time will tell if this level will be followed with renewed expansion or further deterioration. The economies most associated with exporting intermediate or raw goods to China (Australia, Taiwan, Hong Kong, Korea) continue to show contraction in the their PMIs. Indeed, these countries are seeing expectations of 2016 growth marked down. At the same time indexes ticked up in the Eurozone, the UK and Japan last month and a GDP-weighted average PMI increased in October.

International PMI heatmap

Source: Bloomberg, Markit, Astor calculations

• The Fed renewed its hold on investors’ attention last week with Chair Janet Yellen announcing the December meeting could mark the first raise in rates since 2006. Many of us are hopeful that whatever the other consequences, the first hike will at least mark the end of our long purgatory of waiting for the first hike. Focus should shift to the pace and ultimate extent of rate hikes. Given the uncertainty about the amount of slack in the labor market and inflation below target, I expect rate hikes to be much more gradual than in the 1999 or 2004 cycles. In addition, the FOMC members (who have consistently been too bearish in their rate forecasts since the crisis) currently see Fed Funds rate topping out at about 3.5%, well below previous cycles. Perhaps the tightening could be as modest as a two-year long move to a 2% Fed Funds rate
• Why is the Fed interested in rising rates? The FOMC seems to believe the labor market is close to full employment and that core inflation should move back to its 2% target in the next two years or so. Given the uncertain lags associated with monetary policy, the FOMC believes it is best to start to act now.
• Overall, I view the information released in the last month as supporting a slightly more optimistic take on U.S. growth.

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Fixed income outlook for a Fed hike

On Wednesday March 18th the Fed will have a quarterly Press Conference meeting. Since being instituted a few years ago these have quickly become significant as the meetings where new policies are announced. On I expect further measured progress toward higher short term interest rates. This note covers

  • My analysis of the Fed’s likely actions
  • What the short end of the fixed income market seems to be expecting
  • Implications for bonds

As always, there is considerable uncertainly but I think the market underestimates how much the Fed may raise rates.

Long and variable lags

The chart below shows where the economy is relative to the Fed’s dual mandate of full employment and stable prices. The horizontal blue area is a band around the Fed’s 2% inflation target and the vertical pink ribbon is the FOMC member’s estimate of the full employment rate of unemployment. The Fed adjusts monetary policy to nudge the economy toward the intersection of the two shaded areas. Considering where we were in 2010 and the criticism of their actions, we should admit that the FOMC has done a good job over the last several years.

FOMC dual mandate scorecard

Source: Bloomberg, FOMC, Astor calculations

Part of the difficulty with monetary policy is that there is a disconnect between cause and effect. The economy is not a pool table, with each action being in principle calculable from initial conditions. The Fed’s actions are subject to long delays the effects of last year’s easing or tightening works its way through the system.

For example, last week Vice Chairman Stanley Fischer said that the thought the effects of quantitative easing and forward guidance on the economy would not peak until 2016, this of a policy that began to be wound down a year ago. (see his speech or the underlying research) Imagine driving a car with an unknown delay between touching the brake and the car slowing and you will have the idea.

The end of forward guidance

Which brings us around to the question of why is the Fed talking about raising rates now? There are still people out of work, more working part time and still more who left the labor force in the great recession. Even though inflation is low, public comments by several members have led me to believe that it is the uncertainty about the timing of the effects of monetary policy, and the continued stimulus from QE which is still in the pipeline, that will cause the Fed to raise rates shortly.

An action consistent with a hike in the second or third quarter would be for the Fed to change its forward guidance language at the upcoming March meeting. According to Chair Janet Yellen’s recent congressional testimony, such a move will mean that a rate hike is possible, though not ensured at the next meeting.

The practice whereby the fed has been explicitly telegraphing its moves months in advance has been known as Forward Guidance, and is itself believed to be a very significant part of the Fed’s easy stance. That is, by giving strong suggestions, if not quite guarantees, about the future course of short term rates the Fed has shaped expectations which are such a key component to interest rates. This anomalous circumstance is likely to end in a few weeks and the Fed hopes to resume its accustomed inscrutability shortly.

The market’s expectations

Absent a rapid deterioration in the economy it is likely that the new hiking cycle since 2004 will finally begin in the summer or fall. I am concerned that the fixed income market, jaded by repeated disappointments of the Fed failing to raise rates, has convinced itself that the fed will not be aggressive when it finally does so. This chart shows forecasts of the fed funds rates from three sources. The lowest, red dots are derived from fed funds futures, the middle, blue dots are from a survey of primary dealers, the highest green dots are from a survey of FOMC members.

Forecasts of fed funds

Source: Bloomberg, FOMC, Astor calculations

There is a 85 basis point difference between the expected end of year rate for 2015 between the fed fund futures market and the FOMC with a larger difference the following year.

Repeated disappointments have led the market to doubt that the fed will be aggressive when it does begin to raise rates. Recalling the last two tightening episodes may be sobering. In both 1994 and 2004 the economy was slow to come out of recession – the recovery from the 1991 recession was the original “jobless recovery”. Signs of economic slack and tame inflation allowed the Fed to keep rates lower for longer in these recoveries. But when the fed raised rates it was far beyond what the market had anticipated, perhaps lulled by a lengthy period of easy money. In 1994 the market was expecting 100 basis points in two years and got 300 basis points in just over one. A similar mismatch between expectation and reality took place over the feds 425bp hiking jag starting in 2004.

It is hard to say how likely the Fed is to tighten aggressively. On the one hand uncertainty about the amount of slack left in the economy and low rates of other developed nations are likely to lead to a lower funds rate. On the other hand, the consumption-reducing rebuilding of balance sheets by banks and consumers seems to have been completed, leaving them better able to spend.

There is little theory to guide us. James Hamilton and his co-authors detailed recently that economists have not found a clear, empirical relationship between economic growth and a neutral real (that is, inflation adjusted) fed funds rate. We cannot generalize from economic growth or inflation dynamics to where the fed will stop raising rates once it starts.

In addition to fed funds rising, perhaps more and more quickly than the market anticipates, there are signs that some on the FOMC desire fiscal conditions as a whole to be significantly tighter. I am thinking here of two speeches by NY Fed President Bill Dudley who I see as being representative of the vital center of the committee. In a speech last year President Dudley said that the FOMC needs to pay closer attention to financial conditions and that if measures like the ten year yield moves in an easier direction while the Fed is tighten, then they may need to raise more aggressively to make the market get the message.

As always, my thoughts should be assumed to be seasoned with a heavy hand of humility, we can expect the markets to surprise us over the rest of 2015. However, with the Fed looking to raise rates with firm growth in the US, and a decent outlook overseas, I see a significant chance of a meaningful upward move in yields this year.

A tale of two markets

Two authors I respect very much have post I would like to argue with a bit. The different response to the US economy to dramatic stock market declines in 2000-2002 and 2007-2008 is very interesting, what does it tell us about the US economy?

Cecchetti & Schoenholt say that the story is all about leverage in the financial system and surely that is part of the story. In Mian & Sufi’s excellent book House of Debt tells a story I find more convincing about leverage. The key thing is not how much debt is held, but who is holding it.       Yes, banks had leveraged exposure to US real estate prices in the period leading up to the Great Recession.       Consumers, however, had a great deal more exposure to relative to shock-absorbing assets. Mian & Sufi argue that the lower income consumers who had borrowed to buy homes were forced to dramatically curtail their spending after the decline in price of homes they bought with borrowed money.

Imagine you make $10,000 a year and you make a $10 bet. If the bet turns out against you it would not affect your lifestyle very much. Now imagine the losing bet was $1,000, in this case your pattern of spending would have to change a great deal.

Mian & Sufi make a case that this is exactly what happened in the 2007-2009 crisis. Debt acted as “anti-insurance” – focusing losses on those least able to bear them, with results that are readily understandable in retrospect, even if they were not well understood at the time.

How much debt was added and are we back to more sustainable levels?     Since 1980 the Federal Reserve has published data about debt relative to income.


We can see that the total of all interest payments (mortgage, student debt, credit cards etc) as a percentage of income has swung from a high over the life of the series in 2007 to a new low value today – a function of the mixture of lower interest rates and lower rates of debt. As this measure has been fairly table for several quarters, it seems that consumers do not feel the need

I recommend House of Debt (or their academic writings, accessible here) to everyone in the financial services industry, that Cecchetti & Schoenholtz talk about asset returns on the economy and not to mention the composition of the debtors shows that their work has yet to be fully appreciated.

New directions for the Fed in 2015

The big decision for the Fed next year will be if they should start raising interest rates. Remember that the fed is charged to try to maintain price stability and full employment. This chart shows unemployment and inflation along with the Fed’s inflation target (in blue) and the unemployment rate consistent with stable prices (in pink). The economy has improved without inflation over the last five years.


The argument for raising rates is that it is necessary to control inflation.  This this post from The Economist for example.  I disagree for a few reasons:

  • As the chart below shows, over the last 20 years actual inflation has spent a good deal of time below a band around 2% inflation except and only brief episodes above, suggesting that the Fed is too hawkish on average.


  • There is mounting evidence (for example this note published by the Fed) that the recessions, the possible outcome for raising rates prematurely, can involve permanent reductions in the level of output. Simply put, if you have a million people working for a year they make a certain amount of stuff. If there is a recession and they are out of work, they don’t make up all of the lost output once the economy recovers. To take this risk the threat to price stability must be substantial.
  • Finally, inflation expectations (based on surveys or derived from market prices) remain stable.

Of course, what I think doesn’t matter, only the opinions of the voting members of the FOMC count. Every year a shifting cast of regional presidents serve as voting members on the FOMC. This year sees 4 new presidents along with the chair of the NY Fed who is always a voting member in deference to that bank’s constant connection with the markets. We have two members I would characterize as patient about raising rates and two who seem eager

  • Richmond Fed’s Jeffrey Lacker says that “the unemployment rate is an accurate gauge of labor underutilization. ” Suggesting that rates can rise soon.       Interestingly, he not only expects to raise rates, he wants the Fed to sell securities held under quantitative easing, not just cease to purchase. “I believe the Fed’s efforts to normalize monetary policy must include the sale of mortgage-backed securities in order to reduce the Fed’s role in credit allocation. ” Lacker speech
  • Similarly, the San Francisco Fed’s Williams says “Rate hike likely by mid-2015” Williams speech
  • On the other hand Chicago’s Charles Evans sees risks to tightening: “I am concerned about the possibility that inflation will not return to our 2 percent PCE target within a reasonable period of time.” And he emphasizes caution: “As I think about the process of normalizing policy, I conclude that today’s risk-management calculus says we should err on the side of patience in removing highly accommodative policy.” Evans speech
  • At the Federal Reserve bank of Atlanta Dennis Lockhart believes the United States will approach conditions consistent with full employment by late 2016 or early 2017 and in his view undershoot of the inflation target is currently a bigger risk than overshoot. Lockhart speech
  • The New York Fed president William Dudley seems to be willing but not eager to raise rates next year: “The consensus view is that lift-off will take place around the middle of next year.  That seems like a reasonable view to me.   But, again, it is just a forecast.  What we do will depend on the flow of economic news and how that affects the economic outlook” Dudley speech

Incidentally, NY Fed President Dudley says

In assessing inflation expectations, I currently put more weight on survey-based measures of inflation expectations as opposed to market-based measures.  Survey-based measures have been generally stable, consistent with inflation expectations remaining well-anchored.  However, market-based measures, such as those based on breakeven inflation derived from the difference between yields on nominal versus Treasury Inflation-Protected Securities (TIPS), have registered declines over the past few months, even on a 5-years forward basis.  Research done by my staff suggests that much of this decline in market-based measures of inflation compensation reflects a fall in the inflation risk premium—that is, what investors are willing to pay to protect themselves against inflation risk.  Adjusting for the fall in the inflation risk premium, inflation expectations appear to have declined much less than implied by TIPS inflation breakeven measures.

If he is using this as a reason to raise rates, I cannot agree. First of all, surely a decline in inflation risk premiums means that the market is less concerned about sudden jumps in inflation. That is, the market is telling you that the market is not worried about inflation. I am not sure why a policymaker would want to discount that. Second, it is not clear that Survey based inflation expectations are indeed stable. See this chart of expectations for next year from the Consensus Economics survey.


Whatever is ahead, our next landmark is the final FOMC meeting of 2014 which will feature new forecasts from the committee members and a Janet Yellen press conference on December 17. Hopefully we will get more insight into the Fed’s plans then. In the meantime it is worth noting that for Fed Funds to get to what the median member expects of about 1% by the end of 2015 and they proceed in bite-sized 0.25% steps, they will need to start raising rates in their fifth meeting of the year in July. Given the Fed’s reluctance to surprise the markets, I would expect clear warnings at the March press conference at the latest.

Interestingly, the Fed Fund futures seem to expect less easing overall with year-end 2015 rates in the market at 0.5% which implies starting later or not raising rates at every meeting after they start.

FOMC preview

I am expecting little news from the FOMC this week. The committee should take the final tranche of QE off, which might have been an unfavorable surprise amid the financial market volatility two weeks ago, but which is likely to go unnoticed this week.

Some of the regional presidents have been advocating their views towards on the one hand a slower move to higher interest rates (President Evans of the Chicago Fed, see his speech here) or on the other hand, a faster move (President Plosser of the Philadelphia Fed, see his speech here). My personal view is closer to the raise-rates-later view of President Evans. whatever the decision turns out to be, I do not expect any committee level move with this meeting, but we might get some additional information from Chair Yellen’s press conference and the updated “dot plot”, December 17th.

-John Eckstein, Chief Investment Officer

World PMIs (October 2014, preliminary) – steady as she goes

The October preliminary Markit PMIs for major economies were somewhat stronger, on balance, than September’s. The US is off its peak but still quite strong. The Eurozone recovered a bit, thanks to Germany is my guess, though the reading is still around the 50% expansion/contraction line.


In Asia, Japan’s manufacturing PMI posted solid progress and China registered little change.

Overall, the preliminary PMI’s suggest to me no significant changes in global economic growth: Fairly strong in the US, moderate in Asia, weak but positive in Europe.

Don’t Panic

The recent stock sell-off certainly has our attention. Yesterday, October 14th, the S&P 500 closed about 6.6% off its high, set only a month ago. And writing before the opening of October 15th, it looks like another bad day. As always, there is a chance of a further stock market decline, but we think the risk reward proposition of the stock market is still favorable. Accordingly. we have not reduced our exposure to stocks yet, though we are monitoring the situation closely. Why might investors want to cut their positions and why hasn’t Astor?

The fundamental argument for panicking

The strongest fundamental argument for reducing equity exposure is the possibility of a renewed recession in Europe, perhaps leading to deflationary fears in the developed markets. Recent news in Germany in particular has been disappointing, and any growth in the periphery is coming off of a very low base. We started noting weakness in the Eurozone in July, with our latest update last month here. In the last few months, the ECB has raised and disappointed expectations for a dramatic non-traditional easing. A renewed recession Europe would reduce growth prospects in the US somewhat and may have an outsized impact on large cap stocks which generate a good deal of their profits outside the US.

The “fear itself” argument for panicking

Roosevelt said, “The only thing we have to fear is fear itself.” Similarly, the sell-off in stocks itself (and the rise in the VIX, part of the same phenomena) is its own reason to cut positions. While we do understand the inclination, and we think a sober, quantitative risk control framework is important, we are not so sure that just cutting stocks because they are going down in price is always the best method. In fact, if you stayed out of the stock market every month which started with a 5% of greater drawdown you would cut your compounded annual growth rate by half over the period of 1970 – 2014. You would have to be a fearful investor indeed to be able to sacrifice half your returns.

Note that not all of the decline in the price of risky assets (such as stocks and commodities) is bad news. The decline in the price of oil, if translated into its typical relationship to retail gasoline prices could translate to a $600 per family bonus. A little stimulus at just the right time.

The stronger argument for staying the course

At Astor, the current state of the US economy is the primary input into determining the optimal mix of stocks and bonds. As far as we can see today, the state of the US economy is strong. We see it in the strength of the labor market and the strong pipeline for manufacturing. If the economy begins to slide, we will adjust positions. It is possible the current stock market weakness foretells a recession, but in general using the stock market to predict recessions is a losing bet.

In addition to the real economy, we closely monitor the level of a much broader collection of indicators which measure financial stress. The well-known VIX is included in this mix, but so are several other measures. We collect these indicators into a daily index of financial stress. So far, this measure has not risen to the levels where evidence has suggested reducing exposure.

Our conclusion: Don’t Panic

Because of its association with outsized declines, it is uncomfortable to write in October that we expect today’s stock declines to be transitory, as a gut reaction says to head for the hills. Our research counsels a steady hand, however, and as long as the fundamentals do nott change, we will not either.