Eyes on the Fed: No Urgency for a Rate Rise

All eyes are on the Federal Reserve this week and the often-discussed question: Will they or won’t they raise rates? Here at Astor, our prediction of what we believe the Fed will do (spoiler alert: we don’t expect a rate rise in September) comes down to two important data points: employment and inflation.

To learn more about The Fed, watch this video

These data points relate directly to the mandate of the Federal Open Market Committee (FOMC) as stated in The Federal Reserve Act, particularly to promote the goals of maximum employment and stable prices. In the chart below, the blue horizontal band represents the inflation target (roughly 2%) as set by the FOMC, while the pink vertical band shows the unemployment rate (roughly 5%).

fed

 

We can see that as of August 2016 (far left), the Fed has made progress in fulfilling its mandates. The unemployment rate has been cut in half, from the high of 10% in October 2009 (in January 2010 it was still a lofty 9.8%) to 4.9% in August 2016. Inflation, meanwhile, has been not been above the Fed’s target for more than a month or two.

Looking ahead, the question that we believe is on the collective mind of the Fed is what will happen a year or two out, particularly with unemployment being so low. Will a relatively tight labor market lead to higher wages and, in turn, force inflation higher, above the Fed’s target? Recent speeches and comments made by central bankers seems to us an FOMC that is divided on this issue.

The “hawks” have been making their case for raising interest rates; in their view, with unemployment being so low, inflation looks certain to increase. For instance, earlier this month, Federal Reserve Bank of Boston President Eric Rosengren said “a reasonable case can be made” for tightening interest rates to avoid overheating the economy.

On the other hand, the “doves,” who favor keeping interest rates steady, see additional slack in the labor market; with economic growth slowing, they don’t believe higher rates are necessary. Fed Governor Lael Brainard, for example, said in a recent speech that leaving rates unchanged since December 2015 “has served us well in recent months, helping to support continued gains in employment and progress on inflation.”

Here at Astor, our analysis of the Fed’s comments is that the FOMC will refrain from raising rates in September. (We’re not alone in that view: As the Wall Street Journal reported, the widespread expectation in the market is for rates to stay steady.) Come December, though—a full year after the last rate hike, and with another quarter of economic data to digest—we believe the Fed will take the next step and raise rates.

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information.

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September Quick Read on the US Economy

I interpreted last month’s economic releases as somewhat weaker.  Forward looking surveys were concerning though consumer spending in the US, the most important single component of GDP, seems to be stable.

Our latest reading for the Astor Economic Index® (“AEI”) is lower over the month, though I see no discernible trend over the last twelve months.  I still see the US as currently growing above average. The AEI is a proprietary index that evaluates selected employment and output trends in an effort to gauge the current pace of US economic growth. 

aei

 

The nowcasts produced by the Federal Reserve banks of Atlanta and New York are both still showing stronger growth in the third quarter than the first half of the year.  The Atlanta Fed is currently estimating a gaudy 3.3% SAAR and the New York Fed is currently forecasting 2.8%.  These are both significantly stronger than their final Q2 estimates and represent a significant increase from the poor Q2 release.  Both have been updated since the employment report.

Another month of solid job growth means that the we are adding more jobs than needed to absorb the natural increase in the labor force.  We can also see strength in the labor force from some less-often discussed numbers such as the quit-rate which has increased 9% over the last 12 months and the number of job offers, which is at a high for the recovery.  These series can be seen in the JOLTS report put out by the Bureau of Labor Statistics.  On the other hand, there are still signs of higher levels of labor market slack than we would normally expect late in the cycle. The chart below shows unemployment (the headline number) and underemployment.   While unemployment is fairly low and roughly at the level targeted by the FOMC, underemployment shows significant additional slack in the labor market.

unemp-rate

 

The latest purchasing managers surveys from the Institute for Supply Management (ISM) were disappointing. 

pmi

The manufacturing index gave up much of its gains for the year.  I hope this is not a harbinger of renewed manufacturing weakness such as we saw in the first quarter of this year.  Surprisingly, non-manufacturing survey was also quite weak in August and it’s at the lowest level of the recovery.  A diffusion index (such as these) is a bit challenging to interpret exactly and a glance at the chart will show many months spike up or down without signaling sustained shifts in growth.  Digging into the details of the reports we see that much of this month’s weakness was due to drops in new orders and non-manufacturing exports.  This will bear close watching in coming months.

The hawks at the Fed seem to be getting louder, and one month’s survey data is, in my opinion, unlikely to deter them.  See this speech by San Francisco Fed President John Williams who makes the argument that 1) because the unemployment rate is low the Fed will need to raise soon and 2) better to raise sooner by less rather than later my more.  I see both those assertions as questionable (see Tim Duy for an argument about why it might make sense to let the unemployment rate drift lower) but I think a hike is coming in September or December assuming growth stays on its current course. For what it’s worth, my interpretation of Fed Funds futures prices shows that the market places a low possibility of a September hike but a likely hood of December hike.

 Overall, the economy continues its pattern of positive but modest growth.  The ISM numbers make me a bit worried about the fall.  As always I will be monitoring developments in the US economy carefully in the weeks ahead.  Clients are welcome to get in touch for a detailed conversation.

 The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points: including output and employment indicators. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data. The Astor Economic Index® is not an investable product. When investing, there are multiple factors to consider. The Astor Economic Index® should not be used as the sole determining factor for your investment decisions. The Index is based on retroactive data points and may be subject to hindsight bias. There is no guarantee the Index will produce the same results in the future. The Astor Economic Index® is a tool created and used by Astor. All conclusions are those of Astor and are subject to change.

 All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information.

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August Quick Read on the US Economy

My view on the economy is little changed over the month.  I still see the US in an environment of modest economic growth.  A second strong payroll number should quiet the concerns that a period of weakness is beginning.

Our latest reading for the Astor Economic Index® (“AEI”) is still near the highest level posted this year.  I still see the US as currently growing above average. The AEI is a proprietary index that evaluates selected employment and output trends in an effort to gauge the current pace of US economic growth.

usei.long

The payroll number beat expectations for a second month in a row, relieving concerns that any decline in growth is imminent.  There are no obvious signs of weakness hiding in the details and even real earnings are above where they have been in this long, tepid recovery.  Nevertheless, economists do expect payroll growth to moderate as the economy nears full employment, where many believe it is today, so don’t be surprised if average jobs growth in the next year is lower than the last few years.

The “nowcasts”(1) produced by the Federal Reserve banks of Atlanta and New York continue to show stronger growth in the third quarter than in the first half of the year.  The Atlanta Fed is currently forecasting a 3.7% SAAR (seasonally adjusted annual rate) for Q3 2016.  The New York Fed forecast for Q3 is 2.6%.

These forecasts are significantly higher than not only their own respective final Q2 estimates,  but also higher than the BEA’s (Bureau of Economic Analysis) recent release of their preliminary Q2 GDP estimate of 1.2%.

The combination of our proprietary AEI and the “nowcasts” cited above make me somewhat confident that today the US economy is doing fine and would require a shock of some kind to tip us into recession.

How will the Fed react to the passing of the Brexit vote and the bounce from payrolls?

Former Fed Chair Ben Bernanke had a very useful (though a bit wonky) post explaining how the FOMC in aggregate seems to have adjusted its expectations for the near future of the US economy.  The positive news is that the Fed has become more permissive in what counts as “full employment”, meaning the Fed should not be in as much of a hurry to choke off growth because of inflation fears.  On the disappointing side of the ledger, the FOMC seems to think that the US will grow more slowly in the future with GDP growth around 1.8-2% per year where they were hoping for 2.3-2.5% just a few years ago.

The low rate of growth and the continued low level of realized inflation suggest that The Fed sees the natural rate of interest (the level we might expect the Fed Funds rate to gravitate toward over time) to be lower than they calculated it to be before.

The bottom line is that the Fed should see the need to do less tightening to get to a neutral interest rate which may make the Fed more comfortable deferring its next hike.  In other words, lower for longer once again.

Nevertheless, I expect a few Fed speakers to try to remind the markets that they can hike in September, although I still expect a December hike.  To be clear, I do not think that another 25bp would have significant effects on the economy.

Overall, the economy seems to be holding to the same positive but low growth groove it has been in for the last several months.

 

 

(1) “Nowcast” is the GDPNow forecasting model of the Federal Reserve Bank of Atlanta and  “nowcast” is the Nowcasting report of the New York Fed. 

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information.

 The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points: including output and employment indicators. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data. The Astor Economic Index® is not an investable product. When investing, there are multiple factors to consider. The Astor Economic Index® should not be used as the sole determining factor for your investment decisions. The Index is based on retroactive data points and may be subject to hindsight bias. There is no guarantee the Index will produce the same results in the future. The Astor Economic Index® is a tool created and used by Astor. All conclusions are those of Astor and are subject to change.

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February 2016 Quick Read on the US Economy

Our outlook for the economy deteriorated slightly in the last month.  Mainly our measures of output are showing weakness, while our measures of employment continue to show a solid recovery.  The risk is the manufacturing sector’s weakness spreads to the broader economy.  Most economists would agree the chances of this event happening are small, though we believe the chance is probably higher now than it was a few months ago.

Our Astor Economic Index® (“AEI”) shows growth somewhat above the recent average and slightly worse than last month.  The AEI is a proprietary index that evaluates selected employment and output trends in an effort to gauge the current pace of US economic growth.

Source: Astor calculations

Source: Astor calculations

A carefully constructed gauge of the current state of the US economy is GDP Now from the Atlanta Fed.  This uses current economic data as released to try and ‘nowcast’ the current quarter well before the official GDP release.  Currently, this model is seeing the data released thus far for this quarter as consistent with 2.2% GDP growth (SAAR), roughly what the Blue Chip Survey is forecasting.

The important point is that as of the end of January, and despite the concerns sketched above, we do not believe there are signs of broad economic weakness and we believe it would take some additional shock to cause it.

It is just possible we see signs of the end of the deterioration in the world economy. The chart below weights all the G-20 countries by their GDP to average their respective Purchasing Managers Indexes.  These indexes are constructed to show expansion in the manufacturing sector at readings above 50 and contraction below 50.  The world, as a whole, according to this measure may have stopped deteriorating in the last few months after falling steadily from the middle of 2014.

Source: Markit, Bloomberg, Astor calculations

Source: Markit, Bloomberg, Astor calculations

The world equity markets obviously do not agree, with virtually all major markets posting large declines year-to-date.  We believe stock markets can overreact to every worry – the old joke is that they have predicted ten of the last five recessions. A more uncertain world environment may argue for lower levels of earnings and a reduction in the amount investors are willing to pay for them.

On the other hand, the global economic weakness of the last 18 months or so is probably more notable for the dramatic reduction in the price of oil and increase in the value of the US Dollar.  Neither oil nor the dollar has extended those trends so far in 2016.   The first rule when you find yourself in a hole is: stop digging.  Perhaps these markets have stopped digging.  We believe a stable market environment for energy and exporters would be a good foundation for the economy to build on.

We think the financial market volatility has increased the likelihood the Federal Reserve will delay its next rate hike.  The increase in credit spreads over the last few months, for example, has made financial conditions tighter than they were when the Fed last hiked (as noted by NY Fed chair Bill Dudley here). One implication of that is the Fed may need to adjust the federal funds rate less, given this spontaneous tightening.

Fed Chair Janet Yellen testifies before congress on Wednesday, after this note is being composed.  She will presumably attempt to mention financial market volatility but likely be careful to avoid saying anything of interest.  I expect her to reiterate the consensus that the US economy remains intact and that history has shown the US to be resilient to foreign economic conditions.  She will likely say, like the last FOMC statement, that she expects to see economic conditions evolve in such a way as to make a gradual increase in the federal funds rate appropriate.

Overall, I am a bit more concerned about the US economy.  There may be signs of stabilizing in the international environment, but I will need to see a few more months before I breathe easier.  I expect the Fed to not make matters worse in the short run, but at the same time, I do not expect them to take steps to stabilize financial markets absent a dramatic swoon.


All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Analysis and research are provided for informational purposes only, not for trading or investing purposes. All opinions expressed are as of the date of publication and subject to change. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. The investment return and principal value of an investment will fluctuate and an investor’s equity, when liquidated, may be worth more or less than the original cost.

The Astor Economic Index® is a proprietary index created by Astor Investment Management LLC. It represents an aggregation of various economic data points: including output and employment indicators. The Astor Economic Index® is designed to track the varying levels of growth within the U.S. economy by analyzing current trends against historical data. The Astor Economic Index® is not an investable product. When investing, there are multiple factors to consider. The Astor Economic Index® should not be used as the sole determining factor for your investment decisions. The Index is based on retroactive data points and may be subject to hindsight bias. There is no guarantee the Index will produce the same results in the future. 

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August employment day economic read

  • My view of the US economy is for continued modest expansion. Our proprietary Astor Economic Index was essentially unchanged for the month and still showing that the US is solidly in an expansion.
  • Today’s employment report was almost exactly as expected with 215 thousand net jobs added and a steady unemployment rate of 5.3%. These are the solid, gradual improvement in the economy we have seen since 2013. Nobody’s view of the state of the economy or the likelihood of rate hike should have changed with this report. Nevertheless, be prepared to dodge the think pieces on the Fed as September’s meeting approaches.
  • I see contradictory trends emerging in the broader world economy.       On the robust growth side of the ledger the rest of the developed world seems to be stabilizing at levels of positive, if unspectacular growth. We see this, for example, in the Eurozone PMI making new highs for the year. (see chart below)
Source: Bloomberg, Markit, Astor calculations

Source: Bloomberg, Markit, Astor calculations

  • On the negative growth side of the ledger the primary story is the apparent weakness in China. Chinese economic statistics are widely thought to be unreliable but what we can see makes me nervous. If we look at the purchasing managers indexes for China they are at or near multi year lows and showing flat or decreasing orders. We see the same thing in areas which are highly exposed to Chinese orders: Hong Kong, Taiwan, South Korea and Australia for example. Chinese weakness is also a possible explanation for broader weakness in commodity prices. Led by oil, which were one of the more dramatic market developments last month.
  • The rule of thumb used to be “when the US sneezes, the rest of the world catches a cold.”   How contagious is China today? One worrying sign is that the volume of world trade (as measured by CPB Netherlands Bureau for Economic Policy Analysis) is showing an unusual contraction, at least through the latest report for May. Most areas are seeing contractions in volumes of imports and exports and more severe drops in the value of imports and exports. (The drop the value of trade is magnified by lower commodity prices.) While widespread, the drops are most severe in emerging Asia. The chart below shows the CPB volume of trade index with US recessions highlighted in pink. It will be interesting to see the reaction of the US economy if this decline continues. As can be seen in the chart sustained downturns in world trade have been associate with the last two recessions, though obviously a recession in the US would be expected to decrease world trade so causality is murky.
Source: CPB Netherlands Bureau for Economic Policy Analysis, Astor calculations

Source: CPB Netherlands Bureau for Economic Policy Analysis, Astor calculations

  • Overall, I see decent US growth but some worrying overseas developments.

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.

for

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.