Low inflation risk keeps yield curve safe

The Fed is advancing interest rates at a measured pace, with the objective of restoring balance in financial markets rather than to curbing inflationary pressures. Only if inflation spikes is the Fed likely to adopt a restrictive stance.

Elliot Clarke from Westpac sums up the FOMC (Fed Open Market Committee) view from their latest minutes:

Beginning with inflation, whereas the market has recently been concerned that inflation may be getting away from the FOMC (given annual CPI inflation at 2.5%yr and persistent strength in the oil price), the Committee is unperturbed.

Instead of the CPI, the FOMC’s benchmark remains PCE inflation, which is currently 2.0%yr on a headline basis and 1.9%yr for core…..

To see upside inflation risks build, a stronger wage inflation pulse is necessary. At present the employment cost index is only reporting “a gradual pickup in wage increases”, and the signal from other wage measures is “less clear”. Two other important considerations for the pass through of wages to activity and thus inflation is that real hourly earnings growth is currently flat and the savings rate near historic lows. The capacity of households to boost consumption and thus inflation is therefore very limited.

Hourly wage rates are growing at a gradual pace.

Hourly Wage Rate Growth

Personal savings are low.

Personal Savings

And credit growth is modest.

Credit Growth

So not much sign of inflationary pressure.

….Turning to financial conditions, as yet there is no concern of them becoming an impediment to growth or policy. The 10yr yield has moved back to the highs of 2013, but the US dollar has only partly retraced its 2017 depreciation. Further, asset markets remain near recent highs.

Equally significant however is the reference to being nearer neutral and a clear desire to keep the yield curve’s positive slope…..

We do not believe that the yield curve will invert in this instance, in part because higher deficits should see the term premium rise. However, the curve will remain comparatively flat versus history, restricting both the timing and the scale of further rate hikes. This is a key justification for both the market’s and our own view of only two further hikes in 2018 and two more in 2019 – a stark contrast to the FOMC’s seven hikes to end-2020.

Yield Differential

A negative yield curve — when 10-year minus 3-month Treasury yields falls below zero — would give a strong recession warning. But the yield curve is only likely to invert if the Fed steps up interest rate increases. With little sign of rising inflationary pressure at present, the prospect seems remote.

Life left in US stocks

According to market pundits, the latest stock sell-off was fueled by concerns over rising bond yields and slowing growth for Caterpillar (CAT).

From CNBC:

….Caterpillar shares reversed lower during the call, when Chief Financial Officer Brad Halverson said first-quarter adjusted profits per share will be the highest for the year because of increased investment later in 2018.

“We expect the targeted investments for future growth to be higher over the remaining three quarters,” Halverson said. “The outlook assumes that first-quarter adjusted profit per share will be the high-water mark for the year.”

Caterpillar (CAT)

The stock fell 6.2% on Wednesday, ignoring the earnings report:

In the earnings report, the Illinois-based machinery manufacturer raised its 2018 profit outlook by $2 a share over the previous quarter, to a range of $10.25 to $11.25 per share. The rosier guidance exceeds a Reuters analyst survey that expected a range of $8.39 to $10.60 a share. The company cited better-than-expected sales volume as the main driver of its improved full-year guidance.

Since when has “better-than-expected sales volume,” upward earnings revision and increased new investment been a bear signal? The market is unusually jittery at present, focusing on any semblance of bad news and ignoring the good.

Even concern over rising bond yields is nothing new.

10-Year Treasury Yields

10-Year Treasury yields are testing resistance at 3.0%. Breakout would complete a double-bottom reversal, warning of a bear market in bonds as yields rise. But rising long-term rates are not bad news for stocks, especially when off a low base as at present. I would go so far as to say that, over the last 20 years, rising 10-year yields have been bullish for stocks. The chart below compares annual percentage change in 10-year Treasury yields and the Russell 3000 Total Market index.

10-Year Treasury Yields and Russell 3000 Index 12-Month Rate of Change

There is plenty more good news that the market seems to be ignoring.

First quarter 2018 corporate earnings have so far impressed. According to S&P Indices, 117 stocks in the S&P 500 had reported results by the morning of April 24th. Of those, 91 (77.8%) beat, 10 (8.5%) met and 16 (13.7%) missed their estimates. Misses are largely concentrated in Materials ( 3 of 5), Industrials (4 of 26) and Consumer Discretionary sectors (5 of 13).

Freight activity remains strong, signaling a reviving economy.

S&P 500

Wages growth remains tame, with average hourly earnings of production and non-supervisory employees increasing at an annual rate of 2.42%. Growth above 3.0% would warn that underlying inflation is rising and the Fed will be forced to tighten monetary policy. But that does not appear imminent.

S&P 500

Muted wages growth allowed corporate profits (the blue line below) to rebound after a threatened down-turn.

S&P 500

Consumption has recovered. Per capita consumption of non-durable goods is recovering after a flat spot in 2017, consumption of durable goods has been rising since 2016, while services remain strong.

S&P 500

In financial markets, risk premiums on corporate bonds (Baa minus Treasuries) have declined to below 2.0%, suggesting a healthy credit outlook.

S&P 500

Bank credit is recovering after faltering in 2017.

S&P 500

The yield curve is flattening as the Fed gradually raises interest rates. A flat yield curve is not a threat. Only if it inverts, when the yield differential (gray line on the chart below) falls below zero, is the economy at risk of falling into a recession. Growth in the money stock (green MZM line on the chart below) has slowed but remains healthy.

S&P 500

The Fed has committed to shrinking its $4 trillion investment in Treasuries and mortgage-backed securities (MBS) run up by quantitative easing (QE) between 2009 and 2014. So far the decline has had no impact on financial markets as bank excess reserves on deposit at the Fed are declining at a similar rate. The effect is that net assets (Fed Assets minus Excess Reserves) are holding steady at $2.4 trillion.

S&P 500

The Philadelphia Fed’s Leading Index remains healthy at above 1.0 percent.

S&P 500

And our estimate of real GDP is rising (2.14% in March 2018), suggesting that the economy is recovering from its flat spot in 2016/2017.

S&P 500

Valuations are high and investors are jittery but the bull market still appears to have further to run.

Leading Index gives early warning

One of the better composite indicators in the US, the Leading Index from the Philadelphia Fed, points to a slow-down in the US economy. A dip below 1.0% is often early, as in July 2000 and May 2006, but serves as a reliable warning of an economic slow-down.

Leading Index for the United States

The Leading Index predicts the six-month growth rate of the Philadelphia Fed Coincident Index. In addition to the Coincident Index, it includes variables that lead the economy: housing permits (1 to 4 units), initial unemployment insurance claims, delivery times from the ISM manufacturing survey, and the interest rate spread between the 10-year Treasury bond and the 3-month Treasury bill.

The Coincident Index combines four indicators: nonfarm payroll employment, the unemployment rate, average hours worked in manufacturing and wages and salaries.

Coincident Index for the United States

The Leading Index signal does seem early. Low corporate bond spreads and VIX near record lows continue to indicate low market risk, typical of a bull market.

Corporate Bond Spreads and VIX

Monetary policy remains accomodative, with money stock growing at close to 5% p.a. (MZM = cash in circulation, travelers checks, money market funds and deposits with zero maturity).

MZM and Yield Differential

The yield curve has flattened, with the spread between 10-year and 3-month Treasuries falling to 1.0% on the above graph. That is what one would expect when the Fed hikes interest rates in a low inflation environment: short-term rates will rise faster than long-term rates. But a negative yield curve, where short-term rates are higher than long-term rates, is a reliable predictor of recessions in the US economy. Each time the yield differential on the above graph crossed below zero in the last 50 years, a recession has followed within 12 months.

Underlying inflation remains low, with average hourly earnings growth below 2.5% p.a., and the Fed should be careful about single-mindedly raising interest rates without considering the yield curve.

Annual Growth in Average Hourly Earnings

The bull market continues but investors need to keep a weather eye on interest rates and the yield curve.

VIX hits record low

The CBOE Volatility Index (VIX) made a new low of 9.30 indicating record low levels of stock volatility. High levels of stock buybacks and large ETF fund inflows may both have contributed, but this is only the third time in its 27-year history that index has broken below 10%. The first was in late 1993. The second, in late 2006, was followed a year later by a massive market snap-back. This time is no different. Volatility is unlikely to remain at such low levels and eventually we will see a market down-turn, accompanied by high volatility, but there is no crystal ball that can tell us whether this will be in one year or five.

CBOE Volatility Index (VIX)

Corporate bond spreads are also falling, with the spread between lowest investment grade Baa (10-year) and equivalent Treasury yields at their lowest point since 2008.

Corporate Bond Spreads

Source: St Louis Fed & Moody’s

The yield curve is flattening but remains comfortably above a flat or negative yield curve when
the yield differential (10-year minus 3-month yields) falls below zero. A negative yield curve is a reliable warning of recession within 12 months.

Yield Differential

Source: St Louis Fed

The Freight Transportation Services Index displays a steady increase in economic activity.

Freight Transportation Services Index

Source: St Louis Fed & US Bureau of the Census

And the S&P 500 continues its advance towards 2500.

S&P 500

Target 2400 + ( 2400 – 2300 )

Bond spreads bullish for US, less so Australia

Yield Curve

The yield curve is one of the best predictors of US economic recessions. Every time the yield curve has turned negative in the last fifty years, a recession has followed.

First of all, what is a yield curve? It is the plot of yields on bonds, normally Treasuries, against their maturities. Long maturity bonds are expected to have higher yields than short-term bills, to compensate for the increased risk (primarily of interest rate changes). If you tie your money up for longer, you would expect a higher return. Hence a rising yield curve.

A rising yield curve is a major source of profit to the banks as their funding is mostly short-term while they charge long-term rates to borrowers, pocketing a healthy interest margin.

When the Fed steps into the market, however, restricting the flow of money into the economy, then short-term rates rise faster than long-term rates and the yield curve can invert (referred to as a negative yield curve).

Bank interest margins are squeezed — it is no longer profitable to borrow short and lend long — and they restrict the flow of new credit.

Credit is the lifeblood of the economy and activity slows.

The chart below compares US recessions to the yield differential: the difference between 10-year Treasury yields and the yield on 3-month T-bills. The yield differential falls below zero when 3-month T-bills yield more than 10-year T-notes.

Yield Differential: 10-year Treasury yields minus 3-month T-bills

You can see that every time the yield differential dips below zero it is followed by a gray bar indicating a recession. There is one exception: the phantom recession of 1966 when the S&P 500 fell 22%. This was originally certified as a recession by the NBER but they later changed their mind and airbrushed it out of history.

You can also see that the yield differential is declining at present but, at 2.0%, it is a long way from a flat or negative yield curve. This supports my argument last week that current Fed rate hikes are more about normalizing interest rates than about monetary tightening.

That could change in the future but at present the bull market still appears to have plenty in the tank.

Corporate Bond Spreads

Corporate bond spreads — the yield difference between high-grade corporate bonds and the risk-free Treasury rate — are another useful indicator of the state of the economy.

Wide bond spreads indicate increased risk of corporate default. Investors are concerned about the state of the economy and demand a higher premium for taking credit risk.

Narrow spreads suggest that credit premiums are low and confidence in the economy is good.

If we examine the chart below, bond spreads are declining, indicating confidence in the US economy, with even the lowest investment grade BBB dipping below 150 basis points (or 1.50%). This is synonymous with a bull market.

US Bond Spreads

Australian corporate bond spreads are higher than the US, with BBB still at 200 bps. They have also declined over the last year but seem to be trending upward from their 2013 low. This is not conclusive as the current trough is not yet complete, but a higher low would warn that credit risk is rising.

Australian Bond Spreads

Only when the tide goes out do you discover who’s been swimming naked.

~ Warren Buffett

Flattening yield curve & low bank interest margins

The Yield Differential, calculated by subtracting 3-month from 10-year Treasury Yields, is trending lower. This warns that the yield curve is flattening but we are still above the danger area below 1.0 percent.

Yield Differential: 10-Year minus 3-Month Yields

A flat yield curve squeezes bank interest margins and often precedes a credit contraction.

Large US Banks: Net Interest Margins

But there is little sign of slowing credit growth so far.

US Bank Loans & Leases: Annual Growth

The St Louis Fed Financial Stress Index (STLFSI) continues to indicate low market stress.

St Louis Fed Financial Stress Index

The STLFSI measures the degree of financial stress in the markets and is constructed from 18 weekly data series: seven interest rate series, six yield spreads and five other indicators. Each of these variables captures some aspect of financial stress. Accordingly, as the level of financial stress in the economy changes, the data series are likely to move together.

Why is the Yield Curve Flattening? | PRAGMATIC CAPITALISM

Interesting view from Cullen Roche:

Most fixed income traders view long rates as a function of the economy and short rates as a function of the Fed’s views on the economy. So, when the Fed increases rates it means that the Fed thinks the economy is improving and needs some tightening so it doesn’t cause the Fed to create too much inflation and overheat the economy. But fixed income traders account for this and front-run the Fed’s thinking by trying to anticipate their views on the economy. Said more simply – long rates are a function of short rates for the most part. And the fact that long rates are remaining low means that fixed income traders increasingly believe that we’re in a permanent state of low interest rates.

Read more at Why is the Yield Curve Flattening? | PRAGMATIC CAPITALISM.

FT Alphaville » Negative rates as a precursor to the death of banking

Izabella Kaminska: The [European research] team at Morgan Stanley concludes:

Banks earnings have already come under significant pressure from the flattening of the yield curve. Unless negative real rates came with a material steepening of the curves (not our rates colleagues’ view), banks earnings would come under even greater pressure. In fact, the greatest risk our rates colleagues see would be for negative rates 2-3 years down the curve, in which case banks would need to re-price credit further. In our view, as banks’ confidence in loan growth and margins fell, so would their confidence on their capital plans and so lending would remain weak. We see Japan’s experience as good case study in this.

via FT Alphaville » Negative rates as a precursor to the death of banking.

The Power of Cheap Money | Puru Saxena | Safehaven.com

Mr. Bernanke is intentionally suppressing the nominal risk free rate of return and he is forcing investors to search for yield. By keeping interest rates artificially low and well below the rate of inflation, the Federal Reserve has engineered this impressive rally in American stocks.

Figure 2 captures the real US Treasury Yield Curve [after deducting inflation] across various maturities. As you can see, the real yields of the entire US Treasury Yield Curve (except the 30-Year US Treasury Bond) are currently negative.

Real US Treasury Yields

via The Power of Cheap Money | Puru Saxena | Safehaven.com.