Coach Yellen Decides To Punt

Some coaches are gamblers. When faced with 4^th-and-short, they inevitably give in to the crowd’s chants to “Go for it!” Coach Yellen is not one of those gamblers. 

In recent months, there has been a great deal of stress introduced into the global economy. While lower oil prices are a boon for many, they cause great harm to some. The losing economies (ehem, Russia) have introduced a new risk to tepid global growth, and any shocks have the ability to do far greater harm than anticipated. Contagion has been something that investors have become accustomed to ever since Long-Term Capital Management introduced leveraged risks into the stock market. Cyprus, a tiny nation with an outsized banking industry, nearly derailed the global economy a few years back. Russia has a far larger role in the global economy, with the 8^th largest GDP of $2.1 Trillion. Today’s dovish Fed statement may also be an attempt at reducing global instability. We have felt that lower interest rates were inevitable, even before the drop in oil prices. Considerable labor market slack and muted wage growth are a recipe for low inflation, an environment where a rate increase is not justified. With the dramatic drop in oil prices since Thanksgiving, today’s Fed is faced with even less impetus to raise rates.

Inflation on the horizon?

In general, inflation occurs when there are too many dollars chasing too few goods. Moreover, inflation is the result of a decline in the value of the dollar. Therefore, it takes more of them to buy the same goods and services. Given the massive increase in supply of the of ‘Dollars’ , why isn’t inflation higher than 2.0%? There is a good reason for this. 

To begin, let’s discuss how the Fed increases and decreases the money supply. When the Fed purchases bonds through its Federal Open Market Committee (FOMC), it removes cash from its balance sheet and holds the bonds in its place. This increases the reserves which are available for banks to lend and invest and the economy tends to grow. However, over the past six years, much of this “expansion” has remained in reserves rather than entering the actual economy. Why? The economy never provided us with a strong enough read to allow businesses to expand and for banks to lend to new ventures. Too risky. Especially when they could borrow at 0% and reinvest risk free at 7X leverage in US Treasury securities. The money is there, but the will power is not.

Now with the dollar sky-rocketing versus the Yen (see chart attached), which was coming, and strong versus other currencies, inflation is even less of a concern. 

One more item of interest. More than one-third of the US debt is owned by foreign countries, with China and Japan neck-to-neck on the top. Social Security owns 16% followed by other federal government entities (13%), and the Fed (12%). 

Little to no inflation, US is strongest of largest global economies, the ECB is printing, the BOJ is printing. Where is money going to flow? Where is the incentive for higher rates?
I do not see it!

Cutler Investment Group Comments on Bill Gross' Departure from PIMCO

Please find Xavier Urpi of Cutler Investment Group's thoughts on the displacement of bond allocations after Bill Gross' recent departure from PIMCO:

Reuters Article

What a week! 10/3/14

Given today’s positive employment numbers (the unemployment rate dropped to 5.9%) and a Fed that will stop printing money at the end of October, I expect volatility to continue to increase. I also suspect that most asset markets are not set up for this type of uncertainty: no QE, stronger $, improved US economy, all the other geo-political nuances. As such I will continue to bang on a simple theme that seems to be playing out – again, more volatility on the way. However, some of this volatility is a move to a more traditional levels of market volatility as we move to a more traditional monetary policy debate in the US. In addition, we will be weighing  what parts of the accommodation removal process will come from domestic sources (rates) vs international sources (currencies). This, I am confident, will be the next 6 months gear for movement in the markets.

-Xavier

Are interest rates headed lower?

Fitch has issued a report stating that the Fed is now supplying, as of the end of the last quarter, $275 billion to this market. This is a jump from $45 billion at the end of the prior quarter which is a one quarter increase of 611%. This means less liquidity for the large American and European banks and more money for the Fed to invest as it leverages its balance sheet. J.P. Morgan estimates that money market funds may withdraw $100 billion in deposits in the second half of next year as they increase their investments with the Fed. 

As I mentioned yesterday, the Fed, just as stated in the last FOMC minutes, has been buying longer dated Treasuries ($1 billion yesterday). They currently have just shy of $5 trillion dollars on their balance sheet. There is $1.2T of long-term (10+ years) US Treasury debt (face value). Currently, the Fed owns more than 50% of that long-term debt.  Given that the production of new capital is about to end, they are using the interest income, anything that matures and anything that is called to make their purchases. Interest income alone could over $100 billion per year.  I estimate that the $100 billion is just about enough to buy the entire 10+ year US Treasury annual issuance. Now they have an additional sources of funds and it should be noted. They can now use the money generated by their reverse repos for their buying program as well which is not an insignificant increase in their available capital. Here is one more force at work to hold interest rates down.

What Janet Yellen is Sellin'

Yellen, in her remarks yesterday, Wednesday June 18, was sellin’ “nothing new.”  Ms. Yellen reiterated that the central bank expects to keep interest rates at these levels for a considerable time so as to support the economy. This time, however, she did not make the mistake of providing a specific time frame, so the mention of 2015 or 2016 declares, in my opinion, that they are unsure of when this economy will be strong enough to withstand a rate rise.

On the other hand, as we have mentioned before, the Fed will have a balance sheet, at the end of the tapering, of about $4.75 trillion.  If the Fed does not deleverage, then these funds will surely be utilized to lower the US borrowing cost by lowering long-term rates.  In addition, this should continue to help bolster or aid the housing market.  The U.S.’s  10-year bond yield of 2.58% is 22% higher than that of Slovakia’s 10-year bond and 29% higher than France’s 10-year rate.  From a relative value point of view, the US appears very attractive, and with the ECB keeping Europe’s yields low, it is difficult to fathom a spike in US rates at this time.  Once again,  Ms. Yellen is selling “nothing new”—except continued low rates.

Bonds Rally, But Why?

With the ECB poised to announce big changes on June 5, the bond markets are prepared for more intervention, or should I say lower interest rates. It has become crystal clear that the intention of the central banks is to keep interest rates low by any and every means possible. There is no rational or economic sense to keeping rates low, but there is enormous pressure form debt-laden countries. Lower interest rates translate to lower interest payments.  When you stare at the yields of Germany and France and see their 10-year bonds trading at 1.34% and 1.80% respectively, it makes the US 10-year look extremely attractive, even at 2.51%.  As long as the ECB’s policy remains accommodative, a stance which has now appeared to receive the blessings of the German Bundesbank, interest rates will continue to fall and US rates, regardless of the US economy, will be a very attractive venue for global bond buyers. In the end, low rates will be good for the country, good for real estate, good for corporate borrowing, and good for anyone that wishes to borrow. It will also be bad for savers, but that is of little concern, because “country before all else,” right?