Ides of March


Author: Tanya Rawat

On 15th March 2017, Janet Yellen, Federal Reserve (Fed) Chair, announced a quarter percent age rate hike in the Federal Funds rate (nominal rate); the third hike since 2008 financial crisis. While a widely-expected move (as shown by a near 98% probability indicated by the Federal Funds futures contracts traded on the Chicago Board of Trade), I reason it’s premature as inflation isn’t exactly as high nor is there sufficient strength in the labour markets as beckoned by the rate hike.

So what is a Federal Funds rate? And why is it so important? This is a short-term interest rate targeted by the Federal Reserve’s Federal Open Market Committee (FOMC) as part of its monetary policy i.e. to manage money supply in the economy. This rate is important as it forms the basis of the rate used by banks to lend reserve balances to other depository institutions overnight, on an uncollateralized basis. Raising the federal funds rate will dissuade banks from taking out such inter-bank loans, which in turn will make cash that much harder to procure and thus leaving the banks lesser amounts to extend to their customers. This reduces the money circulating in the economy, thus reducing inflation. Inflation is the rate at which the general level of prices for goods and services are rising. While inflation is a harbinger of an economy returning to normal levels of activity and is in fact a regulator along with deflation (fall in prices of goods and services), it carries negative connotations. This is primarily because it reduces the purchasing power of existing currency. For example, if $1 can buy who a chocolate bar, a rise in inflation would be mean the same bar probably costs $2 now. Thus, $1 can no longer buy you the chocolate bar, thereby reducing your purchasing power. In similar vein, if you are earning 2% (nominal interest rate) on your savings account or your equity portfolio, an increase in inflation to 3% would imply you will be earning -1% (real interest rate = nominal interest rate – expected inflation rate) or a negative yield, thus not earning anything ! This will force you to seek alternative sources of investment with a positive yield.

Rewinding the clock to the first rate hike in December 2015, the Fed announced the probability of four rate hikes in the following year 2016. On these rather bullish claims, the primary haven security viz. Gold first rallied up circa 30% before midway through 2016 it erased its gain by circa 17% (peak-to-trough). The rhetoric was carried forward to the December 2016 FOMC meeting when Janet Yellen, talked about three rate hikes to be expected in 2017. This I believed at that time was excessive optimism, given that, only 1 out of 4 rate hikes proposed in the December 2015 materialized in 2016 i.e. a 25% probability of a hike.

Armed with this data point, I inferred that the Fed was expecting high momentum in inflation in 2017 as well, akin to what they envisaged in the previous year i.e. negative real interest rates. This was an ideal scenario for haven securities such as Gold or US Treasuries as asset classes, since the Fed would only raise rates at such high regularity if the real rates turn negative i.e. making them more attractive as the classic inflation hedge along the way. It does the Fed no good to raise rates unless inflation is going up even faster or at least expected to.    The Fed’s measure of inflation isn’t the CPI number, but rather the PCE. (Foot Note 1) Take a glance at the recent PCE release which is indicative of rising inflation expectations, but these March numbers are from a survey for the month of February. Since then, crude oil prices have shaved off ~10%. This weakens any case of rising inflation as input costs will only fall in the coming months. Only in April will we see the markets ‘waking up’ to actual inflation, barring a scenario wherein crude oil goes back up to $55/barrel range. Furthermore, actual production numbers (capacity utilization and industrial production) and retail sales are moving sideways, implying sluggish manufacturing and consumer activity while there is unexplained ‘exuberance’ in sentiment indicators with non-manufacturing and manufacturing PMI and consumer sentiments gauges pointing North.

In the labour market, labour force participation rate is still below 2008 levels while the U-6 measure of unemployment rate (includes involuntarily unemployed and unable to secure jobs and those involuntarily stuck in par-time jobs but want full-time jobs) remains well above pre-2008 levels.

Capture                                                                                                                           (Source: Bloomberg)

This disconnect in actual numbers (fact) versus sentiment indicators (fiction) is unfortunately being overlooked due to the continued uptrend of the financial markets. Breaking down the S&P 500 Stock Index (SPX), we will look at how cyclical sectors are performing versus defensive names. Cyclical sectors as the name suggests do well when there are expectations are of an improving economic outlook and inversely for defensive sectors.

Here too, the sector indicators concur what the sentiment indicators (viz. PMI, Consumer Sentiment Surveys et cetera) are implying and that is the fact that cyclical sectors are gaining momentum while defensive ones are weakening; Information Technology (IT) outperforming the index, Consumer Discretionary has joined the momentum, while momentum in Utilities, HealthCare and Consumer Staples is plateauing. (4-week change in relative strength ratio momentum). Carrying the highest weight in the SPX (~21%), IT is most likely to extend the SPX to higher levels as a weakening Dollar is likely to benefit companies with majority of returns from outside the US Geography. 33% of SPX Index and NASDAQ Composite companies derive their profits from outside US markets with IT being the largest (Data Source: Bloomberg). Style indicators corroborate our findings that only Large Cap (LC) growth companies as improving tremendously whilst value companies are close to lagging the index.    In summary, financial markets merely reflect sentiment which is more times than less rather detached from reality and more so now. Latest economic data from February showed the gap between fact and fiction is widening; with Existing home sales falling showing home buyers are watchful of rising mortgage rates while Core Durable goods orders (goods that do not need to be purchased frequently because they are made to last for a long time viz. three years or more) and is a leading indicator for the health of the US economy, remained stagnant implying consumer sentiment in the medium term hasn’t improved. Because capital goods take longer on average to manufacture than cyclical goods, new orders are often used to gauge the likelihood of sales and earnings increases by the companies who make them.

Worryingly, only one member of the ten member FOMC dissented to a rate hike. Neel Kashkari, President of the Federal Reserve Bank of Minneapolis raised the all-important question which hasn’t been remotely talked about in any of the FOMC meetings yet: When will the Fed start to reduce the size of its Balance Sheet which will be akin to a rate hike in its self. Maybe it’s time we start to take a look.

Footnote 1: The Consumer Price Index (CPI) is released by the Bureau of Labor Statistics and the Personal Consumption Expenditures price index (PCE) issued by the Bureau of Economic Analysis. The CPI and PCE have two measures: headline measure and a core measure, which removes the volatile food and energy components. Over the short term, the core measure is more likely to give an accurate reading of the inflation trajectory. While the CPI is based on a survey of what households are buying; the PCE is based on surveys of what businesses are selling. The CPI only covers out-of-pocket expenditures on goods and services purchased and excludes other expenditures that are not paid for directly; for example, employer-provided insurance which PCE accounts for.

Copyright © 2017 Tanya Rawat. All rights reserved. These materials are proprietary to Tanya Rawat and may not be reproduced, modified, transmitted, transferred or distributed in any form without the prior written consent of the author Tanya Rawat.