Written by Jim Welsh
Macro Tides Monthly Report 01 September 2020
After decades of watching how the combination of monetary policy and fiscal stimulus has reversed every post World War II recession, investors have become conditioned to expect that the economy will recover and a new economic expansion will take hold. This falls under the category of top-down processing which states that our perception is influenced by previous knowledge, expectations, and existing beliefs.
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The strength of our prior perceptions leads us to overlook information that may conflict and not support our expectations. Selective perception is the process by which individuals perceive what they want to and is a form of bias because we interpret information in a way that is congruent with our existing values and beliefs.
It must be noted that selective perception is grounded on a foundation of facts. If it wasn’t it would be considered a delusion. The current perception is supported by the huge increase in the Federal Reserve’s balance sheet when compared to the increase after the financial crisis. After announcing the first Quantitative Easing program on November 25, 2008 and initiating purchases in December, the increase in the Fed’s balance sheet totaled 20% of GDP when QE3 ended on October 29, 2014 almost six years later. In 2020 the Federal Reserve increased its balance sheet by 30% in three months.
The expectation of a much better economy in 2021 is also buttressed by trillions of dollars of government deficit spending to support millions of unemployed workers and businesses large and small. If Congress passes another stimulus program, the deficit as a percent of GDP will be comparable to the record deficit in 1944 and more than triple the size after the financial crisis.
Although the fiscal response to COVID-19 by the U.S. has been the largest of any major economy, a strong reaction has occurred in many countries including Germany, which normally runs a balanced budget or surplus. According to the International Monetary Fund the global amount of deficit spending in 2020 will be more than double what was done after the financial crisis.
Investors expect that the U.S. and global economy will be stronger in 2021 based on the historic level of monetary and fiscal support provided. The disconnect between this perception, based on historical precedence and the current reality, is that after the financial crisis central banks and governments were battling an economic contraction caused by a liquidity crisis rather than waging a war against a Pandemic. Although fiscal and monetary policy won’t provide a medical solution for COVID-19, investors believe a vaccine will be developed in time to allow the economy to return to ‘normal’ by mid 2021.
The expectation for a vaccine is based more on faith than history, since the fastest vaccine ever developed addressed the mumps and took four years. The amount of money, resources, and technology allocated to understanding COVID-19 so a vaccine can be developed is unprecedented, which is why the expectation for a vaccine is not a giant leap of faith. However, the path forward for a medical response to COVID-19 may not be as quick as expected, nor as comprehensive to allow a return to normal in 2021.
There are factors that could limit the effectiveness of any vaccine. Based on vaccines to treat hepatitis B, tetanus, rabies, and the annual flu, scientists know that obesity and age reduces the effectiveness of a vaccine. Scientists studying immunometabolism have found that obesity interferes with the body’s immune response and is why they are at greater risk of infection and have a lower capacity to mount a defense.
Those who are obese experience a constant state of mild inflammation, which interferes with a vaccine’s ability to mount a response to protect the body from a virus or pathogen. A study by the University of North Carolina published in the International Journal of Obesity in 2017 found that adults who were considered obese were two times as likely to contract the flu or develop flu-like symptoms even though they had received a flu shot.
The Centers for Disease Control and Prevention (CDC) considers those with a Body Mass Index (BMI) of 30 as being obese. According to the CDC the age-adjusted prevalence of obesity in adults over 20 was 42.4% irrespective of gender. The age-adjusted prevalence of severe obesity was 9.2% and was more common in women than in men. Importantly there wasn’t much difference in the level of obesity by age, with those over 20 just as likely to be overweight as those over 60.
Vaccines also are known to be less effective in older adults, which is why those 65 and older receive a supercharged annual influenza vaccine that contains far more flu virus antigens to help juice up their immune response. In 2018 there were 52 million people who were 60 years of age and older, and of this group 22 million were obese (52 million x 42.4% = 22 million).
In 2018 there were approximately 107 million adults in the U.S. with a BMI above 30 that were considered obese based on the CDC’s guidelines. To avoid double counting 22 million is subtracted from 107 million to determine that there were 85 million people under the age of 60 suffering from obesity in 2018.
Since age is also a determinant of the effectiveness of a vaccine, the 30 million of those over 60 years old who are not obese can be added to the 85 million younger Americans who are obese to arrive at the number of Americans who may not fully benefit from a vaccine. Of the roughly 330 million living in the U.S., 115 million (34.8%) will be less protected from a vaccine. This is a big deal since this group is more vulnerable to becoming infected, getting sick enough to require hospitalization, and dying.
The Centers for Disease Control and Prevention (CDC) has noted that those with a Body Mass Index (BMI) of 30 and higher have a greater risk of becoming severely ill from COVID-19 and more susceptible to dying irrespective of age. A new study by the University of North Carolina found that those with obesity (BMI over 30) were at a greater increased risk for hospitalization (113%), more likely to be admitted to the intensive care unit (74%), and had a higher risk of death (48%) from the virus.
In June the Scripps Research Institute found a second strain of COVID-19 that is about 10 times more infectious than the virus that originated in China. The original strain in China was labeled D614, while the one found in the UK, Italy, and North America by May is G614. The good news is that the new strain doesn’t appear to make COVID-19 any more deadly, but the higher level of infectiousness has made it more difficult to contain.
After seemingly damping the infection rate down, a number of countries have experienced a second wave of rising infections.
A second wave also developed in the U.S. and forced a number of states to roll back some of the sectors that were allowed to reopen.
Schools are attempting to reopen in the U.S. but for the 56 million K-12 students it is a fluid situation depending on each state. According to the National Retail Federation parents spent $26.2 billion on back to supplies and clothes in 2019. There is no need to buy new clothes if your child’s school isn’t opening and retailers could face a decline of 20% in sales.
But the real hit to the economy will come from state and local government spending, which totaled $660 billion in 2017 according to the Urban Institute. States are facing a double squeeze as tax revenue has fallen and spending increased due to the Pandemic and could lower education spending by $100 billion or more.
Bureau of Labor statistics indicate that 1 million parents are not working due to child care problems up from 624,000 in January. As parents attempt to juggle a job, child rearing, and teaching their children, the Brooking Institution estimates that lost productivity is costing the U.S. economy about $56 billion a month. That seems a bit high to me in light of studies showing that workers are being more productive working from home than in an office. Some of the productivity being lost from parents of young children is being offset. Nonetheless, the disruption will be a net negative for economic growth until schools can reopen completely.
Although nearly impossible to measure now, the quality of education is going to suffer for younger students who depend on in classroom instruction, and those who either don’t have the necessary technology to properly access their lessons. Teaching the A-B-C’s to a first grader is one thing, but a parent trying to help their high school child with algebra, biology, or English literature is going to struggle, or spend way too much time watching You Tube videos. The longer in classroom education is delayed the larger the learning gap will become for many students and could weigh on productivity growth down the road.
It has been estimated that up to 40% of those infected by COVID-19 are asymptomatic and either experience mild symptoms or no symptoms at all. Researchers may be learning why that is the case. COVID-19 is one of six previously knows coronaviruses. Four of the six coronaviruses cause the common cold, but in 2002 Severe Acute Respiratory Syndrome (SARS) killed 8098 people worldwide, and Middle East Respiratory Syndrome (MERS) resulted in 858 deaths. When someone contracts a coronavirus the virus triggers T cells that trigger B cells that create antibodies to attack the virus. This is how the adaptive immune system functions and why so much attention is focused on antibodies. Once a patient recovers antibodies help ward off a future infection, which is why the length of time antibodies remain matters. As I has discussed previously it appears that COVID-19 antibodies don’t have a long lifespan as discussed in the August Macro Tides:
“Researchers at Kings College London in the U.K. have found that antibody responses to the coronavirus tend to peak three weeks after the initial onset of symptoms, but then begin to decline after as little as two or three months afterwards. While 60% of the people in the study had a “potent” level of antibodies on average 23 days after the first onset of symptoms, that figure dropped to 16.7% of those tested 65 days after the first signs of symptoms.”
New research suggests that T cells may have a much longer memory. In May, the esteemed Cell journal published a study that found 20 recovered Covid-19 patients generated antibodies and robust T-cells immune responses. According to Alessandro Sette, Professor and Member of the La Jolla Institute’s Infectious Disease and Vaccine Center:
“What we see is a very robust T-cell response against the spike protein, which is the target of most ongoing Covid-19 efforts, as well as other viral proteins.”
T cells directly kill virus-infected cells. Sometimes individuals with a very vigorous T cell immune response will be protected from a pathogen even though they produce low amounts of antibody. Previous research has shown that T cells tend to last years longer than antibodies. On June 25 a study was published in the Cell journal entitled “Targets of T Cell Responses to SARS-CoV-2 Coronavirus in Humans with COVID-19 Disease and Unexposed Individuals.”
Researchers found that 100% of the 20 COVID-19 survivors had reactivity in their T cells. This wasn’t a surprise. What was a surprise is that blood samples from 2015 through 2018, and well before COVID-19 appeared, showed that 40% to 60% of the samples displayed T cell recognition of COVID-19.
The blood samples showed that people had developed T cell recognition, after having a coronavirus common cold which is why they were asymptomatic. This suggests there may be some level of immunity already in humans to COVID-19 and why so many are asymptomatic. Similar results were found in Germany (34%), the Netherlands (28%), and in Singapore (50%).
This research suggests that a vaccine that elicits a T cell response could provide a longer lasting immunization from COVID-19 that simply relying on antibodies. Testing for T cells is more difficult than for antibodies.
The complexity of developing a COVID-19 vaccine that is capable of addressing the diverse range of medical outcomes, and that provides an immunity that lasts at least a year is a daunting challenge. The expectation that it will be developed by early 2021, mass produced, and widely accepted seems optimistic.
Investors have continued to buy the FAMANG stocks with both hands since these companies have thrived during the Pandemic. Earnings for these stocks were up 2.0% in the second quarter while earnings for the other 495 companies in the S&P 500 plunged -38.0%. Small Cap stocks fared far worse as earnings for the Russell 2000 declined by -97.0%.
The divergence between the haves and the have nots within equity indexes has potentially never been wider. The Awesome 8 stocks have gained almost 70% as of August 27 since December 31, while the Value line average of 1700 stocks is down -13.0% and the Russell 2000 is off -6.2%. Even within the S&P 500 the spread between the S&P 500 +7.8%, which has been lifted by its 25% exposure to the FAMANG, and the average stock as measured by the Equal Weight S&P -3.7%, is extraordinarily wide. The concept that the U.S. economy can do well when so many companies are struggling has been largely overshadowed by the myopic focus on the small number of companies that are doing really well. The perception that monetary policy and government spending will result in a strong recovery doesn’t jibe with what’s happening on Main Street, at least not yet.
The initial rebound in the economy was solid and made possible by quick action by Congress that sent $583 billion to households from April through July. The amount provided exceeded what would have been earned in wages and salaries had the COVID-19 disruption not occurred.
The infusion of money allowed consumers to keep spending, which is why Retail Sales surpassed preCOVID-19 levels in July even as restaurant and bar sales were lower.
After the initial solid rebound the economy hit stall speed in late June after states reopened their economies, infections surged, and the economy hit a speed bump. Small businesses were supported by the Payroll Protection Program (PPP) that enabled them to cover most of their expenses even though revenues were crushed after the economy was closed down.
The PPP funds were intended to provide a bridge for 10 weeks began to run out for many firms by mid July. The July 31 end to the Federal governments $600 weekly Pandemic Unemployment Assistance came and went with no action by Congress to restore any part of the disbursement. Funding for unemployed workers has fallen from $25 billion per week to $10 billion.
The Federal government contributed $16.6 to the weekly total of $25 billion. In order to receive the $300 payment from the Federal government proposed by President Trump, for unemployed workers, states must apply for the $44 billion in funds available from the Federal Emergency Management Agency (FEMA). Many states are struggling to reconfigure their unemployment systems to be able to make the combined payment of $300 plus $100 and currently only 3 states are distributing funds as of August 28. Depending on how many states get approval from FEMA and number of unemployed workers, the amount of FEMA funds could be depleted in six weeks.
The percent of workers employed in mid August is down about 21% from January 2020 levels according to Homebase data, and has trended sideways since early July.
According to the Census Bureau’s Current Population Survey, the number of hours worked in early August was down -14.5% from January. This indicates that earnings, even for workers who are still working, are well below where they were in January. Hours worked are off by -2.5% from June confirming that the labor market has not been improving since then.
The lack of improvement in the labor market is evident in the weekly jobless claims report. As of August 8 there were 27.0 million people receiving regular state unemployment benefits and Pandemic Unemployment Assistance, compared to the 14.535 million on state unemployment rolls. The Bureau of Labor Statistics reported that in July 143.5 million were employed based on its monthly Household survey. The official unemployment rate based on state unemployment is 10.2% but if the total of those receiving unemployment benefits (27.0 million) is used the unemployment rate jumps to 18.8%.
Since the $600 a week Federal Pandemic Unemployment Assistance funds stopped on July 31, spending on clothing, general merchandise, and even at grocery stores declined in the first half of August.
As the $300 a week authorized by President Trump is distributed some of the declines in these categories can be expected to improve. Even when these funds are received the amount of support for unemployed workers will be far less than prior to July 31. The Peterson Institute estimates for each $100 billion reduction in support for households and small businesses GDP will contract by 1.0%. In August the reduction in Federal unemployment funds for households will approach $66 billion (4*$16.6B=$66.4B) and lower GDP by almost 0.7%
As discussed in the June Macro Tides research of prior recessions showed that a high percentage of workers who thought their unemployment status would be temporary wound up being permanently laid off:
“A recent white paper from the Becker Friedman Institute at the University of Chicago, entitled COVID-19 Is Also a Reallocation Shock, estimates that many of the laid off workers who expect their unemployment status to be temporary will actually become permanent.”
According to Nicholas Bloom an economics professor at Stanford University and one of the co-authors of the white paper:
“Looking through history at previous recessions, often these temporary layoffs unfortunately turn out to be permanent. Our best guess is something like 60% of the employment reduction is going to be temporary, and 40% is going to be permanent.”
That estimate may prove optimistic. In April, 80% of those who were unemployed thought they would be rehired by their prior employer, but by July that had fallen to just 40%. The percent of those who didn’t expect to go back to their former employer has soared from 20% to 60%. Some of these workers will again find employment so they may not fall into the long term or permanently unemployed category, but it often takes longer to find a new job than go back to your old job. According to the employment agency Indeed, Job postings are down -21% since February 1, which makes finding a new job tough.
The major airlines agreed to keep their workforces intact through the end of September as a condition for receiving $25 billion government aid. They agreed there would be no layoffs, furloughs, or reductions in pay rates allowed until then. The number of airline passengers’ passing through TSA checkpoints were down 66% from a year ago as of August 23 according to Statista. The decline in passengers could lead to a wave of layoffs taking effect on October 1 that could wipe out a significant portion of the 750,000 people employed as pilots, flight attendants, baggage handlers, mechanics, and other support staff.
Recently airlines have announced that they may layoff 6,101 pilots and doubtless thousands more support staff on October 1. The coming job losses will affect workers whose income is well above median income and will thus have a negative drag on consumer spending. I suspect that President Trump will try to use an executive order to prevent the loss of these very visible jobs less than 5 weeks before the November 3 election. This may temporarily help the economy but won’t increase the number of passengers on flights.
Small businesses continue to bear the brunt of the ongoing slowdown in the economy with revenue down by 21.1% from January at the end of July. Sales likely weakened further in August after the end of Federal unemployment benefit funds and end of the PPP program.
For the first half of 2020, total commercial Chapter 11 filings are up 26% with 3,604 new filings, up from 2,855 from the same period last year, according to BankruptcyData.com. These ugly numbers would have been worse if it hadn’t been for the PPP program.
In the second quarter banks significantly increased lending standards for every type of credit. A whopping 71.2% of banks increased lending standards for Commercial loans for large and median sized firms and 70% for small companies. Lending standards for consumer loans were also ramped up with 71.7% of the banks raising standards on credit cards and 55.4% for auto loans. While the Federal Reserve and Treasury are trying to push more money into the economy, banks are pulling back on credit availability.
Despite the Federal Reserve’s historic decision to buy corporate bonds, which enabled companies to issue a record amount of junk corporate debt in just the first 7 months of 2020, the number of large bankruptcies is poised to exceed the prior record set in 2009.
Unless and until a vaccine is developed, deployed, and inoculates the majority of people in the U.S. and around the globe, the labor market in the U.S. will not heal and economic growth will not return to a normal level. It took more than 6 years for all the jobs lost after the financial crisis to be recovered. The damage caused by COVID-19 has been far worse. Even with the aid of a vaccine, it is likely to take at least several years for the 22 million jobs lost in just two months to come back.
Based on the historic level of monetary and fiscal support provided by the Federal Reserve, U.S. Treasury, Congress, and Central Banks and foreign governments, the perception held by investors is that the U.S. and global economy will be much stronger in 2021. The disconnect between this perception and the current reality is extraordinarily wide, as virtually no one believes a double dip in the U.S. and global economy is even possible, which is why the risk of a larger correction in the stock market may be under appreciated.
Consumer confidence and the S&P 500 may have played leap frog after bottoming in 2009, but they have trended higher over time. In 2012 to 2015 the S&P 500 moved ahead of consumer confidence, only to have confidence lead the way after the 2016 presidential election until February 2020.
The current gap between the S&P 500 and consumer confidence has never been so wide. It’s possible that consumers are overly depressed by what they are experiencing and the social unrest they see on TV. And maybe the stock market is discounting a bright economic future that lies just a few months into the future. It’s also possible that perception has overshadowed reality.
Inflation Perceptions
As discussed in the August Macro Tides the big increase in M2 money supply has caught the attention of inflation watchers and fed the expectation that inflation will arrive sometime in 2021.
“In the five months since February 24 the annual growth rate in the M2 money supply has exploded from less than 3% to 19.2% as of July 6 and 24.9% from a year ago. This extraordinary increase has led some strategists to say the Federal Reserve has planted the seeds of future inflation that will become apparent in 2021 and beyond. These forecasts are understandable since M2 is growing faster than at any time since 1945 and almost 50% faster than M2 growth in the 1970’s, which preceded a period of great inflation. The large increase in M2 money supply has already sparked ‘talk’ that inflation could be a problem in 2021. The recent rally in Gold and Silver only confirms this risk to those that believe markets are a discounting mechanism.”
The perception that the increase in M2 money will lead to a wave of inflation was given a boost when the July core Consumer Price Index (CPI) and core Producer Price Index (PPI) jumped far more than expected. The core CPI came in at 1.6% versus the 1.1% expected and the biggest increase since 1991, which made for a great headline.
The core PPI was 0.3% compared to being unchanged.
Selective perception is the process by which individuals focus on information that conforms to their expectations, which often leads them to overlook the details. Special circumstances related to COVID-19 played a role in the larger than expected uptick in inflation in July. The cost of food at home has increased 4.6% over the last 12 months, with the prices paid for beef increasing 14.2%. As you likely recall a number of meat processing plants were forced to close after many of their workers became ill with COVID-19. The shutdown caused a shortage in supply just as consumers were anxious to stock their homes with meat, poultry, fish, and eggs, which caused their prices to jump 8.4% from a year ago. Prices are now coming down after production at those affected plants was restored.
After stocking up and a bit of hoarding, sales of a number of food groups are coming down. Sales growth of frozen dinners averaged about 9% for the three weeks ended Aug. 16, compared with 17% for the previous two weeks, according to the IRI CPG Demand Index.
Cereal sales have slowed from 6% average growth in July to 2% in August. The decline in sales is evident in packaged food, beverages, and refrigerated food. As demand has fallen so have prices for soup, cheese products, chocolate candy, and even milk. Even if the prices for these categories merely stabilize, core CPI inflation from food will moderate.
The July increase in inflation was also due to sectors that had previously experienced sharp declines in prices so the jump in July was merely a rebound.
The index for used cars and trucks jumped 2.3% in July from June, after declining for the 3 prior months. Auto insurance soared 9.3% after plunging more than -10% in April and May. Airline fares rose 5.4% after tumbling more than -5% in April and May, and clothing rebounded after dropping by more than -9.0%. These increases are not sustainable and will also contribute to a moderation in the core CPI in coming months.
The breakeven inflation rate is a market base measure of expected inflation and is the difference between the 10-year Treasury yield and the yield of the 10-year Treasury Inflation Protection Security (TIPS). When inflation expectations fall the 10-year breakeven declines and rises if higher inflation is expected. After plunging during the height of the Pandemic in March, the 10-year Breakeven Rate has rebounded and sits just below where it was in January 2020.
This is an indication that market participants have accepted the M2 money supply story. There has been a good correlation between Capacity Utilization and the 10-year Breakeven Rate for the past 20 years. Capacity Utilization rose to 70.5% in July, which is -8.3% below its monthly average since January 2000.
There is plenty of spare capacity that will weigh on price increases for many months. The 10-year Breakeven Rate looks like it is pricing in more inflation than likely given the current gap with Capacity Utilization.
In the short term the concern about inflation is misplaced and driven by perception more than reality, since most of the liquidity the Fed has created will not flood the economy with a surge in demand that drives prices higher. The labor market is weaker than the 10.2% unemployment rate implies and consumer spending is dependent on Congress passing an extension to the Federal Pandemic Unemployment Assistance program. Many small businesses are struggling and another wave of bankruptcies is likely unless Congress provides more assistance soon. Large firms that have access to capital are looking for ways to lower costs as revenue growth remains weak.
According to Market Desk Research, the number of companies talking about cutting costs including layoffs or furloughing more workers is more prevalent now than in 2008. The risk of a second dip in the economy is growing.
This assessment from the August Macro Tides still applies:
“COVID-19 is a dam that is containing the huge buildup in liquidity the Federal Reserve and Congress have created. Until there is a vaccine or a group of therapeutics that minimize the impact of the Pandemic, consumers and companies will husband their savings and cash and not increase spending significantly.”
The caveat to this assessment is that a vaccine or therapeutics is developed and deployed sooner than expected. The caution that is curbing consumer and corporate spending could be reversed quickly should the health care crisis be solved. Once consumers and corporations are confident that it’s safe to return to normal activities, the economy has the potential of roaring back to life as consumers spend a portion of their increased savings and run up their credit card balances after lowering them by more than $100 billion in the past 5 months.
Federal Reserve
In January 2012 the Federal Reserve established its 2% inflation target in the belief that it would influence inflation expectations and ultimately lift inflation to 2%. Ironically at the time of the Fed’s announcement the core Personal Consumption Expenditures index (PCE) was 2.1%. In the 103 months since the PCE has been above 2.0% just 12 months or less than 12% of the time.
Given the FOMC’s blind faith in its 2% target for the PCE this failure of forward guidance would likely illicit this response if questioned, “Imagine how much lower the PCE would have been without our target!“
The average lifespan in the U.S. is 76 years for men and 81 for women. The cost of living quadruples in 72 years if inflation averages 2% annually. Only a central banker would say they have achieved ‘stable’ prices with those results.
Last year the Federal Reserve introduced the goal of inflation averaging 2.0% over a complete business cycle. Since inflation typically falls below 2.0% during a recession, the FOMC would need to tolerate inflation rising above 2.0% during the expansion phase of the business cycle for inflation to average 2.0% over a complete business cycle. This was discussed at length in the August Macro Tides and included a statement by Fed Chair Jerome Powell, which should have alerted investors that this change was coming:
“On July 17 Fed Chair Jerome Powell made the following comment which summarizes the Fed’s dedication to not only getting inflation to 2.0% but attempting to lift above 2.0% for a period of time.
“The Fed will not just emphasize actual inflation over forecasted inflation, but will also attempt to push the inflate rate above its 2% target. It’s a whole new ballgame.“
The new ball game officially started on August 27 at the annual Jackson Hole symposium when Chair Powell proclaimed:
“The Committee seeks to achieve inflation that averages 2% over time and therefore judges that, following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time.”
The timing of this change may have been influenced by the level of economic uncertainty and the quandary it presents for the FOMC as noted in the August Macro Tides:
“As long as COVID-19 continues to ravage the U.S. economy and prevent a full blown reopening, the Federal Reserve will pursue the most accommodative posture as possible. Although there is a risk that a medical solution will unleash a torrent of the liquidity the Fed has created, the downside risk to the economy if a vaccine remains elusive is too great not to take that chance. The members of the FOMC are keenly aware of this risk and how the Treasury market might over react with interest rates spiking higher should a vaccine become reality.”
The intent of this new forward guidance is to inform the Treasury bond market that it needn’t overreact if inflation does manage to exceed 2.0%, since the FOMC will refrain from increasing the federal funds rate for years. The FOMC hopes that by keeping the federal funds rate near 0% it will act as an anchor and help moderate any increase in long term Treasury rates.
The FOMC thinks its new forward guidance will limit future increases in long term rates and the new policy is likely to have as much success as its saying that it wanted PCE inflation to average 2% in January 2012. It won’t take much of a decline in Treasury bond prices to inflict real damage and fear of additional losses. The FOMC’s whole new ball game won’t deter more selling. This is the math as covered in the August Macro Tides:
“Although the odds of Core PCE inflation getting above 2.0% are low, that may not matter to the bond market with Treasury interest rates at their lowest level since 1790. It wouldn’t take much of an increase in yields to create pain for investors who own the 30-year Treasury bond. If the 30-year Treasury yield rose from 1.25% on July 27 to 1.75%, the price of the Treasury bond would fall almost 10%, and would lose 20% if the yield spiked to 2.25%. The 30-year Treasury yield was 1.75% on June 6 and 2.25% in January, so a return to these levels is certainly possible.”
On August 27 after Chair Powell threw the first pitch in the new game, the yield on the 10-year Treasury bond rose to .746% up 5.9 basis points and the 30-year jumped 9.4 basis points to 1.50%. Off to a great start!
The challenge facing the FOMC is that we live in an era where perception overshadows reality. Investors look at the increase in M2 money supply and expect inflation to follow, even though as covered in the August Macro Tides, much of the increase in M2 is never going to find its way into the economy. The excess liquidity on the sidelines won’t come into the economy until a vaccine makes it possible for a return to normal.
This may not matter though if investors expect inflation in 2021, since they will focus on data points that support their view and dismiss information that doesn’t conform. Long term Treasury yields could rise as investors sell Treasury bonds to avoid the expected increase in inflation and trigger more selling as Treasury bond prices fall.
As discussed in the August 10 Weekly Technical Review there is a 4 year cycle in the 30-year Treasury bond that suggested a trend change was likely in 2020:
“The 30-year Treasury yield has established a 13 high or low every four years since 2000. In 2000 and 2004 a high in yield was recorded while an important low was reached in 2008, 2012, and 2016. This suggests it is wise to be on the lookout for a potential low in the 30-year Treasury sometime in 2020. Even if a low develops, the initial uptick may be modest.”
The 30-year Treasury yield has jumped from 1.165% on August 6 to 1.508% on August 28, so the 4 year cycle may have turned just after Powell’s stating on July 17 “It’s a whole new ballgame.”
Jay may be right but not in the way he expected.
If the bond market misbehaves and Treasury yields rise too much, the FOMC has an answer for that too, as I noted in the March 2019 Macro Tides:
“And if owners of Treasury bonds express their displeasure with the Fed’s ambitions of allowing inflation to rise somewhat above 2.0% by selling bonds, Vice-Chair Clarida had a ready answer for that too. The Fed would simply establish a “temporary ceiling for Treasury yields at longer maturities by standing ready to purchase them at a preannounced floor price.” This is what the Bank of Japan did in recent years when it announced it would only buy bounds if yields rose to 0.10%, and it worked. The Federal Reserve also executed this strategy during World War II to fund the war effort at a low cost.”
In World War II, the Fed pegged interest rates at a low level in order to facilitate the financing of government debt by holding the 3-month T-bill rate at 0.375% from 1942 until 1947, and 2.0% for the 10-year Treasury bond. I have no idea what levels the FOMC would mark as a ceiling but I have no doubt they will establish a ceiling by offering to buy an unlimited amount of Treasury paper at the stated rate ceilings should Treasury bond yields increase too much.
Some economists have been surprised that the FOMC hasn’t discussed yield curve control (YCC) more in recent months. Why would the FOMC discuss YCC with long term Treasury yields at or near all time record lows? My guess is that the FOMC will elevate YCC in their meetings if Treasury yields increase more than expected and use their discussions as another form of forward guidance in keeping Treasury bond yields down. Like a parent wagging a finger at a misbehaving child and saying “If you don’t stop raising Treasury yields we will do it for you!“
The Federal Reserve has made it abundantly clear that the FOMC will do whatever it takes to support the economy until a vaccine is available in order to prevent a deflationary collapse while we wait. Lifting asset prices is part of that endeavor so there may be no ceiling on equity and home prices that prompts the FOMC to curtail monetary accommodation.
However, higher Treasury yields could derail stock the market since so many strategists have justified the current record valuation on low Treasury yields.
The Buffett Indicator divides the value of stock prices as measured by the Wilshire 5000 divided by GDP, as calculated by the Bureau of Economic Analysis. The Buffett Indicator is not suited for identifying a top in the market since valuations can always get stretched further as investors gleefully bid stocks higher. As of August 27 the current valuation is more than 2 standard deviations above the long term trend and approaching the dot.com bubble in 2000. The Buffett Indicator may not do a good job in nailing a top in the stock market, but ignoring it during a Pandemic doesn’t seem wise.
The argument that the stock market is not overly expensive based on the low 10-year Treasury yield falls apart when one considers that the German 10-year Bund yield is -0.40%. If the interest rate and valuation relationship was legitimate, German stocks would be far more expensive than U.S. stocks. The P/E ratio for the S&P 500 is 28, while German stocks command a P/E of 23.6, a 15.7% discount to the S&P 500.
So much for that theory.
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