USA: The Fed and long bond yields

Thursday, February 02, 2017 // Written by Enzio von Pfeil

Even though the Fed won't raise short rates until mid-June, watch the long end of the curve!


 The Fed has left interest rates on hold. In a unanimous decision, the federal funds target range remains at 0.5% to 0.75%, following a quarter per cent rise at the previous meeting. That was only the second increase in 10 years.

 In its statement the Fed said it expects inflation to reach its 2% target and noted improvements in consumer and business sentiment. However, it gave no indication as to when the next rate rise would occur.

 The decision on rates came as the latest economic data showed a strengthening U.S. economy.

 Growth in the US manufacturing sector rose at the swiftest pace in over 3 years in December. The Institute for Supply Management’s manufacturing gauge rose to 56 last month, from 54.5 in December. That’s well above the 50 line that separates expansion from contraction. The report also showed inflation expectations increasing with the prices paid index at its highest level since May 2011.

 In more good news for the U.S. economy, payroll processor ADP reported that the private-sector added 246,000 jobs last month easily beating Wall Street estimates. That compares to a 151,000 increase in December.

 Tomorrow, the U.S. labour department will report the closely watched non-farm payrolls number.

  1.  Tightening bias unfolds. As with the BoJ and the ECB, the Fed remains on hold. But the drift is towards tightening, towards intensifying its “excess demand for money” – precisely because America’s “excess demand for goods” keeps  improving.  Indeed, JP Morgan Asset Management’s global strategist, is quoted in Tuesday’s Financial Times as stating that a) since Lehmans collapsed, 50 central banks have slashed interest rates over 700 times AND b) these central banks also have purchased USD 23 trn worth of assets, which equates to about half of all government bonds outstanding! Obviously this profligacy cannot continue unfettered, so consider 2016 the peak of global loose money.

 a.   Tightening ahead. In the context of our Economic Clock®: precisely because things are improving, global Central Banks are poised to tighten, with America leading the way, albeit haltingly.

2.  Manufacturing.  That output has risen the fastest in three years reflects a growing “excess demand for goods” in America’s Economic Time®.  It would be useful to know how much of this intensifying  output is going towards

 a.  Rebuilding inventories, or

 b.  Feeding an excess demand for goods in the US economy

3.  Inflation

 a.  Cholesterol. It’s like cholesterol. Some of it is not harmful, some is.

                                         i.    Cost-push.  Unharmful inflation stems from “cost-push” pressures: rising commodity prices are very much at the root of rising inflationary pressures. But Central Banks cannot do much about cost-push inflation!

                                       ii.    Demand-pull. Harmful, as this is the traditional “stronger demand begets stronger wages begets stronger (demand-pull) inflation….

b.  Policy outlook.My view remains that the bulk of inflation is cost-push, stemming from two key sources

                                          i.    Rising commodity prices,

                                        ii.    Stagnating productivity, implying rising unit labour costs, and

                                       iii.    Rising import costs, courtesy of a dollar that has kept softening in trend since kick-off in 1973, when a dollar bought you 400 yen and 4 Swiss Francs…

4.  Jobs

 a.  More jobs are being created, which means that with increasing DEMAND for labour is being matched by increasing SUPPLY of labour – so how can wages rise if the following are rising?:

                                          i.    The labour force participation rate, as well as

                                        ii.    The number of employed people.

 b.  Non-farm payrolls, thus, will rise tomorrow: more and more jobs are being created. Again: if payrolls, if the SUPPLY of labour rises, then its price surely must stagnate if not fall, according to Economics 101.

5.  Flatter yield curve.  Along with higher short – term rates, long term yields have risen faster, and that has favoured banking stocks.  But peering ahead, I am less convinced that bond yields must remain high/ keep rising:

 a.  Balance sheet shrinkage. The Fed wants to start reducing the size of its balance sheet, which is technical talk for a simple operation: stop buying so many bonds; sell more bonds!  This consequent fall in bond prices, of course, drives-up yields, BUT

 b.  Greater risk aversion.  The real end-demand for long bonds must rise in line with increased global geo-political risks, courtesy of Donald Trump’s impetuousness….

 c. Outlook.  Expect the next rate decisions come on 15th March and 3rd May. I don’t think that they’ll tighten Fed Funds until the mid-June meeting ; but keep your eye on the long bond yields….

 d.  Investment Conclusions

                                          i.    Banking stocks. Risk aversion will trump balance sheet shrinkage, so look for long yields to FALL, and that, in turn means that you want to start SHORTING banking stocks which you had bought previously on account of a steeper yield curve.

                                        ii.    The dollar.  Keep buying. Even if the global Economic Time® is improving gingerly, US rates will remain the highest among the G-3 for many months.


Chinese PMI DATA

  Chinese manufacturing has slowed slightly in January but activity in the service sector has picked up speed. The National Bureau of Statistics has reported that China’s official manufacturing purchasing managers index fell to 51.3 in January from 51.4 in the previous month. New orders and production fell last month, while employment and exports rose

 China’s official nonmanufacturing PMI edged up to 54.6 in January from 54.5 in December.

1.  China.  For some time we at PCL have suggested a worsening in China’s Economic Time®, courtesy of RMB support calling for evermore RMB support: the PBoC “gets” (buys) RMB and “gives” (sells USD), thus shrinking the monetary base. This, along with weak-ish global trade growth, impairs Chinese manufacturing output.

 a.  Services economy. We are leery of China’s false precision re data on her “services “ economy: how can these be reliable, when they are inherently tough to measure accurately?

b. RMB: expect it to resume its falling trend.  Too much covering of currency-mismatched liabilities, and strong incentives to park money abroad ahead of the Party Congress this Fall…Finally, if Trump accuses China of “currency manipulation”, Beijing well could turn around and stop manipulating her RMB, instead allowing it to fall to a new level, say of RMB 8 – 9/ USD. 

c. HK Dollar.  Were it to reach 8/$, then I wonder whether our peg would be attacked...

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