October 19, 2016
Fed vs. Fed
It's not as if there hasn't been plenty of headlines to hit the tape over the past few weeks; there has just been a dearth of useful information on which to base investment decisions in many of the stories. We are mostly referring to the presidential elections when we make this statement, as there has not been a lack of headlines, although an increasing portion seems better suited to the gossip pages. This is not to say that we will not be following it intensely, including tonight's debate, if not only for the entertainment factor, but the movement in the polls toward Clinton over the past few weeks is creating a calm in the markets versus the more difficult to assess planks espoused by Trump. We therefore have turned to the tidbits offered by fed speak since the minutes and before the next round of central bank meetings. Yellen always commands attention, particularly as market expectations have firmed over the prospects of a 25 bp hike in December. Her statements of running a high pressure economy are being construed as her willingness to run more accommodative policy until the lingering negative effects of the financial crisis are reversed. While she did not mention the prospects for a December hike, her statements introduce more than a modicum of doubt into the willingness of the FOMC to raise rates this year.
In contrast, Boston Fed President Rosengren affirmed his view that a rate hike would occur this year, which one would expect given that he voted for a hike in September. He also raised the concept of yield curve targeting, taking a page from the Bank of Japan's play book. This certainly is possible, as the Fed presently owns $580 billion in treasury securities with maturities 10 years or longer (approximately 25% of its portfolio). We think that curve targeting would require selling securities from the portfolio, however, which has not been discussed lately and therefore is only a remote possibility in our view. Lastly, Vice Chairman Fischer also implied he would support a hike as there are risks with keeping low rates for too long. Therein lays the struggle within the Fed that has become evident since the September meeting, with the policy statement and dots highlighting a growing division between the doves and hawks. The neutral tone of the minutes also highlights that division to us, with September proving to be a close call. In what we think is likely a great deal of horse trading, 14 of the 17 dots imply at least one rate hike is in the cards before year end. While Yellen has raised doubts with her high pressure comments, we don't feel that she is one of the three that feels no hikes are appropriate this year. With odds of a December hike stuck in the mid-60% range, we think the Fed is happy with market expectations and would like to keep markets stable going into the elections.
Questions also continue to swirl over the ECB's next steps, with rumors/concerns over a tapering of its asset purchases as soon as early 2017. Given the current set of buying restrictions, including the capital key, minimum yield bogeys and single issue concentrations, its ability to vastly extend or expand its sovereign bond purchases are limited. Apparent concerns over the efficacy of current measures as well as potential unintended consequences have raised the specter of less, not more accommodation from the ECB. Therefore, tomorrow's ECB meeting, which starts the current round of CB gatherings, will be closely watched as a possible pivot away from the dovish stance that has dominated their actions ever since the financial crisis. Policy limits from the BOJ and patience on the part of the BOE further supports this line of thinking. As such, sovereign yields have backed up from their post Brexit lows, with various parts of various sovereign curves returning most, if not all, of their summer tightening. The general trend has also been towards a steepening curve, particularly out to the long end, as inflation concerns have increased, despite continued expectations of slow growth. For instance, the 30-year treasury presently stands in the 2.55% range, essentially where it was just before Brexit, having bounced from 2.10% in early July. The curve flattening trade for USTs has also retraced between 65%-80% of its summer move. Similar moves have been experienced in a number of core bond markets, including Bunds and Oats. UK yields remain lower given idiosyncratic issues, as do Spanish yields as the risk-on environment has narrowed its spreads versus bunds. It is worth noting that Italian yields are now weaker versus pre-Brexit levels, an indication that the upcoming referendum is introducing market volatility in that market.
Doubts over the path of rate hikes introduced by Yellen over the past week have created a moderate risk-on environment, which has been supported by better than expected earnings and firm oil prices. As we wrote in last week's earnings preview, bottoms up analysts had expected a -2% to -4% decline in earnings, which would represent the sixth consecutive quarterly decline if these estimates proved accurate. Given the earnings massaging process, we felt it unlikely that this would come to fruition, and the early read on the earnings season appears to support this view. With 15% of the S&P 500 companies having reported, almost 80% are beating expectations, while 19% have missed. Earnings are therefore running 5% ahead on a y/y basis, with financials and healthcare providing the biggest boost in the early stages of this reporting season. This environment has also proven supportive of credit, with investment grade and high yield posing excess returns over the past month. IG spreads have tightened 7 bps since the start of the month, retracing back to levels last seen in spring 2015. High yield has been supported by higher energy prices, as overall spreads are 15 bps better since the start of the month. Spread tightening has occurred even as issuance has picked up as companies exit their earnings quiet period.
We have had limited economic data over the past week, with GDPNOW estimates for 3Q:16 GDP stable at approximately 2%, while NOWCAST indicates a 2.3% growth rate. There are a number of housing data releases over the next week, along with durable goods, although the first reading of 3Q:16 GDP on October 28th will be the most significant release during the remainder of the month. This report comes just three days before the FOMC meeting, which precedes elections day by a week. All offer plenty of important data points, although we sense that volatility will remain muted until election day.
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