The quarter always starts busy for me, so I’ve been rather quiet lately. More importantly, there just hasn’t been much I’ve been compelled to opine about. After I gushed a lot of real, actionable, timely material during the last broad market drawdown, everything since just feels like fluff, noise. Given the lull here, I did some digging through my files to find entries that never saw the light of day, and I thought I’d post a few of significance–particularly those to which I expect to refer in the future. (There are a lot of works I write but never publish, for one reason or another.)
This first piece, as follows, is a roundup/reaction in the wake of the FOMC’s June 19 meeting, which was accompanied by the Chairman’s press conference–not to mention global capital market turmoil.
I hadn’t the time to sufficiently polish such a long-form entry over the past weeks, but clients have unanimously queried as to our position on the matter, so I think it’s good to crystallize my deductions herein, complete with an amalgam of citations. Plus, I want to set the record straight, because what was said and what subsequently occurred seems to be widely misunderstood by Main Street…
Diary entry dated June 20, 2013
The Fed has continually offered explicit, quantitative, long term targets for growth (GDP 2.3-2.6% by 4q13), unemployment (6.5%), and inflation (2% core PCE) that it would like to achieve before raising interest rates like Fed Funds. Let’s be clear: we’re talking about moving ZIRP, not QE, once these goals are achieved; further, a rise in the policy rate comes after QE fin.
GDP for 1h13 likely won’t break 2% now, so 2H will have to come in between 2.5-3.2% to satisfy the growth qualification by December. That said, a disappointing print for FY13 GDP will not give the Fed enough latitude to even consider paring QE purchases—nevermind the early, September start date on which traders are now focused. The unemployment rate is currently 7.6% and core PCE is 1.05%—an alltime low for the latter, since the index began in 1960. All three macro datapoints say there’s a large gap between where we are and where we need to be for the Fed to move on anything. Monetary accommodation will wholly recede (QE and ZIRP) only upon sustainably reaching these goals or at least nearing them with sustainable momentum.
Accordingly, Mr. Bernanke delivered this bit of good news at his press conference following the FOMC June meeting:
“If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year. And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year.”
That newly professed yardstick for QE was all commensurate with Street consensus and every survey out there. Note that it’s a yardstick, not a timeline, because it relies on data, not the calendar. More importantly, it affirmed the notion: ‘The economy will be great, or else you can keep eating cake.’ Why would that prompt a market selloff? That’s what confuses most onlookers. Why would $SPX immediately drop -1.39%, $AGG -0.67%, $HYG -1.5%; 65 ES handles and 27bps on the 5y ($FVX) in the subsequent two days?! Yes, the Fed/economists are historically miserable at forecasting macro data, but the Chairman said he expects the monetary accommodation to start being withdrawn conditional upon the economy being great, ex ante. What about that upsets you, Mr. Market!? I know there’s that aforementioned economic performance gap, but you have this promise from the Fed, a “Bernanke Put,” which says ‘we’re going to keep doing everything in our power until the economy is great again.’ Direct quote from the Chairman:
“The key point I’ve tried to make today is that our policies are tied to how the outlook evolves, and that should provide some comfort to markets because they will understand—I hope—that we will be providing whatever support is necessary.”
In that case, shouldn’t the market meet any Fed pronouncements with ambivalence?
Normally, yes, but in this instance, capital markets’ internals were pretty imbalanced. Here’s the money shot: Consensus was for a taper in 1H14, with rising Fed Funds around May 2015. Mr. Bernanke’s comments pulled-forward expectations, as the Fed Funds yield curve can attest, implying a new, December 2014 rate hike ever since the FOMC presser. Risk markets were poorly positioned (i.e. overleveraged) to handle the sharp, outward shift in rates, because NYSE margin balances entered June at historically high levels, with net credit deficits also near record levels. Given the market’s leveraged status, it makes sense that something as anticipated as a outward shift in the yield curve would cascade into a multiasset drawdown.
While maintaining the 6.5% unemployment target for raising the policy rate, the FOMC offered a new, 7% unemployment projection (not a target) for the end of QE flow in its entirety:
“When asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7%, with solid economic growth supporting further job gains.”
Again, that is not a starting line (at the beginning of QE tapering), nor a finish line (at the end of ZIRP altogether), but a milemarker (at the end of LSAPs). Since the 7% unemployment milemarker is obviously short of the Fed’s 6.5% long term target, that means the Chairman is promising significant economic momentum after QE has been whittled down to nil, as I’ve mentioned already.
So, the Committee expects some economic wildcard to not only usher us down to 7% unemployment, but also propel us beyond? I’m certain Mr. Bernanke is looking at two primary catalysts. First, the health of state and local governments’ balance sheets. In aggregate, municipalities’ budgets have swung to a surplus, and with the end of their austerity, spending will now be a boon to GDP, having materially dragged on growth since 4q09. Second, housing, wherein demographics and household formation have both home starts and residential investment ready to surge. Those real estate-related data are two of the most reliable leading economic indicators. Just eliminating the drag of state/local government austerity and housing inactivity materially bumps GDP and helps breach the gap. Explicitly, albeit briefly, Mr. Bernanke mentioned both factors in his Q&A.
Do we have to mind the gap between today’s data and the Fed’s ultimate targets? I’ll let Mr. Bernanke repeat, “we will be providing whatever support is necessary.” The real inputs for your models are 2.3, 6.5, and 2%–growth, unemployment, and inflation, as aforementioned. It’s those goals or bust; so, if you’re a near term doomsayer (on CNBC or in the webosphere), you’re betting on bust and taking the other side of the Fed’s trade. Best of luck.
If the market expects the Fed to attain its targets, Treasury yields should float higher to reflect an increasing required rate of return, while stocks rise per higher future earnings expectations.¹ Empirically, that’s a dynamic we experienced between May 1-22. If the market expects the Fed will miss its calendar guidance, Treasury yields might waffle, but risk should rally–albeit at a tempered pace. If the market expects the Fed will terminally fail, yes, stocks and bonds should implode together, crashing in a fiery heap.
At the end of the day, the market is always right, because that’s from where we derive our bottom line. I myself still recognize the [investing] win-win in choosing between a great economy or continued accommodation, which is why I buy a dip like the one between May and June. I believe in the promise of economic momentum—not out of blind faith, but due to hard data. Echoing the words of Bill McBride, “The future’s so bright, I gotta wear shades.”
I may doubt that the Fed’s targets can be reached in the timeframe they’ve predicted (YE13/1h14),² but the odds are high that they’ll attain those targets eventually. What I know for certain is that the Fed will keep jawboning to guide expectations wherever they deem necessary. When leverage grows too high or asset values too rich, Fed regional presidents will spew rhetoric to let some air out of bubbles. Mind the economic gap? the calendar? No. Mind NYSE margin levels. Also, mind the fundamentals, bound by the limits of 2.3% growth, 6.5% unemployment, 2% inflation, and an SPX earnings yield with some relative spread over IG corporate credit.
¹I’d suggest that multiple expansion might slow or even contract slightly, with growth in the numerator “P” outpaced by the denominator “E,” for a number of reasons. For example, earnings yields should correlate with rising bond yields, respecting relative spreads (e.g. equity risk premium). Plus, a fair amount of forward EPS growth has already been priced-in.
²…especially with 2q13 GDP tracking at 1%.