Thursday, May 25, 2017

Fed tightening has been a positive for markets

For years people have worried that a Fed "tightening" would derail the economy and the markets, but the facts say otherwise. The Fed first hinted at a tightening a few years ago, with the first hike coming in late 2015. Since then, short-term interest rates have risen by 75 bps and another tightening is virtually assured for next month's FOMC meeting. Today the dollar is stronger, but not too strong; the yield curve is flatter, but not too flat; credit spreads are tighter, but not too tight; equity prices are up, but the equity risk premium is still positive; commercial real estate is up, but not to record highs; equity and bond market volatility is down; and inflation is relatively low but not too low.

What's not to like? To be sure, the economy hasn't yet picked up from the 2% pace that has prevailed for the duration of this rather long recovery, but business and consumer optimism is up significantly in recent months, and that combined with Trump's tax and regulatory reform proposals, if passed, would almost certainly result in a stronger economy. Things could be better, but they aren't half bad—except for the growing threat of a nuclear NoKo and radical Islamic terrorism. For my money, NoKo is the darkest cloud on the horizon. Unfortunately, there's not much an investor can do in the face of that kind of uncertainty.

Here are some charts which put some meat on the story:

The chart above compares the inflation-adjusted current Fed funds target rate (blue) to what the market expects that rate to average over the next 5 years (red). This is effectively a picture of how the real yield curve has evolved over time and is expected to evolve. Recessions are almost always preceded by a flat to inverted real yield curve, because that is the market's way of saying that monetary policy is too tight and it is hurting the economy. Today the market is saying that the Fed will probably raise the real funds rate another couple of times over the next year or two, but not by much more. That tells me the market is not pricing in a robust economy, nor is it predicting a weaker economy, since that would call for a reduction in the real funds rate. It's more a prediction of "steady and slow as she goes."

Note also the all-time low in real 5-yr yields in March 2013, when they fell to almost -1.8%. That was a sign that the market was extremely pessimistic. We've come a long way since then, but real yields are still very low from an historical perspective.

As the chart above shows, 5-yr real yields are still right around zero, where they've been for several years now. It's not a coincidence, I would argue, that real GDP growth has been stuck at 2% for about the same length of time. Translation: the market doesn't see much if any improvement for the foreseeable future. This is not an optimistic market.

Credit Default Swap spreads are a little tighter than they were in March 2013, despite higher real yields and a flatter yield curve. They've been tighter before (e.g., in the late 2000s).

The chart above compares the yield on a variety of assets as of March 31, 2013 (when real yields hit their all-time lows and Fed policy was effectively extremely easy) and as of today (red). Note that short-term yields have risen much more than longer-term yields, resulting in a flatter yield curve. Note also that yields on REITS, BAA bonds and equities have declined even as the Fed has tightened and market yields have risen. All of this is pretty straightforward, right out of the textbooks. Tighter money flattens the yield curve, and when it's not too tight it's good for most asset classes because a positively-sloped yield curve is symptomatic of a reasonably healthy economy. The Fed is not threatening anybody these days.

The dollar began rising once the market started pricing in Fed tightening. That's a good thing. But the dollar today is far from being too strong, as it was in 1985 and 2001. Today it's only marginally higher than its long-term historical average.

With the dollar just above the middle of its long-term range, it's not surprising to see real oil prices trading close to their long-term range. Oil is neither expensive nor cheap, and that can't be bad for the outlook for the economy.

As the chart above shows, 5-yr inflation expectations (as embodied in the market for TIPS and Treasuries) say that consumer price inflation will likely average about 1.7% for the foreseeable future. That's not bad at all: not too high, not too low. In my ideal world, inflation would be close to zero and stable, but nobody is going to worry much if it's 1.7%. Indeed, the Fed would prefer to see inflation above zero. The Fed is not a threat in these conditions.

As the chart above shows, the equity market has suffered from numerous panic attacks in recent years (i.e., spikes in the Vix/10-yr ratio, accompanied by declines in equity prices). Today, however, implied equity volatility is quite low and nobody expects anything outrageous from the Fed, so it's not surprising that equity prices are floating higher.

PE ratios (using earnings from continuing operations) today are a bit over 21, according to Bloomberg, but that's not at all unusual given the very low level of 10-yr nominal and 5-yr real yields. As the chart above shows, the earnings yield on the S&P 500 tends to follow the inverse of the real yield on 5-yr TIPS. If anything, the current earnings yield on stocks suggests that real yields are too low (meaning the Fed could be tighter and real yields higher). Stocks, in other words, appear priced to higher yields than the bond market is assuming.

As the chart above shows, the equity risk premium (the difference between earnings yields on stocks and the yield on 10-yr Treasuries) is still relatively high. That means investors are quite willing to forego the yields and capital gains potential of stocks in exchange for the safety of Treasuries. Again, this is not an overly-optimistic market. If the market were exuberant, the equity risk premium would be negative, not positive. 

What's driving equity prices higher is not anything sinister nor dangerous. Given that the market doesn't expect things to change much, investors are reluctantly conceding that the much higher yields on equities and other asset classes—relative to cash and Treasury note and bond yields—are attractive.


Rich said...

So hypothetically, in the absence of tax reform, and in turn a slower pace of removal of accommodation by the FED, would the recovery last longer than it would if there is a transition to a period of faster growth fueled by tax reform, leading to a more active FED?

Or is the plow horse recovery likely to roll over on its own absent fiscal stimulus?

Scott Grannis said...

Rich: very tough to answer those multiple hypotheticals. It all depends on a lot of things and how they come together.

Rich said...

Thank you.

randy said...

This article in American Affairs brutally reviews modern finance - concluding that at least in part it's a charade used to persuade investors to pay a lot for advice. That they really don't need. I don't necessarily agree with all the statistics (like value always beats growth in the long term), but the fundamental idea I do agree with.

I've seen just a couple of benefits of active management. First, managing investors tendency to make rash decisions like selling in fear (guilty). That is the most valuable service. Second - active management in less developed markets. For example an emerging markets index is in a large part a proxy for commodities. If an investor desires exposure tied to something other than commodities, an active manager might be beneficial.

Over the last many years, Scott's analysis has also provided the intelligence that helps one not over-react. Often criticized for persistent optimism, well, he's been mostly right to not discount the resilience of the economy. And to observe that underlying economics continue to be fundamentally OK. Thank you Scott!

Benjamin Cole said...

"commercial real estate is up, but not to record highs";--Scott Grannis.

I think I can finally win an argument, or at least a point, with Scott Grannis!

Egads, commercial real estate is well past record highs (2008-era) and actually flatlining a bit.

I wish I could reproduce a chart here.

But see if this link works from Green Street Advisers, very smart guys in your neck of the woods.

In fact, the Green Street indexes the US commercial property prices at previous peak at 100 back in late 2007, and now we are at 126.2. So today commercial property prices are about 26% higher than the old 2007-8 peak.

Overseas markets? China and Hong Kong have gone nuts.

The Henderson Land Development recently paid $3 billion for a plot of land in Hong Kong, upon which they can build a 465,000 square foot building. In other words, even if they built the building for free, they need to sell it for $6,451 a square foot to break even.

Commercial property prices are at record highs, and in some parts of the world, seem too high. CP prices are cooling off in the US, which could be good, or spooky---let's hope for plateau, not a rout. If the Fed squeezes too much and we get a rout---well then the banks start to falter, and lenders pull in their horns. Recessions beget recessions in the US financial system.

But great post by Scott Grannis, as always.


The Cliff Claven of Finance said...

So, Fed tightening is good news?

Then Fed easing must be bad news?

But investors treated Fed easing as good news!

So, this has to be a rare blog where ANYTHING the Fed does is good news?

Stock average valuations are among the highest ever recorded.

Median stock valuations are the highest ever.

Never in the history of the stock markets have such high stock valuations been a wise time to buy stocks.

This time is different, I suppose?

They said that last time !

There will be no Trump tax reform, or anything else Trump wants, requiring Senate approval.

Trump has been thoroughly demonized Saul Alinsky-style

(1) All legislation will be filibustered by Senate Democrats and permanently blocked.

It's true that Republicans could change the filibuster rules (bad news since being revised in the 1970s, after which filibusters exploded 37 fold) with a simple majority vote, but they are afraid of riots ... and what the next Democrat majority legislature would do.

(2) Democrat judges have shown they can block just about anything Trump wants, such as the limited immigration ban, without even citing anything in the executive order itself that was unconstitutional.

(1) and (2) above were not in the Constitution, or envisioned by our founders ... even in a bad dream.

The Democrats will see that Trump accomplishes less than any President in history during his first term.

They will try to impeach him even if the charges are phony.

Few Americans realize how much power the minority party has.

The Trump Bump to the stock markets after the election was unjustified optimism -- he promised so much spending and tax cuts before the election it was almost like watching a Saturday Night Live skit.

Remember: To most Americans, the economy looked great in 2007 ... and in 1999.

Here's some of what I wrote about filibusters in one of my blogs last year:

"Filibusters are not in the US Constitution.

They exist because of a Senate rule, and could be eliminated by a simple majority vote.

Filibusters were rarely used in the Senate when they required a Senator to be at his desk, and on his feet, talking without a break.

In 1917 a new filibuster "cloture" rule (rule to end a filibuster) was approved, requiring a two-thirds vote of those present to end a filibuster (later changed to three-fifths of the Senate, or 60 votes).

The new cloture rule did not result in many filibusters, because any filibuster halted all other Senate business until it was over.

From 1917 to 1969 there were 58 filibusters:
(an average of 1.1 per year over those 52 years).

But from 1970 through 2016 there were about 1,700 filibusters:
(an average of 37.0 per year over those 46 years).

What changed in 1970?

In 1970, Senate Majority Leader Mike Mansfield launched a "two-track system" that allowed the Senate Minority Leader to bypass a filibustered bill and move on to other Senate business.

The new bypass rule meant a filibustering Senator didn't have to talk all day.

Filibusters were used to force debate on a bill before 1970.

That was good.

Filibusters were used to prevent debate on a bill after 1970.

That is very bad."

bob wright said...


Do you know of a way to track the quarterly earnings of EAFE or of NASDAQ or even S&P mid cap or small cap stocks without buying a bloomberg subscription?

I see lots of reporting on the "E" for the S&P 500 but nothing comparable when it comes to large cap stocks in Europe or small and mid cap stocks in the U.S.

Thank you in advance for any suggestions you may have.

Ian Hunter said...

Hi, Scott,
Thanks for your insightful blog. Is it accurate in your Equity Risk Premium chart has been below zero for much of the 90s? How did investors accept that?

Scott Grannis said...

bob: Sorry, but I rely on Bloomberg for everything and thus am not aware of alternative sources for earnings data.

Scott Grannis said...

Ian: the equity risk premium was indeed negative for many years. That implies that investors were very confident that the combination of capital gains on stocks and increased dividend yields would be higher than the yield on 10-yr Treasuries. In other words, investors were pretty optimistic about future returns on stocks. Today investors are much less optimistic.