At the December 12, 2012 FOMC meeting, the committee increased the previously announced QE III to include US Treasuries amounting to total stimulus of approximately $85 billion per month. At the same time they introduced economic "thresholds" targeting a 6.5% unemployment rate while not exceeding a 2.5% inflation rate. At the time I viewed this simultaneous raising of the inflation rate from 2.0% to 2.5% in order to bring down unemployment as a de facto nominal GDP target which was something Chairman Bernanke had said would be "reckless" at the previous April FOMC press conference.
My concern was this new "open-ended" QE would introduce the risk that if it didn't work the market would begin to lose faith that the Fed was relevant. In Bernanke Capitulates, Launches De Facto Nominal GDP Target, I concluded:
I would like to think Bernanke's intentions are pure, but I am also starting to wonder if his date with deflationary destiny is clouding his judgment. Either way it's pretty clear that he's making this up as he goes along.
As I have been saying since the Fed launched QE3 in September, the biggest risk in the markets today is a loss of confidence that Bernanke can hold this thing together. In my opinion there is a very large false sense of security that they know what they are doing and can indeed wield a wand to control asset prices. However, at the end of the day, this is still a confidence game. They can only do so if the markets believe that they can. If the markets lose faith, then all bets are off and the costs and unintended consequences could be severe.
This past Wednesday the Fed released the minutes from the subsequent January FOMC meeting that not only sounds like a serious case of QE III buyer's remorse but also suggests they are clearly making policy up as they go along:
However, many participants also expressed some concerns about potential costs and risks arising from further asset purchases.
Several participants discussed the possible complications that additional purchases could cause for the eventual withdrawal of policy accommodation, a few mentioned the prospect of inflationary risks, and some noted that further asset purchases could foster market behavior that could undermine financial stability.
Several participants noted that a very large portfolio of long-duration assets would, under certain circumstances, expose the Federal Reserve to significant capital losses when these holdings were unwound....
A few also raised concerns about the potential effects of further asset purchases on the functioning of particular financial markets....
In light of this discussion, the staff was asked for additional analysis ahead of future meetings to support the Committee's ongoing assessment of the asset purchase program.
There was one? FTN's Chris Low nicely summed up the apparent chaos in an email brief to clients:
The one word that best describes the January FOMC minutes is "confused." There were a lot of headline-worthy statements about ending QE early stemming from misgivings which one can't help but think should have been discussed and settled before the program was initiated last year, and certainly should have been resolved before QE doubled in size in December.
If you had any doubt about whether they knew what they were doing, well now you know. Nevertheless, the bond market didn't seem to care and went on consolidating the range around 143-00 that we have been watching for almost a month. In fact I'm beginning to think this is all a big joke and the bond market has just been humoring Bernanke into thinking he is in control.
What if the 10-year yield actually belongs at 2.0%?
The first reading on Q4 2012 YOY nominal GDP (NGDP) growth was a bleak 3.3%. This was the lowest print since Q1 2010's 2.5% which was the first quarter of positive real growth coming out of the recession. Likely because the stock market was at new highs at the time of release, the first interpretation was that it was an anomaly caused by a sharp drop in government spending. However the 3.3% growth rate matches up pretty well with Q4 earnings reports and recent comments from consumer product companies.
Every week Bloomberg's Rich Yamarone publishes his "Orange Book," which is a fascinating compilation of anecdotal comments from corporate executives on their earnings conference calls. Without going into the massive detail Rich accumulates after reading a few of the comments from the likes of BEAM Inc. (BEAM), The Clorox Company (CLX), Tyson Foods (TSN), Whirlpool (WHR) and Elizabeth Arden (RDEN), the net takeaway remains depressing.
The Bloomberg Orange Book Sentiment Index for the week ended Feb. 22 was 48.67, a slight decline from the 49.47 registered during the prior week. Sub-50 readings suggest contractionary conditions, while above-50 is indicative of expansion.
10YR Yield Vs. YOY Nominal GDP
There is a fairly consistent relationship between NGDP and interest rates. As you can see on the 50-year chart, historically NGDP and 10-year yields tend to converge. Obviously there have been statistical outliers, but eventually the 10-year yield equals the growth rate of the economy, and over the 50-year history the average spread between the two is just 17.5bps. If you think about it this makes sense as a risk-free government bondholder should, over time, at least be compensated for nominal economic growth. The current spread of -155bps is inside 1 standard deviation and looks to be converging towards zero. The question is whether the spread converges with yields rising towards 3.3% or nominal growth falling towards 2.0%.
One likely factor contributing to the weakening nominal growth rate is the fall in inflation. This week's Fed minutes showing concern about the risks of QE were juxtaposed with the January readings on producer and consumer prices. The YOY PPI came in at a mere 1.4% with CPI registering a 1.6% gain falling from the December 1.8% rate. This 1.6% gain is notable because it is near the lower bound of inflation rates over the past 10 years and is not far from the levels in 2010 that raised deflationary fears at the Fed and brought about QE II. It also flies in the face of the market's inflation expectations which according to the 10-year TIPS (Treasury Inflation Protected Securities) inflation breakeven spread implies a 2.5% CPI, near the recent historical highs.
TIPS B/E Vs. CPI
As you can see on the chart's lower frame, this divergence between the market's inflation expectations and actual inflation has reached a historically wide level near 100bps. With the exception of the 2009 blowout, the last two times this spread reached 100bps was in 2010 and 2006. This relative cheapening of nominal vs. real yields occurred for very different reasons but eventually produced similar outcomes. In 2006 as the housing market was peaking, actual inflation began to fall yet inflation expectations remained high. In 2010 it was the opposite as inflation was already low but inflation expectations spiked due to QE II. Both spread divergences, however, preceded massive rallies in the 10-year eventually pushing yields lower by nearly 200bps on each occasion. It's highly unlikely we see a rally of that magnitude, but this spread divergence should be supportive of the long end of the curve, and contrary to consensus, could be signaling significantly lower yields in the near future.
Due to the lower nominal growth trajectory, even when/if the Fed begins to normalize interest rates they are not likely going very high. I plotted the relationship between the YOY NGDP growth rate and the Fed funds (FF) rate going back 40 years running a regression analysis on the spread. In general you might say that money is tight (restrictive) when the FF rate exceeds the NGDP growth rate and money is easy (stimulative) when the FF rate is below NGDP with a flat "breakeven" spread being neither tight nor easy. This is evidenced by showing that each of the six recessions over the past 40 years occurred when NGDP dropped below the FF rate. However it is interesting to note that the regression line is downward sloping spending the past decade below zero suggesting that the structurally declining NGDP is now so low it is potentially sensitive to interest rates before they exceed the growth rate.
Nominal GDP Vs. Fed Funds Rate
The -1.50% regression spread is extrapolated into 2014, so by using different NGDP growth rate assumptions you can derive what level the FF rate will become restrictive. With NGDP averaging 4.0% over the past decade, and since the recession ended, I think this is a conservative benchmark. A -1.50% spread produces a breakeven FF rate of 2.50%. But if the Q4 NGDP 3.3% growth rate is more indicative of the new longer term trajectory and you average something closer to 3.5%, then the breakeven spread is 2.0%, basically right where the 10YR yield is trading today. Hmmm....
Perhaps there is no more widely held belief than in the assumption that the Fed is artificially holding down long term interest rates. The Fed themselves believe this to be true, and until recently, I have been operating under the same assumption. I have been anticipating that when the Fed begins to withdraw from their asset purchases, long term interest rates will begin to rise, converging back towards their historical mean of the NGDP growth rate.
Having cut my teeth in the bond market I have always looked to the curve and 10-year yield as a forecasting tool for future discounts of growth and inflation. The track record has served me well throughout my career. That changed when the Fed launched QE as I thought the free market had been compromised and manipulated beyond recognition. Furthermore I believed Bernanke had taken the discount out of the discount rate. Now I am not so sure.
Various indicators are beginning to prove the bond market may have been correct all along. Growth and inflation are anemic and appear to be decelerating, anecdotal evidence from retailers point to tepid demand for non-discretionary items, and despite meager net interest margins, banks are continuing to favor securities rather than make loans, suggesting demand for credit is weak.
The outlook for corporate profits doesn't look much better. Last week FactSet reported that recent estimates now point to a decline in YOY Q1 2013 earnings growth.
Based on current estimates, the estimated earnings growth rate for the index for Q1 2013 now stands at -0.04%. There has been a steady decline in the growth rate over the past five months. On September 28, the estimated earnings growth rate was 5.1%. By December 28, the estimated growth had declined to 2.4%. Last week, the growth rate was slightly positive at 0.04%. Today, it stands at -0.04%.
You wouldn't know by the price action in stocks, but if you look under the hood, all is not well. This is not a surprise though; equity investors are usually last to get the memo. Usually the first to get the memo are bond investors, and despite insanity in currency and equity markets that has driven attempts to take out 2.00% in the 10-year and my critical 143-00 level in the US bond futures contract, the bond market remains bid. Don't get me wrong. I will respect a failure of these two levels, but if the market makes this area support as fundamentals continue to deteriorate we could see a significant rally as Bernanke's date with deflationary destiny becomes a reality.
If you want to understand how this story ends, all you need to do is read Hoisington Investment Management's Dr. Lacy Hunt and Van Hoisington. I know you must be tired of me citing these guys, but no one makes the deflationary case more elementary yet effectively than Hunt and Hoisington. In their Q4 letter to investors they provide the bottom line (emphasis mine):
We have been of the opinion that the 30- year Treasury bond rate could not go up and stay up since well before the initiation of QE1. It has been an expensive wait for those expecting higher interest rates, as they have actually declined. Today, with long-term Treasury yields around 3%, our view remains the same. Interest rates may, will and have gone up based on periodic changes in psychology. However, underlying fundamentals have insured they have not been able to remain elevated. The fundamentals of insufficiency of demand and its root cause, over-indebtedness, still point to an environment in which long-term interest rates remain on a path to lower levels.
There you have it.