Tag: USA

FED Flags Rate Rises; Again, But Holds

The FED held their benchmark rate again, but the latest Federal Reserve FOMC statement contains a firm indication of rises ahead, if but slowly. Meantime, the balance sheet normalization is proceeding.

Information received since the Federal Open Market Committee met in September indicates that the labor market has continued to strengthen and that economic activity has been rising at a solid rate despite hurricane-related disruptions. Although the hurricanes caused a drop in payroll employment in September, the unemployment rate declined further. Household spending has been expanding at a moderate rate, and growth in business fixed investment has picked up in recent quarters. Gasoline prices rose in the aftermath of the hurricanes, boosting overall inflation in September; however, inflation for items other than food and energy remained soft. On a 12-month basis, both inflation measures have declined this year and are running below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Hurricane-related disruptions and rebuilding will continue to affect economic activity, employment, and inflation in the near term, but past experience suggests that the storms are unlikely to materially alter the course of the national economy over the medium term. Consequently, the Committee continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, and labor market conditions will strengthen somewhat further. Inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term. Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.

In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1 to 1-1/4 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.

The balance sheet normalization program initiated in October 2017 is proceeding.

US Banks’ Net Interest Margins Are Still Increasing

The ANZ Net Interest Margin (NIM), reported last week was 1.99%, and typically banks in Australia are achieving a NIM slightly above this. So, it was interesting to see this note from Moody’s, discussing the NIM of US banks, which has risen to 3.21%, and continues a positive trend over the past year.

Last week, US banks’ reported third-quarter earnings and higher net interest margins (NIM), a credit positive because NIM is a key driver for net interest income, which accounts for more than half of most banks’ net revenue.

Quarter over quarter, the average NIM for the largest US regional banks increased three basis points (Exhibit 1) to 3.21% from 3.18%, continuing a four-quarter positive trend. However, the rate of improvement is slowing. The Federal Funds rate increased 25 basis point (bp) in each of the past three quarters. However, as the bars show, the rate of improvement for listed regional banks’ average NIM has declined each quarter.

Accelerating deposit costs explain why the NIM is not increasing at a consistent rate with each 25 bp increase in the Federal Funds rate. Exhibit 2 shows deposit betas for total deposits (interest-bearing and noninterest-bearing) for each of the past three quarters. Deposit beta is the increase in cost of deposits relative to the increase in the Federal Funds rate. There was a significant step up in beta in the second quarter, which continued in the third quarter. In their earnings calls, most bank managements indicated that retail deposits are not repricing upward, despite the rise in market interest rates. This is not the case with deposits from the banks’ wealth management clients, and especially from their commercial clients, which are both more price sensitive.

US GDP At 3% Says FED Likely To Raise Rates

According to the US Bureau of Economic Analysis real gross domestic product (GDP) increased at an annual rate of 3.0 percent in the third quarter of 2017, according to the “advance” estimate released by the Bureau of Economic Analysis. In the second quarter, real GDP increased 3.1 percent.

The Bureau emphasized that the third-quarter advance estimate released today is based on source data that are incomplete or subject to further revision by the source agency. The “second” estimate for the third quarter, based on more complete data, will be released on November 29, 2017.

The increase in real GDP in the third quarter reflected positive  contributions from personal consumption expenditures (PCE), private inventory investment, nonresidential fixed investment, exports, and federal government spending. These increases were partly offset by negative contributions from residential fixed investment and state and local government spending. Imports, which are a subtraction in the calculation of GDP, decreased.

The deceleration in real GDP growth in the third quarter primarily reflected decelerations in PCE, in nonresidential fixed investment, and in exports that were partly offset by an acceleration in private inventory investment and a downturn in imports.

Current-dollar GDP increased 5.2 percent, or $245.5 billion, in the third quarter to a level of $19,495.5 billion. In the second quarter, current-dollar GDP increased 4.1 percent, or $192.3 billion.

The price index for gross domestic purchases increased 1.8 percent in the third quarter, compared with an increase of 0.9 percent in the second quarter. The PCE price index increased 1.5 percent, compared with an increase of 0.3 percent. Excluding food and energy prices, the PCE price index increased 1.3 percent, compared with an increase of 0.9 percent.

Higher Bond Yields Could Depress Share Prices

From Moody’s

Any analysis regarding the appropriate valuation of a long-lived asset must account for the influence of interest rates. All else the same, a rise by the interest rates of lower-risk debt obligations, namely US Treasury debt, will reduce the prices of other financial and real assets. Whenever asset prices defy higher interest rates and rise, a worrisome overvaluation of asset prices may be unfolding. Today’s high price-to-earnings multiples of equities and narrow yield spreads of corporate bonds have increased the vulnerability of financial asset prices to a widely anticipated climb by short- and long-term Treasury yields.

As of 2017’s third quarter, the market value of US common stock was 15.4 times as great as the prospective moving yearlong average of US after tax profits. Third-quarter 2017’s ratio of common equity’s market value to yearlong after-tax profits was the highest since the 16.2:1 of second-quarter 2002. More importantly, the ratio last rose up to 15.4:1 in first-quarter 1998 and would ultimately peak at the 26.0:1 of third-quarter 2000. Stocks may be richly priced relative to after-tax profits, but that does not preclude a further overvaluation of equities vis-a-vis corporate earnings. (Note that the measure of after-tax profits employed in this discussion is from the National Income Product Accounts, excludes changes in the value of inventories and some extraordinary gains and losses, and uses economic depreciation instead of accounting depreciation.)

Today’s equity market differs from that of 1998-2000 for reasons extending beyond 1998-2000’s average aggregate price-to-earnings ratio (P:E) of 21.2:1, which was so much greater than the recent 15.4:1.

In addition, 1998-2000’s equity market seems even more overpriced compared to the current market because the recent 2.43% 10-year Treasury yield was so much lower than its 5.64% average of 1998-2000.

The valuation of equities very much depends on interest rates. Holding everything else constant, priceto-earnings multiples will climb higher as benchmark interest rates decline. If benchmark interest rates fall, the market will be willing to accept a lower earnings yield, or a lower ratio of earnings to the market value of common stock. At some level of corporate earnings, the attainment of a lower earnings yield will be achieved through an increase in share prices. To the contrary, a rise by interest rates will push the earnings yield higher. Barring a sufficient climb by after-tax profits, a higher earnings yield will require lower share prices.

The Best Indicator Yet Rates Are On Their Way Up

The US 10-Year Bond Rates climbed above 2.4% yesterday and provides a strong signal that interest rates in the USA are on their way up as the FED reduces QE and moves benchmarks higher. After the Trump effect took hold late last year, we reached a peak in March, before falling away but the current rates are level with those in May.

There will be a knock on effect on the global capital markets of course, and as Australian Banks are net borrowers of these funds, will feel the effect of more expensive capital, and this is likely to flow through to their product pricing. As Treasury Head John Fraser said today:

“…though global monetary conditions can also impact upon the wholesale funding costs of Australian banks”.

We suspect the markets are underestimating the potential for rates rises, and soon.

 

How Might Increases in the Fed Funds Rate Impact Other Interest Rates?

From The St. Louis Fed Blog.

The Federal Reserve’s main instrument for achieving stable prices and maximum employment is the target for the federal funds rate. The idea is that by affecting the rate at which banks lend to each other overnight, other interest rates may be affected. In turn, this would also affect nominal variables (such as inflation) and real variables (such as output and employment).

In December 2015, the Fed ended seven years of near-zero policy rates. Through a series of increases since then, the target rate has been gradually raised by one percentage point. The current monetary policy outlook, as stated recently by Fed Chair Janet Yellen, is to continue increasing the target rate due to worries that a strong labor market may create inflationary pressures.1

Questions about Rate Increase Impacts

The fed funds rate is thus expected to continue rising in the near future. This would undoubtedly mean that other short-term interest rates will increase in tandem.

But what about long-term interest rates? What would the impact be on those rates that arguably matter the most for real economic activity, such as mortgages rates, Treasury bond yields and corporate bond yields?

The future is always hard to predict, but we can take an educated guess by looking at the recent behavior of short-term and long-term interest rates, and how they move with the fed funds rate.

Impact on Treasury Yields

The figure below displays three key interest rates over a period of 30 years:

  • The federal funds rate
  • The interest rate on a one-year Treasury bond
  • The interest rate on a 10-year Treasury bond

As we can see, the fed funds rate and the one-year Treasury rate track each other very closely. Although it is still debatable whether the Fed leads or follows the market, movements in the policy rate are associated with similar movements in short-term interest rates.2

In contrast, the interest rate on a 10-year Treasury bond does not appear to move as closely with the fed funds rate. While there appears to be some co-movement, the 10-year interest rate appears to follow its own declining path.3

Impact on Mortgage Rates

Is the interest rate on a 10-year Treasury bond representative of long-term interest rates? The next figure compares this rate to the average rate on a 30-year mortgage.

Clearly, the two move very closely together, though there is a difference in level due to the higher risk, lower liquidity and longer term of mortgages. If we were instead to look at other long-term interest rates, such as the average rate on corporate bonds, the results would be similar.

Impact on the Yield Curve

Given that movements in the fed funds rate are closely linked to movements in short-term interest rates, but less so to movements in long-term interest rates, changes in the policy rate are likely to impact the yield curve.4 The next figure compares the fed funds rate with the difference between 10-year and one-year Treasury bond rates.

This difference is meant to represent the yield curve at each moment in time with a single number. Note that there is a strong negative correlation between the fed funds rate and the term premium of Treasury bonds. When the policy rate increases, the spread between one- and 10-year Treasury bonds decreases.

Although it is still too early to tell, this pattern appears to be present in the latest period of interest rate hikes.

Overall Impact of Fed Funds Rate Target Increases

If the past is any evidence, the projected increase in the fed funds rate will successfully raise short-term interest rates but have a limited impact on long-term interest rates. This will imply a reduction in the term premium for bonds and loans.

These observations rely on the Fed not letting inflation stray significantly away from its annual target, which has been set at 2 percent. It is thus likely that, despite the continuing rate hikes, the government, firms and households will all continue to enjoy historically low interest rates on their long-term liabilities.

There is, of course, the possibility that some unforeseen and fundamental change in the economy will drive long-term interest rates up, but this increase would unlikely be driven by monetary policy alone.

Notes and References

1 For example, see Appelbaum, Binyamin. “Janet Yellen Says Fed Plans to Keep Raising Rates,” New York Times, Sept. 26, 2017.

2 The interest rate on a three-month Treasury bond would look even more similar to the fed funds rate.

3 For further analysis on these trends, see Martin, Fernando M. “A Perspective on Nominal Interest Rates,” Economic Synopses, No. 25, 2016.

4 The yield curve plots interest rates as a function of maturity dates.

U.S. Home Prices Climb to Pre-Crisis Levels

Home prices in the United States have now climbed to levels last seen a decade ago, though unlike 10 years prior, much of the country’s growth is now sustainable, according to Fitch Ratings in its latest quarterly U.S. RMBS sustainable home price report.

Home prices grew at nearly a 5% annualized rate last quarter and are 36% higher nationally since reaching their low in 2012. As a result they are now slightly above peak levels reached in 2006 – 2007. The difference this time around compared to a decade ago rests with several other notable factors aside from the much talked about low mortgage rates and falling unemployment.

“The U.S. population has increased by more than 30 million people and personal income per capita has increased by more than 30% since 2006,” said Managing Director Grant Bailey. “Both the significantly higher population and income levels provide much greater support for the price levels today.”

That said, growth remains somewhat disjointed in some regions of the US. “Prices in major metro areas of Texas are now more than 50% higher than they were in 2006, while prices in New York, Philadelphia and Washington DC are still 4% – 10% below 2006 levels,” said Bailey. “Elsewhere, home prices in major cities throughout Florida remain more than 15% below 2006 levels.”

The overheated home price pockets remain largely in the Western United States (Texas, Portland, Phoenix and Las Vegas), which Fitch lists at more than 10% overvalued.

Bond Returns, Lower For Longer?

From Moody’s

A less accommodative US monetary policy may heighten market volatility near term. However, over time, the fundamentals that give direction to business activity and financial markets will prevail. For now, current trends involving demography, technology, regulation, and globalization favor the containment of core price inflation and still relatively low US Treasury bond yields.

Because price deflation is anathema to both profit margins and credit quality, a low enough rate of price inflation will adversely affect both equity prices and systemic financial liquidity. If US core consumer price inflation (which excludes volatile food and energy prices) now eases amid a relatively low and declining unemployment rate, what might become of core consumer prices once unemployment inevitably rises? Today’s already sluggish rate of core consumer price growth increases the risk of outright price deflation if sales volumes endure a recessionary contraction.

US consumer price inflation lacks both the speed and breadth necessary for a lasting stay by a 10-year Treasury yield of at least 2.5%. Because the Fed’s preferred inflation measure — the PCE price index — can be temporarily buffeted about by wide swings in food and energy prices, our focus is on the core PCE price index, which best captures consumer price inflation’s underlying pace.

Pockets of price deflation warn against aggressive tightening

The annual rate of core PCE price index inflation was merely 1.4% in July. The accompanying -2.0% annual rate of consumer durables price deflation underscores the considerable risk of pushing too hard on the monetary brakes. Both persistent consumer durables price deflation and August 2017’s -0.9% annual rate of core consumer goods price deflation (as measured by the CPI) warn that too rapid a rise by interest rates risks even lower prices among businesses already burdened by a loss of pricing power. Prolonged core consumer goods price deflation might yet thin profit margins by enough to necessitate layoffs.

The CPI tells roughly the same story as the PCE price index, where inflation gives way to deflation outside of consumer services. By far the fastest price growth has been posted by consumer services, whose pricing benefits from the category’s relative immunity from global competition. For example, August 2017’s 1.7% annual rate of core CPI inflation consisted of a 2.5% annual rate of consumer service price inflation that differed considerably from the aforementioned -0.9% annual rate of core consumer goods price deflation. Core consumer goods price deflation has held in each month since March 2013 and it posted its worst reading since August 2004’s -1.2% in August 2017.

Moreover, consumer service price inflation has been skewed higher by the relatively rapid growth of shelter costs. After excluding August 2017’s 3.3% yearly increase by the CPI’s shelter cost component, the 1.7% annual rate of core CPI inflation drops to 0.5%, which was the slowest such rate since the 0.5% of January 2004.

Expectations of a 2% to 3% Return from Bonds May Become the Norm

Investment professionals now include expectations of a prolonged containment of price inflation in their long-term outlook for prospective returns. For example, a member of Vanguard Group’s global investment-strategy team reiterated Vanguard’s expectation of expected returns for the next decade of 5% to 8% for equities and 2% to 3% for bonds, according to Bloomberg News.

The expected 2% to 3% return from bonds during the next 10 years is at odds with both the FOMC’s median projection of a 2.75% federal funds rate over the long-term and consensus forecasts of a 3% to 3.5% average for the 10-year Treasury yield during the next 10 years.

The cited Vanguard investment manager claimed that bond yields will be reined in by low price inflation stemming from demographic change, globalization, and technological progress. Aging populations will weigh on household expenditures. An aging population implies less in the way of household formation that otherwise accelerates spending vis-a-vis income and, by doing so, imparts a powerful multiplier effect.

Furthermore, the US workforce now ages in tandem with the overall population. According to the Labor Department’s household survey of employment, the employment of Americans aged at least 55 years surged by a cumulative 31.2% since June 2009’s end to the Great Recession through August 2017. Because the latter was so much faster than the accompanying 9.6% increase by total household-survey employment, the number of employees aged at least 55 years rose to a record 23.2% of household survey employment in August. The unprecedented aging of both the US workforce and population will limit the upsides for household expenditures, core consumer price inflation, benchmark interest rates, corporate earnings growth, and corporate debt growth.

Globalization has weakened the tendency of a tighter US labor market to quicken wage growth and, thereby, stoke consumer price inflation. Globalization exposes US workers to the often cheaper and increasingly skilled workforces of dynamic emerging market countries. Heightened labor-market competition implies that employee compensation will be more closely aligned with a worker’s individual performance. Attractive across-the-board wage hikes are a thing of the past.

Meanwhile, technological progress will facilitate the production of higher quality products at lower costs. Thanks to technology, cost-push deflation may push aside cost-push inflation.

Faster price growth requires the sustenance of faster income growth

A recurring annual rate of consumer price inflation of at least 2% requires that consumers be able to afford such a steady and broadly distributed climb by prices. The atypically slow 2.6% annual rise by wage and salary income of the 12-months-ended July 2017 questions consumer spending’s ability to sustain consumer price inflation at 2% or higher. An improving trend has yet to materialize according to July’s merely 2.5% yearly increase by wages and salaries.

Never before has wage and salary income grown so slowly over a yearlong span more than three years into a business cycle upturn. Yes, it may be true that 2017’s deceleration by wages and salaries reflects an attempt to delay receiving employment income until after possible income tax cuts take effect, but most workers are incapable of timing the receipt of income. Thus, to the extent any slowing of 2017’s wage and salary income reflects a tax-driven postponement of such income, attention is brought to a distribution of income that may be increasingly skewed toward higher income individuals. If true, then any percent increase by wage and salary income will supply less of a boost to household expenditures
and business pricing power compared to the past.

Today’s dearth of personal savings and weakened financial state of America’s lower- and middle-income classes subtract from business pricing power. Less personal savings leaves consumers with less of a buffer with which to absorb widespread price hikes. When savings are low or practically nonexistent, affected consumers may react to broadly distributed price hikes by cutting back on real consumer spending, which, in turn, leads to an accumulation of unwanted inventories and remedial price discounting.

When the core PCE price index averaged a rapid annual advance of 6.6% during 1971-1981, the US personal savings rate averaged 11.6% of disposable personal income. By contrast, since the end of 1995, the 1.7% average annual rate of core PCE price index inflation has been joined by a much lower average personal savings rate of 5.0%, where the personal savings rate was an even skimpier 3.9% during the 12-months-ended July 2017. Moreover, to the degree the distribution of income has become increasingly skewed toward the top, the personal savings rate of middle- to lower-income consumers may now be noticeably lower.

The FOMC now believes that the annual rate of core PCE price index inflation will remain under 2%, but only through 2018. However, core PCE price index inflation is likely to average something less than 2% annually through 2027, especially if employee compensation cannot sustain a pace faster than 4% annually.

Fed Holds Stance on Rate Hikes

In the September 2017 statement the FED remains bullish on the US economy, and says it will start to normalise its balance sheet in October (reversing QE).

Bond yields rose, putting upward pressure on capital market funding. In fact there has been a significant change in trajectory since mid September, with yields rising again.

The immediate impact on US mortgage rates was to lift them, and the expectation is more down the track.

All this points to more upward pressure on Australian mortgage rates, thanks to a combination of higher bank funding costs, and the sense the RBA may lift sooner than was expected even a few days ago.

This will all play out over the next few months, but the sense we get from the market is a stronger view of higher rates sooner.

Here is the Fed’s statement:

Information received since the Federal Open Market Committee met in July indicates that the labor market has continued to strengthen and that economic activity has been rising moderately so far this year. Job gains have remained solid in recent months, and the unemployment rate has stayed low. Household spending has been expanding at a moderate rate, and growth in business fixed investment has picked up in recent quarters. On a 12-month basis, overall inflation and the measure excluding food and energy prices have declined this year and are running below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Hurricanes Harvey, Irma, and Maria have devastated many communities, inflicting severe hardship. Storm-related disruptions and rebuilding will affect economic activity in the near term, but past experience suggests that the storms are unlikely to materially alter the course of the national economy over the medium term. Consequently, the Committee continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, and labor market conditions will strengthen somewhat further. Higher prices for gasoline and some other items in the aftermath of the hurricanes will likely boost inflation temporarily; apart from that effect, inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term. Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.

In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1 to 1-1/4 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.

In October, the Committee will initiate the balance sheet normalization program described in the June 2017 Addendum to the Committee’s Policy Normalization Principles and Plans

 

S&P 500 Reaches New Heights (Again)

The US index has reached another high and a 5-year view highlights the strong growth, and momentum since Trump won the election last year.

So, what are the expectations ahead? Well, according to a piece from Moody’s:

An overvalued equity market and an extraordinarily low VIX index offer no assurance of impending doom for US equities. Provided that interest rates do not rocket higher, expectations of corporate earnings growth should be sufficient for the purpose of avoiding a severe equity market correction that would doubtless include the return of corporate bond yield spreads in excess of 700 bp for high yield and above 200 bp for Ba a-rated issues.

For now, the good news is that early September’s Blue Chip consensus expects core profits, or pretax profits from current production, to grow by 4.4% in 2017 and by 4.5% in 2018. Moreover, earnings-sensitive securities should be able to shoulder the 2.5% 10-year Treasury yield projected for 2017’s final quarter. However, the realization of a projected Q4-2018 average of 3.0% for the 10-year Treasury yield could materially reduce US share prices.

Since 1982, there have been seven episodes when the month-long average of the market value of US common stock sank by at least -10% from its then record high. Only two of the seven were not accompanied by at least a -5% drop by core profits’ moving yearlong average from its then record high.

In conclusion, the rich valuation of today’s US equity market very much warns of at least a -10% drop in the market value of US common stock in response to either unexpectedly high interest rates or a contraction of profits. Perhaps, the prudent investor should be braced for at least a -20% plunge in the value of a well-diversified portfolio at some point during the next 18 months.