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There’s some thought that goes around saying that once the Federal Reserve starts raising interest rates more aggressively (i.e., three hikes this year) – or running assets off its balance sheet – this will be the end of the bull market in stocks. However, one needs to take into account that forward-looking beliefs are always baked into the curve. A drop in asset prices due to central bank tightening would come as a consequence of interest rates going up faster than what’s presently discounted in the interest rate curve, rather than the basic act of tightening itself.
During the Fed’s last tightening cycle from June 2004 to July 2006 (shown below), the S&P 500 (NYSEARCA:SPY) increased by about 13%, which is a fairly normal rate of appreciation for a 25-month time period.
Presently we’re expecting the federal funds rate to be 1.25%-1.50% at the end of 2017 and 2.00%-2.25% by the end of 2018. If we take market-implied expectations as of the time of writing, the market expects the effective federal funds rate to stand at 132.2 bps by January 31, 2018. So the market is very much onboard with the Fed’s expectations, only lagging by a few basis points.
If the Fed raises faster than these expectations, then asset prices are likely to go down. Valuation is predicated on a series of cash flows discounted back to the present value.
When discount rates go up relative to expectations, being a denominator term, asset prices fall. Higher or lower economic growth and inflation relative to embedded expectations will also impact the equation. This could lead to Fed tightening that either lags or outpaces the market’s aggregate terminal rate expectation, which is around 3.00%.
Last year (2016) was a good year for stocks even when economic growth was slow and corporate earnings were coming out of a “recession” wherein they fell 19.7% from Q4 2014 to Q4 2015 (the S&P was still very slightly up in 2015 – 1.25% – largely due to a wave of share buybacks and M&A activity).
(Source: St. Louis Federal Reserve)
The S&P’s 2016’s performance was abetted by the Fed under-running public expectations of about three rate hikes, which were already discounted into the curve, by increasing just once in December.
The reduction in the curve by ~50 bps made a material difference in how asset prices reacted. 2016 was shaping up to be a relatively flat year for the stock market (similar to 2015) due to earnings disappointments, oil cratering below $30 per barrel, and general stagnation in both growth and inflation on a broader level. Through the first ten months of the year, the S&P was up a modest 2%-3%.
But anticipation of fiscal policy changes after the November US elections altered the trajectory of asset prices. The prospect of tax cuts and deregulation wasn’t discounted into future expectations to any appreciable extent. There was also a slight boost due to a renewed pick-up in earnings. Instead it became a +12% year for stocks and was beneficial for other risk assets, such as real estate, high-yield credit, and emerging markets.
Currently, the influence of monetary policy is asymmetrical. Tightening monetary policy is easy. There’s a ton of debt everywhere – the US has plenty, Europe has plenty, Japan has a ton. Tightening monetary policy will work very effectively in slowing inflation if central banks need to go that route as it makes debt more expensive. When you have a lot of debt, the extra cost of debt leaves less funding available for other economic and financial initiatives/activities at the government, corporate, and household level.
Accordingly, we can’t have a large tightening cycle. With the degree of disinflationary pressures in the economy, the amount of debt in the system, what would happen to asset prices (volatility, negative wealth effect from a decline, etc.), and the mal-effects of an overly strong dollar, we can’t tighten the economy too significantly. If the Fed tightens above a lower-bound rate of 3% this cycle, it would be very surprising and signify that growth and inflation likely ran higher than expected.
Because of various disinflationary pressures, Japan can’t tighten at all practically and is on a perpetual diet of QE stimulus of very weak effectiveness because spreads between bonds and cash have virtually closed. When spreads close – or contract more generally – among different asset classes, further stimulus becomes less effective as the capacity to lower yields and thereby boost asset prices is no longer as viable as it once was. The wealth effect becomes diminished and the boost to economic activity decreases.
Europe isn’t healthy enough to begin tightening either. Europe is in the process of beginning to gradually reduce its QE-related purchases and then begin increasing its benchmark rate from zero sometime in 2018 or 2019 assuming economic conditions continue to hold up. The US is of course already tightening, but it’ll be a short cycle as aforementioned.
What’s worrisome about the situation is that in the next downturn, whenever it might occur, we’re going to be in an environment where quantitative easing is less effective and consequently a new form – or at least unconventional or rarely used form – of monetary policy may need to be used or innovated. In the US, you get about 2.4% nominal return on an investment in a 10-year Treasury. You have some room for QE at that spread, if necessary, but it’s not a lot.
Will bond yields increase?
After the November elections, there were predictions that the rise in intermediate- and back-end Treasury yields would keep going as part of a trend, but I argue in a different article why that’s unlikely to happen, and it fundamentally goes back to broader structural forces in the global economy.
The Fed’s hiking of rates by 50 bps since December 2016 has had no substantive impact on this yield and I don’t believe that the Fed’s continued hiking is going to have that much of a material impact on these longer-duration yields. Going out over the next 2-3 years, the outlook on mid- and long-duration is more neutral to slightly down (in terms of price), but it’s probably not going to be a big move.
Now some folks make the argument that the balance sheet run-off will materially increase these yields. The idea is that this will load additional supply of US debt into the market and, holding everything else constant, when supply goes up price goes down (and yields up). I made a very crude calculation in a different article that a $1.5 trillion run-off in Treasuries from the Fed balance sheet would be the equivalent to tightening monetary policy by about 150 bps.
However, the Fed doesn’t unilaterally control the market and a tightening of monetary policy, through whatever method it might choose, doesn’t necessarily entail a boost in back-end yields.
The reason for this is that when monetary policy is tightened, this increases risk within the system. And with monetary policy as asymmetric as it is concerning the effectiveness of tightening (high) versus further easing (relatively low), an increase in risk through tightening increases the demand for safe assets. This in turn keeps their prices relatively elevated and will work to moderate any increase in yields.
Issues concerning future monetary policy
In the event of a downturn, if the spreads between cash and bonds aren’t very high and there aren’t attractive investments relative to bonds, then quantitative easing’s effect on further lowering credit spreads and creating a “wealth effect” (as asset prices rise in response) is going to continuously become less effective.
This is an issue given a central bank needs to ensure that financial assets are more attractive than cash for the economic system to work more broadly. The only time when cash is more attractive than financial assets is in a severe economic contraction.
Market participants chase spread to motivate their investing decisions. If there isn’t an alternative to Treasuries that provides sufficient spread, you get less effective monetary policy. This means when you move investors into riskier asset classes they are becoming less wealthy relative to what this mechanism could provide in the past and it becomes less stimulatory.
Again, we already see this in Japan, where spreads on safe assets are essentially zero (i.e., essentially nothing earned over cash). The 10-year yields 0% (the BOJ engineers a 0.00%-0.10% band on the 10-year to steepen the curve). Japan’s nominal growth rate is around 1.5%-2.0%, and the economy isn’t meeting inflation targets. This means further zero-interest rate policy and more QE to keep the nominal interest rate sufficiently below the nominal growth rate.
Europe is close to being there, though to slightly less of a degree than Japan. Obviously Europe is comprised of multiple countries so it largely depends on where you go.
The US has a slight bit of wiggle room, given it can tighten its overnight rate to maybe 200-300 bps and perhaps run off 30%-40% of its QE-related assets from its $4.5 trillion balance sheet in the process.
How interest rate moves can manifest when QE becomes less effective
If you effectively can’t have further interest rate moves given asset spreads are closing, then it will manifest in a different way; that is, through changes in the currency markets.
In the case of Japan and Europe, if their interest rate and QE policies have resulted in spreads where investors are indifferent between cash and bonds, then the natural tendency is for a depreciation in said currencies. When interest rates are being bid down and returns are so low, then this incentivizes the shift of capital out of these markets even if there’s no actual change in interest rates themselves, particularly if other markets become more attractive in relation.
On the supply side, the continuous printing of money creates more supply, which causes depreciation as well holding all else equal. Inflation, however, will not be affected unless changes in spending behavior occurs. This is why Japan can increase its M2 money supply by 4%-5% per year and not suffer undesirable inflationary effects – spending simply hasn’t been materially impacted.
If you look at yen (NYSEARCA:FXY) and euro (NYSEARCA:FXE) currency charts over this past five years relative to US dollars (NYSEARCA:UUP)(NYSEARCA:UDN), we can see this movement in favor of the USD. There are factors that influence currencies beyond central bank decisions, but increasingly less influential monetary policies will continue to manifest in foreign-exchange markets even if interest rates are perpetually at zero or effectually below.
I was formerly long USD/JPY as I thought this was a reasonably good idea in how to express this sentiment though I took it off some time ago, as it’s no longer generating the type of returns I expect in order to justify allocating the capital to the idea. But over the long-term I still expect some type of appreciation of the US dollar relative to the yen and, to a slightly lesser extent, the euro.
I should also note that the yen is also subject to safe-haven inflows when market participants reduce risk in the US. In that sense, it functions quite similarly to gold (NYSEARCA:GLD), with a +0.94 correlation over the past five years, so there is that to take into account as well.
What to take from all this
1. US stocks are in okay shape. Returns are lower than before due the disinflationary economic forces the globe has been subject to the past ~35 years (see diagram below) and how policymakers have responded to this secular shift through their QE policies. This has effectively bid down the future returns of assets.
(Source: St. Louis Federal Reserve)
These lower returns will turn many off to the idea of investing into equities at all and they may consequently value equities intrinsically lower than what the US stock indices are trading at currently. However, the TINA principle (“there is no other alternative”) is very much true. Stocks, in terms of return, are better than bonds (NYSEARCA:LQD)(NYSEARCA:TLT)(NYSEARCA:IEF), which are better than cash over the long-haul on an absolute – though perhaps not risk-adjusted – basis.
So I can understand the “stocks are overvalued” sentiment in the sense that they simply won’t provide the type of returns they did in the past. Accordingly, if you plug in these higher returns expectations you’re probably not going to discount the S&P 500 back to a 2,400 or better figure.
But at the same time, you have to play with the hand you’re dealt with. Not necessarily remain wholly concentrated in a long-only US equities portfolio, but having some continued long-biased exposure to US stocks in the context of a well-diversified, risk-balanced portfolio is probably a good idea for now.
An asset price correction is likely to be associated with a credit-related event, of which we don’t see in the cards currently. Asset prices can decrease if the Fed tightens too quickly relative to what’s implied in the curve. What’s embedded in the curve is basically on par with the Fed’s guidance in its projection materials or just slightly below.
2. Japanese (NYSEARCA:EWJ) and European (NASDAQ:ADRU) stocks remain okay for now as well. There’s a lot of liquidity in the system and nominal interest rates are below nominal growth rates, which mechanically favors a shift into risk assets.
But forward returns are lower in the same fashion as US equities and risks are asymmetrically skewed downward. Having monetary policy become “one unit” too tight will have more of an impact than having monetary policy “one unit” too loose, given the marginal stimulatory influence of QE is being eroded over time as the yield spreads between cash and financial assets decrease.
3. Having exposure to US dollars is more attractive in my view than having exposure to the yen and euro. Being explicitly long the dollar relative to the yen or euro may not be necessary as I’m not sure the prospective returns would encourage taking such a position.
Increased Fed tightening does not mean an automatic stalling or contraction in asset prices, either in bonds or equities. We already have another 50 bps of tightening implied in the interest rate curve through the remainder of 2017, another ~75 bps on top of that in 2018, and an additional 75-100 bps beyond that.
This is implied alongside an expected real growth rate of 2.1% over the 2017-18 period and 1.8%-1.9% beyond that, to go along with 1.85% in inflation. If some combination of nominal growth overruns these projections or the Fed remains behind current expectations in its tightening regimen, then we can expect that equities might outperform their current embedded expectations of about 5.5%-7.0% in year-over-year nominal returns moving ahead. And we could expect an underperformance in the equities market if nominal growth runs lower than expectations and/or the Fed tightens too quickly.
From my own personal vantage point, I don’t think bonds or equities are very appealing in terms of long-run returns at their current levels, but I think one can continue to make a reasonable argument for a bullish intermediate stance.
This is certainly not a contrarian view by any means. The drop in the VIX (NYSEARCA:VXX) below 10 this week occurs on less than 1 in every 600 trading days, meaning demand for downside protection is among all-time lows relative to when the index was first introduced on January 2, 1990.
(Source: St. Louis Federal Reserve)
The VIX and S&P 500 hold a correlation of -0.67.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long 30-year US Treasuries.