Thursday, September 22, 2016

Twilight of the Central Bankers?

Gina Chon, a Reuters Breakingviews columnist, wrote an op-ed, Fed “forward guidance” blows too much smoke:
The U.S. Federal Reserve is still enabling financial markets. The central bank on Wednesday again declined to raise rates, despite recent remarks from Chair Janet Yellen suggesting an increase was becoming more likely. The Fed counts talking to the market – what it calls giving “forward guidance” – as one of its tools, but the story has changed so often that Yellen and her colleagues might do better being less chatty.

The Fed initially signaled four rate hikes in 2016 after raising the range for the federal funds rate to 0.25 percent to 0.5 percent last December, the first increase since the financial crisis. Falling unemployment and an improving housing sector helped push the central bank to make the move. At that time, the jobless rate was at 5 percent. U.S. GDP increased by 2.4 percent last year.

In March, rate-setting officials scaled back the central forecast to two hikes this year. GDP growth had fallen to a tepid 1.1 percent in the first quarter and despite signs of labor-market tightening, the central bank’s 2 percent inflation target was nowhere in sight. Yellen said the slowdown in the global economy warranted caution.

Maybe that remains the case, but central banks around the world are facing questions about the continued effectiveness of loose policy given that in many markets interest rates are already ultra-low or in negative territory. The Bank of Japan tried another tack with its decision earlier on Wednesday, saying it would aim to keep 10-year government bond yields at zero.

Moreover, the U.S. economy is in better shape than the rest of the world. That is most evident in the healthy pace of job growth, which averaged 232,000 new positions over the last three months, and an unemployment rate of 4.9 percent. In late August, Yellen said the case for a rate hike had “strengthened in recent months.”

She hasn’t yet followed through. The Fed’s latest forecast shows just one increase this year. In its statement, the bank said the case for higher rates was stronger but it wanted to wait for more evidence of progress. The central bank’s story morphed once again. No wonder Third Point hedge-fund founder Dan Loeb, speaking at a Reuters Newsmaker event earlier on Wednesday, argued that loose monetary policy was like a drug and “we must take the crack pipe away.”
I don't understand why portfolio managers, journalists and bloggers get so emotional about the Fed not raising rates. They obviously never read my comment last September that there is a sea change at the Fed.

The Fed didn't raise rates in September which in my opinion is a good thing. The BOJ is another story, not sure exactly what it's doing but it's so far behind the deflation curve that it's desperate to try anything new. It's now attempting to stoke inflation expectations higher by artificially steepening the yield curve. I'm highly skeptical these measures will work because deflation is so ingrained in the Japanese economy that they're fighting a lost cause.

Some journalists think central bank tools are losing their edge while others feel central bankers are throwing in the towel and are now waiting for policymakers to crank up fiscal stimulus.

I wouldn't go that far but clearly monetary policy alone won't be enough to address structural issues weighing down global growth and pushing inflation expectations ever lower. In July, I discussed these structural factors when I went over the bond market's ominous warning.

Speaking of the bond market, Bill Gross came out after the Fed meeting on Wednesday to say don't fight central bankers and long bonds will lead the way:
There’s one message that Bill Gross took away from a day dominated by two of the world’s most important central banks: longer-dated debt is back in vogue.

U.S. 30-year Treasuries led a rally Wednesday after the Federal Reserve held off on raising interest rates. Officials indicated a hike later this year is likely, although they lowered projections for 2017 and beyond. In Japan, longer-maturity obligations also fared best after the Bank of Japan shifted the focus of its monetary stimulus to controlling bond yields. The central bank said it would aim to keep 10-year yields around current levels.

For Gross, who runs the $1.54 billion Janus Global Unconstrained Bond Fund, the latest round of policy decisions give fixed-income investors a clear signal: extend duration. That’s been the best approach for traders during the three-decade bond bull market, and this year has been no different. Thirty-year Treasuries have returned 14.5 percent in 2016, Bank of America Corp. index data show.

“The timing of a bond bear market has certainly been delayed,” Gross said in an interview on Bloomberg Television. The BOJ’s plan “provides what I call a soft cap on Treasuries and on gilts and on bunds,” and signals limited downside in terms of price. “You can’t fight central banks.”

The yield on U.S. 30-year bonds fell six basis points, or 0.06 percentage point, to 2.38 percent at 5 p.m. in New York, according to Bloomberg Bond Trader data. Yields on two-year notes, the coupon securities most sensitive to Fed policy expectations, were unchanged at 0.77 percent (click on image).


With the BOJ’s new policy, Gross sees a “soft cap” of about 1.8-1.85 percent on 10-year U.S. notes, compared with 1.65 percent at present.

His comments underscore the interconnectedness between global bond markets. Even with Wednesday’s rally, 30-year Treasuries are still on pace for their worst month since June 2015 after losses the past two weeks fueled in part by speculation the BOJ was poised to reduce purchases of long-term debt.

Over the past five years, though, investors have won by buying the longest-dated debt amid persistent signs of slow economic growth globally and subdued inflation. Longer maturities have a higher duration, meaning they gain more in price when interest rates decline. The difference between two- and 30-year Treasury yields fell Wednesday to about 1.6 percentage points. In 2011, it exceeded 4 percentage points.
Gross isn't the only one who sees opportunities in the bond market. Prudential Financial's Michael Collins also appeared on Bloomberg stating the Bank of Japan’s decision to freeze the yield on its 10-year government bond near zero will continue to fuel opportunities in the US debt market amid a global hunt for yield:
The BOJ’s decision "is going to keep the U.S. 10-year pegged and lower the volatility of that, which presents an opportunity," Collins, Prudential’s senior investment officer for fixed income, said on Bloomberg TV. "It exacerbates the reach for yield."

A divided Federal Reserve left its main interest rate unchanged at 0.5 percent Wednesday, while projecting that a hike is possible by year-end. It meets Nov. 1-2 and Dec. 13-14.

The decisions by central banks to leave rates "lower for longer" mean the quest for yield in the U.S. credit sector, including corporate and high-yield bonds, and asset-backed securities, will continue, said Collins.

He said he sees opportunities in U.S. banks, consumer products and smaller companies that have not increased their borrowing, even though corporate America’s leverage is at record high.

"I’m underweight on average all those big high-quality industry companies that are levering up, and overweight the part of the economy that have actually de-levered and in the early innings of their own cycle," Collins said. "One of our favorite parts of the bond market is the asset-backed world, commercial mortgage-backed securities, collateralized loan obligations, kind of esoteric stuff."
Interestingly, bank stocks around the world surged on Wednesday as investors cheered the prospect that the Bank of Japan’s policy adjustments will translate into improved profitability for the industry, but the response was far more muted in the US after the Fed's decision as it signaled rates will be lower for longer.

I've said it before, I think banks, insurance companies and other financials (XLF) have a big problem ahead dealing with what increasingly looks like a prolonged debt deflation cycle where ultra low and negative rates are here to stay. Jim Keohane is right, some big banks are cheap using a price-to-book metric, but there's a reason why they're cheap (and might be getting a whole lot cheaper).

Also, Collins mentions that one of their favorite part of the bond market is commercial mortgage-backed securities but back in March I wrote a comment on cracks in US commercial real estate and during her press conference, Fed Chair Janet Yellen specifically mentioned the Fed is monitoring developments in commercial real estate and other assets:
"I would say in the area of commercial real estate, while valuations are high, we are seeing some tightening of lending standards and less debt growth associated with that rise in commercial real estate prices. But more generally we are not seeing signs of leverage building up or maturity transformation in the way that we saw in the run-up to the crisis and we are keeping a close eye on it."

Yellen on moderate threats to financial stability:

"The threats to financial stability I would characterize at this point as moderate. In general I would not say that asset valuations are out of line with historical norms."
Of course, some money managers beg to differ with her assessment of financial risks. Zero Hedge posted this comment from Tad Rivelle of TCW, an $195 billion asset manager. Rivelle thinks "the time has come to leave the dance floor":
While every asset price cycle is different, they all end the same way: in tears. As obvious as this truth is to investors, when the sad end to the credit cycle comes, it always comes as a big surprise to many, including the central bankers who, reliant on their models, confidently tell you that no recession is (ever) in the forecast. But, successful, long-term investing is predicated on not just knowing where the happening parties are during the reflationary parts of the cycle but, even more importantly, knowing when the time has come to leave the dance floor. In our view, that time has already come.

Allow us to properly explain ourselves. Consider the chart below which plots the trajectory of cumulative asset prices (stocks, bonds, real-estate) against that of aggregate income (GDP):

Source: Bloomberg, TCW

The chart reveals something rather extraordinary: over the course of the past 25 years, the traditional business cycle has been replaced with an asset price cycle. Rather than let recessions run their painful but necessary course, central bankers move forthwith to dispense the monetary morphine. The Fed’s playbook on this is well worn: first, policy rates are lowered. This triggers a daisy-chain of events: low or zero rates promote a reach for yield; the reach for yield lowers capitalization rates across a variety of asset classes which, in turn, spurs a rise in asset prices. Rising asset prices – the so-called wealth effect – “rescues” the economy by rebuilding balance sheets and restoring the animal spirits. And voila! Aggregate demand rises, businesses invest, and a virtuous growth process is launched.

Well, maybe not so much. If it were all so simple, then why is it that after ninety something months of zero or near zero rates, growth is sputtering, the corporate sector is in an earnings recession, and productivity growth is negative?
I will let you read the rest of this bearish comment here but it basically states central bankers have done all they can, the music has stopped and you better leave the dance floor or risk a serious morphine withdrawal. All I can state is the notion of a "central bankers' bubble" is just as silly as a bubble in bonds.

And Bloomberg's Simone Foxman reports, Tiger Cub Citrone Sees Market in Biggest Correction Since 2008:
Robert Citrone, the Tiger cub who now runs one of the best-known macro hedge funds, is warning investors that the market moment they’ve been anticipating is at hand.

“We believe we are in the midst of the market correction we have been expecting," Citrone, founder of Discovery Capital Management, told investors in an e-mail obtained by Bloomberg. “It will likely persist over the next 3-4 months and be the largest correction since the 2008 crisis,” he said. The firm managed about $12.4 billion at the start of 2016.

Money managers including Paul Singer have signaled that the markets may be on the precipice as central banks reexamine monetary policy. In remarks last week at the CNBC Institutional Investor Delivering Alpha Conference, Singer said years of easing had created "a very dangerous time in the global economy and global financial markets." Carl Icahn, who warned of risks at the same event, described predicting the moment of a correction as "sort of a guessing game."

Market volatility returned on about Sept. 9, when concern that central bankers may be losing their appetite for further stimulus efforts spurred the biggest slump since the U.K. secession vote in June, ending the summer’s calm. The CBOE Volatility Index has increased about 19 percent this month through Sept. 20.

Citrone, whose fund specializes in making wagers on macroeconomic events, tempered his view by describing the correction as a "healthy adjustment from overvalued market levels, which are primarily a result of exceptionally easy monetary policies." One of the many hedge fund managers dubbed Tiger cubs after working at Julian Robertson’s Tiger Management, Citrone founded Discovery in 1999.

Patrick Clifford, an external spokesman for Discovery, declined to comment.
Scary stuff but my advice is to ignore all these Delivering Alpha doomsayers as well as anyone who tells you central bankers are powerless and focus on selectively plunging into stocks even if it will be a rough and tumble ride. I'm still trading shares in the biotech sector (XBI and IBB) and continue to recommend bonds (TLT) as the ultimate diversifier in a deflationary world.

Will there be a major correction at some point? Sure, it might happen after the Fed hikes rates in December (if it hikes again this year that month) but there's a reason why there is a crisis in active management, many active managers don't understand the macro environment and it's costing them huge performance.

Below, Jeffrey Gundlach, DoubleLine Capital LP, shares his reaction to the latest Fed speak from yesterday's FOMC meeting. Listen carefully to his comments on "WIRP" and the likelihood of a December rate hike.

I also embedded the entire press conference after the FOMC meeting where Fed Chair Janet Yellen answered many questions, including whether there is a bubble in commercial real estate (minute 26).


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