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Get ready for the Trump administration’s next shakeup…the Federal Reserve. As Fed Chair Janet Yellen heads into her semi-annual testimony before Congress this week, she knows the score--this is probably the penultimate appearance at what is likely to be a historically short term for a Fed Chair. Yellen’s term as Chair expires in February 2018 and during the campaign, candidate Trump said that he would “most likely” replace her, because “She is not a Republican."
The world’s largest central banks are once again dominating the chatter among traders and economists. Last week, the European Central Bank announced additional measures to simulate the moribund Eurozone; this week, the Bank of Japan will weigh potential action after its surprise decision to adopt negative interest rates in January; and the U.S. Federal Reserve will likely refrain from a rate hike at its two-day policy gab fest. The heightened central bank focus made last week a perfect time to interview Dr. Mohamed El-Erian, author of The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse. El-Erian is Chief Economic Advisor at Allianz, chair of President Obama’s Global Development Council and a LinkedIn Influencer. Between December 2007 and March 2014, he was chief executive and co-chief investment officer of global investment management firm PIMCO.
I sat down with El-Erian during a LinkedIn webcast to discuss how far the economy and markets had come since the bear market lows of March, 2009 (the S&P 500 has soared over 240 percent, including reinvested dividends), as well as the significant challenges that still lie ahead for investors and for the global financial system.
It’s not as if the Fed, the ECB and the Bank of Japan don’t get it, but just when global central banks are looking to hand off the responsibility of promoting growth, there seem to be no takers.
So where do we stand right now, seven years after we bottomed out? We have come to what El-Erian calls a “T-Junction”. As we approach the end of this recovery road, there is an equal probability that we turn left and right. On one side of the T, we remain in a stable, but slow growth world, riddled with high unemployment, increasing income inequality and political extremism. On the other side, we have politicians who wake up and get serious about creating an inclusive economy; make pro-growth structural reforms, remove debt overhangs in problem areas like student loans and get the overall architecture right. The result would be higher growth, job creation, decreasing income inequality and a drop in financial instability.
Could the stakes be any higher this political season? That’s why El-Erian says that we desperately need candidates to acknowledge the anger that the “inequality of opportunity” can breed; and then to address that anger with policies that promote inclusive growth and restore faith in the system. In other words, we need an “Economic Sputnik” moment. Perhaps that seems like a distant possibility this moment, but El-Erian remains optimistic that one can occur.
MARKETS:
THE WEEK AHEAD:
Mon 3/14:
Tues 3/15:
Bank of Japan meets
FOMC Meeting Begins
8:30 PPI
8:30 Retail Sales
8:30 Empire State Mfg Survey
10:00 Business Inventories
10:00 Housing Market Index
Weds 3/16:
8:30 CPI
8:30 Housing Starts
9:15 Industrial Production
2:00 FOMC Decision
2:00 FOMC Economic Projections
2:30 Janet Yellen Press Conference
Thursday 3/17:
8:30 Philadelphia Fed Business Outlook Survey
10:00 JOLTS
Friday 3/18:
10:00 Consumer Sentiment
The January jobs report did little to help the Fed prepare for its March policy meeting. The US economy added 151,000 jobs last month, slightly lower than expectations; and the unemployment rate edged down to 4.9 percent, the lowest level since February 2008, even as about half a million Americans joined the labor force. That’s progress, but the participation rate (the percentage of those who are in the labor force or actively seeking a job) of 62.7 remains at near 40-years. The broader measure of unemployment, which includes those who are not looking for work or who are working part-time because they can’t land full time positions, held steady at 9.9 percent. There was progress in several industries, which have seen consistent gains over the past year, including retail, food services and drinking places and health care. Manufacturing, which has been mired in a recession and saw essentially no job growth in 2015, added 29,000 new positions in January. The brightest part of the report was wage growth. Average weekly earnings were up by 12 cents an hour, which translated into a 2.5 percent annualized increase, close to a post-recession high.
This report complicates the Fed’s outlook. While job creation is decelerating, wages are accelerating, putting the central bank’s next move in March up in the air. In addition to concerns about a slowdown China, emerging market debt burdens and plunging oil prices, the central bank must now add this mixed message about U.S. employment to its list of “Why we should do nothing in March”.
Even before the January report, Fed Governor Lael Brainard said “Recent developments reinforce the case for watchful waiting.” And New York Fed chief Bill Dudley noted that the world has changed since the Fed’s December confab and “if those financial conditions were to remain in place by the time we get to the March meeting we would have to take that into consideration in terms of that monetary policy decision.”
Some have thought that the central bank made a big mistake by raising rates at the last December. Writing in the FT last week, economist Danielle DiMarino Booth noted, “The Fed had never before initiated a tightening cycle when the manufacturing sector was shrinking” and while employment gains in the final quarter of 2015 looked impressive, “History has shown time and again that labor market data are the most lagging and least predictive indicators.”
While the January data may seem less illuminating about the economy’s future direction, perhaps it’s murkiness makes clear that the Fed will likely pursue its watchful waiting and will skip a rate increase in March.
MARKETS: Investors should be rooting for the Panthers, according to the Super Bowl Indicator. When the winner of the big game comes from the National Football Conference (Carolina), the Dow rises 11.4 percent on average that year. But when the victor is from the American Football Conference (Broncos), it rises just 3.6 percent. Of course like any silly stat, don’t trade based on the outcome of the game…after all, in 2008, after the New York Giants of the NFC defeated the AFC’s New England Patriots, the Dow plummeted 34 percent and in 2013, when the AFC’s Baltimore Ravens won, the Dow soared by 26 percent.
THE WEEK AHEAD:
Mon 2/8:
Hasbro
Chinese Stock Market closed for Lunar New Year (all week)
Tues 2/9:
Coca-Cola, CVS, Viacom, Disney
6:00 NFIB Small Business Optimism Index
10:00 Job Openings and Labor Turnover Survey (JOLTS)
President Obama releases FY 2017 budget
Weds 2/10:
Time Warner, Twitter, Whole Foods
10:00 Fed Chair Janet Yellen delivers semiannual testimony on monetary policy and economy before House Financial Services Committee
OPEC publishes monthly oil-market report
U.S. Energy Information Administration releases oil inventory report
Thursday 2/11:
CBS, Kellogg, Pepsico
10:00 Yellen testimony before the Senate Banking Committee
Friday 2/12:
8:30 Retail Sales
Import and Export Prices
10:00 Consumer Sentiment
3:00 Consumer Credit
“I expect that it will be appropriate at some point later this year to take the first step to raise the federal funds rate and thus begin normalizing monetary policy.” - Federal Reserve Chair Janet Yellen, July 2015
This week, the central bank will do something that it has not done in over nine years: raise short-term interest rates. With the economy growing at a decent, though not great 2.25 percent annualized pace, 2015 monthly job creation averaging 210,000 and unemployment sitting at a seven-year low of 5 percent, Yellen and her cohorts have reiterated that now is the time to normalize policy.
This will be the first of many Fed actions that will eventually return rates to somewhere in the vicinity of 3.5 percent. How quickly they get there is up for discussion. Today the bond futures market anticipates that it will take around three years, but Yellen has said that the future path of interest rates will be entirely data dependent. If inflation rears its head, hikes may be quicker than the expected pace of every other meeting for the next three years. If the economy stalls, the central bank could pull back and skip a meeting.
Considering that it rates have been sitting at zero for seven years, it is helpful to review where we were then and where we are now. Though Americans may complain about slow growth, how quickly we forget what rotten looks like.
December 2008:
December 2015:
HOW WILL THE FED’S ACTIONS IMPACT INVESTORS?
Another big difference between where we are today versus seven years ago is that the Fed will be increasing rates with a balance sheet that has more than quadrupled through three rounds of bond buying (quantitative easing). How various markets will react to the first hike is unknown, because of the very fact that we are entering unchartered and choppy water.
Stocks: Typically, stock markets have dipped after the first rate increase, but usually regain their upward momentum, as long as the rate increase is in response to stronger economic activity. Stocks usually top out after the final increase. The last tightening cycle began with interest rates at 1 percent in June 2004 and ended with rates at 5.25 percent two years later. The stock market peaked in October 2007 and you know what happened after that!
Emerging markets are already feeling the effects, as investors exit risky bets in once high-flying markets like Southeast Asia, Brazil or Turkey. At the same time, US stocks are feeling the weight of sliding corporate profits. And while continued improvements in the economy and the slow pace of rate hikes could help equities regain more solid footing, many investors have forgotten how low interest rates made their stocks look attractive, relative to bonds.
Bonds: Billions of dollars have flowed into global bond markets over the past seven years, as nervous investors sought the safety of fixed income. Many investors are now fearful that rising interest rates will destroy the value of their bond positions. While it is true that as interest rates increase, prices on bonds that have already been issued, drops, that is not a good reason to abandon the asset class.
For most investors who own individual bonds, they will hold on until the bonds mature and then purchase new issues at cheaper prices/higher rates. For those who own bond mutual funds, they will reinvest dividends at lower prices and as the bonds in the portfolio mature, the managers will reinvest in new, cheaper issues with higher interest rates. In other words, being a long term investor should help you weather rising interest rates, though you may want to consider lowering your duration, using corporate bonds and keeping extra cash on hand. (For more on bonds, check out this post.)
HOW WILL THE FED’S ACTIONS IMPACT CONSUMERS?
In the seven years since financial crisis, companies, governments and consumers have gotten used to ultra-low interest rates. Here’s how the change in policy could impact you:
Savers: Any increase in the Fed Funds rate will help nudge up rates on savings accounts, so savers will finally be rewarded. That said, rates will still be low and the likely slow pace of increases will mean that savers’ suffering is not likely to end any time soon.
Borrowers: While rates for mortgages key off the 10-year government bond, adjustable rates are linked to shorter-term rates, which means that consumers should be careful about assuming these loans and also should consider locking in a fixed rate now. Additionally, as rates increase, the availability of 0 percent credit card and auto loans could diminish.
MARKETS: Oil, oil everywhere…and nobody wants to stop producing. Crude oil saw its worse week of the year, as evidence continues to mount that supplies are expanding amid withering demand.
THE WEEK AHEAD: All Fed, all the time…
Mon 12/14:
Tues 12/15:
Fed begins two-day policy meeting
8:30 CPI
8:30 Empire State Manufacturing Index
10:00 Housing Market Index
Weds 12/16:
8:30 Housing Starts
9:15 Industrial Production
2:00 Fed rate decision/Economic projections
2:30 Yellen Presser
Thursday 12/17:
8:30 Philadelphia Fed Survey
Friday 12/18:
As much anticipation as there was for the last Federal Reserve meeting, expectations are low for this week’s central bank confab. There is about a zero percent chance that the Fed is going to act at the second to last policy meeting of the year and the reason is clear: slowing growth and deflationary pressures around the world has washed up on US shores. According to most estimates, when the government releases the first estimate for third quarter growth this week, it will likely show a slowdown to a 1.5 – 1.8 percent annualized pace. And unlike the first quarter’s dismal result, we can’t blame the weather! Although consumers are trying hard to carry the load, the sagging energy sector, weakness in manufacturing and a stronger dollar are all taking a toll on the US economy and as a result, job growth downshifted in August and September. As a result, Fed fund futures contracts suggest that the odds of a rate hike this year have dropped to 30 percent. Meanwhile, the Fed’s likely delay in liftoff, combined with the Peoples Bank of China (a 6th rate cut in the past 12 months) and the European Central Bank’s announcements of more (or potentially more, in the case of the ECB) monetary accommodation, helped push stock markets higher on the week.
MARKETS:
THE WEEK AHEAD:
Mon 10/26:
10:00 New Home Sales
Tues 10/27:
Ford, Apple, DuPont, UPS
8:30 Durable Goods Orders
9:00 S&P Case-Shiller HPI
10:00 Consumer Confidence
Fed begins two-day policy meeting
Weds 10/28:
2:00 Fed Announcement (no presser)
Thurs 10/29:
Starbucks, Mastercard
8:30 Q3 GDP (1st estimate)
10:00 Pending Home Sales
Fri 10/30:
8:30 Personal Income and Spending
8:30 Employment Cost Index
9:45 Chicago PMI
10:00 Consumer Sentiment
