The dollar did a big drop today after the FOMC announcement left rates unchanged. The Federal Reserve said the reduction of the balance sheet will begin relatively soon. I think relatively soon means September 2017.
Corporate bond yields spreads are falling which suggests there is a low default risk. Using Fred and Moody’s we can chart the spread between lowest investment grade (Baa) and equivalent 10-year Treasury yields.
Corporate Bond Yields Spread Chart
Corporate bond spreads are at there lowest point since 2008. This suggests that markets are pricing in a very low risk of default which is bullish for the economy.
BAA Corporate Bond Yield
Corporate Yield of a Moody’s Graded Bond. For instance, a Seasoned AAA Corporate Bond of 30 Year is the yield return of bonds graded AAA by Moody’s with a maturity of 30 years. Bonds less than specified timetables are dropped along with bonds with redemption and rating risks.
Moody’s BAA corporate bond yields are instruments based on bonds with maturities of 20 years and above. For instance, a seasoned BAA corporate bond of 30 Year is the yield return of bonds graded BAA by Moody’s with a maturity of 30 years. Bonds less than the specified timetables are dropped along with bonds with redemption and rating risks.
The credit ratings of AAA and BAA are the two ends of the ratings spectrum for investment-grade corporate bonds as provided by the Moody’s rating agency. The yield difference between bonds with these ratings has historically indicated whether the economy was in a period of recession or expansion.
The credit-rating agencies Moody’s and Standard & Poor’s provide credit ratings on bond issuers and their bonds to give investors an idea of the investment reliability of the bonds, concerning the payment of interest and principal. AAA is the highest bond rating and indicates the safest bonds for investors. Bonds rated below BAA — BBB from Standard & Poor’s — are considered to be non-investment grade. That makes the BAA rating the lowest investment grade rating. The lower the credit rating, the higher the yield a bond will pay.
The corporate bond yields spread chart above shows riskier BAA rated bonds (lowest investment grade rating), versus 10-year Treasury yields. In periods of higher default risk, the plot rises. The plot falls in periods of lower default risk.
U.S. Treasury yields are falling because of low inflation. With inflation so low, the Federal Reserve will likely not raise interest rates again until 2018. Remember, the main reason the Fed raises interest rates is to combat inflation in an over-heated economy. Clearly we do not have that.
Tax cuts and a $1 trillion infrastructure spending program would push inflation higher.
With Congress failing to repeal and replace ObamaCare, it is pushing the Trump Administration’s tax cuts and infrastructure jobs program out further. Inflation is staying low for longer as a result.
The Federal Reserve now is in a position where they do not need to raise rates to combat inflation. As a result, the Fed funds futures rate has dropped and is now showing about a 40 percent chance of a rate hike in December 2017.
Next week when the Fed meets, we could get clarification on when they will begin unwinding their $4.5 trillion balance sheet.
If you have an opinion on what the drop in corporate bond spreads means, please add your comment below.
The US economy is healthy enough to absorb gradual rate increases and the reduction of the Federal Reserve’s balance sheet, Fed Chair Janet Yellen testimony before Congress on July 12, 2017.
Federal Reserve Chair Janet Yellen told Congress on Wednesday that the bank hopes to keep raising a key interest rate and also intends to begin this year, the reduction of its bond holdings.
Yellen took note of several factors, such as household wealth and job gains that she said should fuel growth.
In what could be one of her last appearances on Capitol Hill, Yellen portrayed a market that, while growing gradually, continued to add jobs, gained from continuous household consumption and a recent leap in business investment, and was currently being supported too by stronger economic conditions overseas.
She blamed the economic slowdown in the first half of 2017 on inflation. She said Fed officials are watching developments closely to be certain price gains go back toward the 2 percent inflation target of the Fed.
Janet Yellen Testimony Freak Out Over Inflation
Janet Yellen seemed a little freaked out over the big drop in inflation over the last few months.
I take Yellen’s comments on inflation to mean that the economy should not have the CPI plunging in this part of the economic cycle. In fact, just the opposite should be occurring. But she added that it was considered by officials as an anomaly; inflation is predicted by the Fed next year.
Many economists believe the Fed, which has raised rates three times, will increase rates yet another time this year.
The Fed continues to anticipate that the development of the market economy will justify gradual increases in the federal funds rate over time while reductions in the Fed’s holdings of more than $4 trillion in securities will probably start “this year”.
In her prepared testimony before the House Financial Services Committee, Janet Yellen testimony repeated the message she’s been sending: the market has improved enough that it no longer requires the support the central bank began providing in 2008 in the aftermath of a serious financial crisis and the deepest recession since the 1930s.
In light of the continuing expansion, the Fed plans to keep raising its benchmark rate of interest and to lower its investment holdings, Ms. Yellen said in prepared testimony. She did not offer details concerning the time of the next actions of the Fed. Analysts expect the Fed to begin shaving its bond portfolio before the end of 2017.
The economy began the year with a slow growth rate of just 1.4 percent, it has regained momentum in recent months, aided by strong job gains, a revival of business investment and a strengthening of international markets.
Bottom line: the market is at full employment and the Fed is moving rates. As the Fed reinvests some of the bond holdings which mature monthly, they will decrease that reinvestment to reduce their balance sheet which will mark the beginning of QT (quantitative tightening). Many believe that QT began this year when the Fed did a series of rate hikes.
The Fed needs to keep policy accommodative to keep on supporting the recovery, but may hit a “neutral” rate quicker than anticipated. Estimates are that inflation has been dropping so fast that we could be near zero right now. Yellen has said the Fed expects estimates of the inflation rate to grow over time.
Yellen said in her testimony that as it stands rates “might not need to rise all that much farther” to reach neutral.
Yellen said growth remains moderate with business investment and consumer spending picking up, and the US economy is benefiting from growth in other countries too.
A strengthening in economic development abroad has provided significant support for U.S. manufacturing production and exports, Yellen said.
The Fed slashed its key policy rate to near zero to fight the worst economic recession since the 1930s, and kept it there for seven years before nudging it higher in December 2015. It left the rate unchanged before increasing it again in December 2016, March 2017, and June 2017 of this year.
At its June meeting, the Fed indicated that it expected to start decreasing its $4.5 trillion balance sheet after this year, a measure that could put slow upward pressure on longer-term prices for such things as home mortgages.
Yellen said, the market seemed to be in a virtuous loop of hiring, investment and spending which should increase resource usage somewhat further, thereby fostering a quicker rate of wage growth and price increases.
The Janet Yellen testimony was fairly uneventful except for her comments on falling inflation which seemed to baffle the Fed as to why this was happening at this point during the economic cycle.
The JOLTS Job Openings report showed U.S. companies posted fewer job openings in May but hiring picked up and people are quitting their jobs — both bullish signs for the economy.
New government statistics show American companies have made progress filling their record number of job openings, as hiring rose in May while the amount of job openings in the labor market dipped to just shy of 5.7 million.
JOLTS Job Openings
There were broad increases in professional, retail, and business services. That narrowed the gap between job openings and hiring, which had raised concerns of a skills mismatch in the market.
JOLTS job openings dropped 5 percent in May to 5.7 million, the Labor Department said Tuesday. Meanwhile, hiring rose 8.5 percent to just under 5.5 million.
The hiring rate rose two-tenths of a percentage point to 3.7 percent.
The Bureau of Labor Statistics’ monthly JOLTS job openings report — an acronym for Job Openings and Labor Turnover Summary showed openings in May dropped off to the lowest level since January.
The job openings dip in May shows further evidence that the economy is hitting the wall of maximum employment.
This JOLTS job openings report is a sign the market at 4.4 percent unemployment is nearing full employment when almost all people who need a job have one and the unemployment rate mainly reflects the normal churn of people that are temporarily out of work. Usually when unemployment drops this low, companies have to offer more pay. I think faster wage growth is coming.
As the bull economy ages, there is going to be fewer available jobs out there simply because companies have hired all the workers they need for now.
Hiring, meanwhile, surged north of 5.4 million to the highest level the market has seen since December 2015. Substantial upticks in hiring from business and professional services, and educational services, resulted in 25,000 and 121,000 more employees than the month before.
The JOLTS report is among the data watched by Federal Reserve officials as they track both inflation and the labor market.
Quits are typically regarded among analysts as a sign of optimism that employees feel good about their choices.
The amount of people quitting their jobs has increased 7.1 percent to 3.2 million. People usually quit when they either find a new job, often at higher pay, or are convinced they will be hired elsewhere. Quits gauge workers’ willingness to depart present positions in search of higher wages. Coupled with increased hiring across sectors, the equally broad-based increase in the quit rate bodes well for continued wage gains.
Average hourly earnings have failed to break above 2.5 percent on a year-over-year basis. Economists say a growth rate of between 3 and 3.5 percent in salary is needed to bring inflation near the Fed’s 2 percent target.
Layoffs were also up in May at nearly 1.7 million, tying March for the second-worst month so far this year. That’s still a respectable level at this stage in the economic recovery, but layoff upticks were seen across many different industries such as education and health services. Still, current job growth is more than enough to absorb the uptick in layoffs.
The Federal Reserve shouldn’t be tightening policy with the evidence so clear that it’s falling well short of its inflation mandate. The interest rate policy is wrong because their math is wrong.
Right now the Fed’s inflation goal is 2 percent. Why so low? Fed rate hikes are keeping inflation too low and possibly will lead to the next recession.
Central bank officials are being too vigilant against an inflation problem that doesn’t currently exist.
When the next downturn hits, there will not be much of an inflation safety margin against deflation.
The US has had interest rates at near zero for nearly seven years. When the next recession hits, rates will fall back to zero again like they do during almost every recession. Is the central bank’s interest rate policy meant to keep rates stuck near zero for 7 years? No. So the logic behind a 2 percent target is wrong. If a 2 percent target doesn’t get rates high enough to keep them away from zero, then maybe a 4 percent one will.
Capital expenditures are very low, so most of the increase in debt was returned to shareholders, either in the form of M&A or stock buybacks. The increase in debt suggests that companies find borrowing cheap because interest rates are low. So money is easy, but demand is not very strong. Demand for products will continue to fall as the Fed hikes rates and makes borrowing more expensive.
Interest Rate Policy Is Too Tight at 2 Percent Inflation Target
Credit-card users, home-equity borrowers and homeowners with adjustable-rate mortgages, auto loans, all will likely see their monthly payments rise as the Federal Reserve’s interest rate hikes ripple on the other side of the economy.
The flattening yield curve seems to be saying rates are nearing a peak. The decelerating inflation rate as well as the slowing loan origination markets are signaling that Fed policy is a bit too tight. If policy is already too tight now, when the Fed begins reducing its balance sheet in a few months things will get even tighter.
You can think of the yield curve as a gauge for how far away the Fed is from completing its rate hike cycle. The fed funds rate is currently around 1.16%. The two-year is 1.35%. This suggests the market thinks there is one more rate hike coming. But the five-year is at 1.77%, which suggests the market doesn’t think interest rate policy will reverse in the coming years.
The inflation rate is too weak for a June Fed rate hike. According to a report in Reuters (link above), inflation expectations are falling fast.
The reason inflation is falling is from Fed rate hikes. That’s what hikes do. The Federal Reserve usually hikes rates into an overheated economy with prices running rampant. Businesses raise prices because there is so much money in the economy that consumers keep consuming regardless of what it costs. Rate hikes slow down economic growth and thus rising prices.
The CPI shows that we have been in a period of deflation since February.
The Fed hiked in December 2016, then again in March 2017, and now markets are betting they will do it again in June. Didn’t the Fed say that the pace of rate hikes would be gradual? I suppose “gradual” is a subjective term like most everything else the Fed says.
Where is the catalyst for economic growth going to come from that will absorb all these hikes? With the republican economic agenda practically derailed by Democrats and with the government running out of money fast, I don’t see it.
With the stock market hitting all-time highs, everybody wants to know if we are in a giant bubble.
You can’t trade and make money if you’re not in the market. If the fear that we are in a bubble is keeping you out, then you’re not making money.
The honey badger doesn’t care. The honey badger loves to climb walls of worry.
You can get an early read on which way the market is headed by tracking transports. Fedex is a bellwether stock in the transports industry.
The chart of FedEx just did a breakout above 180 and hit a new high. The rising Twiggs Money Flow shows FedEx is under heavy accumulation.
Remember folks, bull markets don’t die of old age, they are murdered by the Fed.
The chart below shows profit margins [blue] are falling as employee compensation [brown] rises.
Since 2015, employee compensation has started to recover as the labor market tightens and corporate earnings are falling (as a % of Net Value Added).
If you look back to the 1960s, you can see that when the labor market reaches capacity, profits fall as labor costs rise. The Federal Reserve intervenes to battle inflation from rising wages which will cause the next recession. The Fed does not usually intervene in a meaningful way until wages rise above 74% of corporate profits. In other words, we have a long way to go regarding rising wages before the Fed is going to hike rates so high that it causes the next recession.
Financial Education posted this video on if we are in a giant bubble. While I don’t agree with everything he says, he does make some good points IMO.
Inflationary expectations are the expectations that consumers have concerning future inflation. If buyers expect higher prices in the future, they increase their demand in the present. This shifts the aggregate demand curve outward (to the right) which is good for the economy. For example, if the price of a house is expected to be higher next year, consumers decide not to wait, but to buy now. The increase in inflationary expectations causes an increase in consumption expenditures and subsequently an increase in aggregate demand. Continue reading “Inflation Expectations On The Rise Shifts Aggregate Demand Outward”
The less volatile sticky CPI confirms the uptrend.
ObamaCare has exploded the cost of medical care higher.
Medical care commodities, which are prescription and non-prescription medications, have exploded higher.
Inflation is finally trending higher which is what the Federal Reserve has been trying to engineer for years through monetary policy. The WSJ writes…
Fed Chairwoman Janet Yellen herself said last week that letting the economy run hot for a while might have some benefits… None of this is enough to take a rate increase at the Fed’s December meeting off the table. But it does mean that, even as prices pick up, further rate increases will be slow to come. Investors accustomed to inflation running below the Fed’s target may be in for some retraining.
Folks, this is another reason why we need to start getting more bullish on the stock market as we head into November and the start of the best six months of the year. Remember, a big part of the bearish scenario was a slowing US economy pressured downward by deflation as a result of Saudi Arabia destroying our shale oil industry. Lots of good jobs were lost and replaced by lower paying service sector ones as a massive wave of disinflation hit our economy. The latest inflation numbers suggest that the worst is behind us as the price of oil is in a slow fade upward, and more oil rigs are brought back online as evidenced by the upward trend on the weekly Baker Huges rig count.
All traders are watching this earnings season closely to see if the falling earnings streak is over. That’s the confirmation data point that is needed. In an inflationary environment, businesses are raising prices to keep up with the growing demand from a strengthening consumer. Traders want confirmation that the inflation we are now seeing is signaling a bottom in the earnings recession we have been in since Q1 of 2015.