02 Aug 2013 The Fed Says: Not So Fast
Our economy is not ready to stand on its own according to the Federal Reserve as of its latest meeting ended Wednesday of this week. In fact, they believe it is not expanding as fast as earlier hoped, as they downgraded their characterization of growth from “a modest pace” to “a moderate pace.” Their focus remains on the labor market which we learned today failed to meet expectations.
The Fed’s decision to avoid ‘tapering’ or reducing its $85 billion monthly purchases of Treasuries and mortgage bonds was a bit of a surprise to markets and this may have been intentional. Mortgage and Treasury rates shot up after June 19th when Chairman Ben Bernanke said the Fed would begin tapering their purchases soon in anticipation of ending the program in about a year IF the data supported such a move.
The conditional part of his statement is what the market seems to have missed. The Fed is going to adjust its tapering according to their view of the health of the economy and employment. Either market investors had a much higher opinion of the economy than the Fed did or investors didn’t believe them when he said they were going to TAPER, not stop altogether.
In response to Bernanke’s comments in mid-June Treasury yields shot up as though the program was going to be ended overnight. A study recently completed by Goldman shows that prior quantitative easing programs required Treasury purchases of an average of 1.3 TRILLION to move rates as much as they moved following Bernanke’s suggestion they might soon begin tapering the monthly $85 billion in Treasury purchases. It takes 15.3 months of $85 billion purchases to amount to $1.3 trillion. The market compacted what would likely be two years of tapering into a week’s worth. More on this subject a little later.
The two stalwarts of the economy’s strength have been manufacturing (since the recovery) and housing (more recently). Manufacturing continues to impress with its resilience. The ISM’s manufacturing report jumped a strong 4.5 points in July to 55.4, the strongest reading in more than 2 years, according to Econoday. The PMI index confirmed the strength in manufacturing with its reading of 53.7, well above its June reading of 51.9. The higher the reading over 50, the greater the rate of growth in manufacturing. Interestingly, prices show contraction which is a big surprise given all the activity and especially the increases underway in fuel prices.
The steep rise in mortgage rates combined with increasing home prices dented growth in the housing market a bit as evidenced by the National Association of Realtors’ Pending Home Sales. Their index for June showed a 0.4% decline. Typically, about 80% of pending home sales become existing home sales within two months according to the Realtors.
The S&P Case-Shiller index tracks home prices in 20 metropolitan regions across the US. Given the difficulty of amassing the data, this index lags others by a month. Home prices in May rose 1% nationally, a little softer than the prior two months of 1.7% and 1.9%. Given what we see happening with mortgages, we might expect to see the slowing trend continue in June and July. Home prices and stock prices are major components for consumer confidence.
On Tuesday, the Conference Board released its report of consumer confidence for July. Their overall index fell by 2 points this month to 80.3, but the present situation component jumped nearly 5 points as consumers feel better because of rising home and stock prices and a general feeling that the economy continues to improve, albeit slowly.
The government reported in its first estimate of GDP that the economy grew 1.7% in the second quarter, better than expected, but offset by the first quarter’s growth being revised sharply downward from 1.8% to 1.1%. Low inflation expectations included in the report continue to give the Fed room to continue easing. Headline inflation for the GDP price index rose an annualized 0.7% after a 1.3% in the first quarter. When excluding food and energy, inflation eased to 1.1% in the second quarter from 1.6% the prior quarter. If anything, the Fed wants to boost inflation.
The most important economic data for the week is today’s employment situation and it was a slight disappointment. Growth in jobs fell off in July to 162,000 following a strong June of 188,000. Hourly earnings also fell off 0.1% and hours worked in a week declined from 34.5 to 34.4. the headline unemployment number, however, dropped from 7.6% to 7.4%.
For You Treasury Bears
Earlier in the Brief, I promised a deeper look into this latest drop in Treasuries and the fear of even greater declines. It is argued by many that bonds are hugely overvalued and that they are due for a tumble when the Fed stops buying them and even greater one when inflation ultimately rises. The first argument is defensible, as it is obvious the Fed cannot go on indefinitely buying bonds at $85 billion a month. It may also be argued that the 6.8% drop already experienced by the 7-10 Year Treasury index since June 19th represents the lion’s share of their Fed-induced premium.
The argument that bonds are about to fall off a cliff due to impending inflation is a tougher one to swallow given that the economy is growing at well under 2% and unemployment remains stubbornly high at 7.4%. It is generally accepted that growth in GDP of at least 3% and near full employment are necessary ingredients for inflation to seriously take hold in the US.
Granted, there are some significant outliers that make this time different, or do they? Yes entitlement spending in this country is a ticking time bomb for growing US debt. And Obamacare brings huge uncertainties as 25% of the US economy will change almost overnight. While potentially inflationary for a time, ultimately, these forces are economy killers, bringing not inflation, but deflation and maybe depression. But I digress; let’s get back to inflation and what it might do to Treasuries.
What if the US were to experience inflation averaging 11% for the remainder of president Obama’s term and most of the his successor’s. What if this inflationary spiral would at no time fall below 6.5% (9 times today’s rate) and would at times reach 15%? What do you think would happen to Treasuries under these extreme circumstances? As you might expect, such a period exists in US history.
Between 3/1/1978 and 2/28/1982 the US economy experienced raging inflation that averaged 10.7%. What happened to 7-10 year US Treasuries during this time? Take a look a the blue line below. By February of 1982, the index had returned 2.74% with a worst 12-month return of -9.45%. That’s not a bad return for an insurance or hedge policy during one of the worst inflation periods in American history.
The big drop leading up to early 1980 was caused by the worst of the inflation as rates peaked at 14.8%. But what caused the strong bounce in mid-1980? Remember that Treasuries have a quality that no other bonds do – they are where investors run when the world is falling apart. During this time eight US special servicemen were killed and five injured when their helicopter and a cargo plane collided a desert raid to rescue American embassy hostages in Teheran. The ousted ruler of Nicaragua and two aides were assassinated in Paraguay. The Iran-Iraq war started, and later, three US nuns and a lay worker were found shot in El Salvador. Treasuries rise with economic uncertainty.
So, how did portfolios fare during this period of high inflation, particularly those with high concentrations of Treasuries? Our Risk Averse model contains the highest allocation of 7-10 year US Treasuries (60%). The index representation of that portfolio appears below as the green line. The stocks representing 30% of the portfolio performed well enough to keep pace with inflation until the late 79 period when it raged in the mid-teens.
But in just one more year, those who were patient and held on were rewarded. You can see that as Paul Volker, Chair of the Fed reigned in inflation and President Ronald Regan reigned in spending and global chaos, both stocks and Treasuries soared.
Arguably these two periods are not much alike. In early 1978 the US was spending just under $500 billion, had a federal debt of $780 billion, GDP of $2.3 trillion, debt to GDP of (.34%), and unemployment was 6.1%. Jimmy Carter was president. Inflation in 1978 was about 4%, but would rise to a high of just under 15% and average 10.74% for five years.
Today our government spends $3.6 trillion annually, has generated a debt of $16.9 trillion, GDP is $15.8 trillion, debt to GDP is 106.7%, and unemployment is 7.4%. Barack Obama is president. Today our inflation rate is .7%.
One of the biggest drivers for inflation in the 1978-1983 period was caused by huge demand that was placed on the American and global economy by the Baby Boomers. Today, that generation will arguably be more of a disinflationary force as they downsize homes and spending, continue to occupy spaces in the workforce that might otherwise be filled by bigger spenders and consumers, and sell stocks to buy annuities and bonds.
If we are headed for hyper-inflation, then some very powerful opposing forces that lie in its path must certainly be overcome first. The bond market, which looks considerably further into the future, does not currently fear inflation.