Friday, May 30, 2014

Friday, May 30, 2014 - Record Highs, Bonds, Coal Mines

Record Highs, Bonds, Coal Mines
by Sinclair Noe

DOW + 18 = 16,717
SPX + 3 = 1923 (another record)
NAS – 5 = 4242 (not a record)
10 YR YLD + .01 = 2.45%
OIL - .71 =  102.87
GOLD – 4.60 = 1252.30
SILV - .23 = 18.91

For the week, the Dow rose 0.7%, the S&P 500 gained 1.2% and the Nasdaq added 1.4%. For the month of May, the Dow gained 0.8%, the S&P 500 rose 2.1% and the Nasdaq climbed 3.1%. Meanwhile, if you are looking for action, the bond market is the place; the yield on the 10 year note has dropped from 2.65% to 2.45% this month.

Nearly everyone is looking for an explanation as to why longer-term interest rates continue to fall in the face of reduced Fed support and what is being hyped as better economic data. This wasn’t supposed to happen. The Federal Reserve has been propping up Treasury bond prices, and suppressing yields, for the past several years by buying large quantities of bonds each month in an effort to increase investment and consumption, and force investors into riskier assets. To some extent, the Fed’s QE purchases have worked; ultra-low interest rates have supported housing price increases and have led to skyrocketing stock prices.  Household net worth has increased by $25 trillion from the financial-crisis lows in the first quarter of 2009.  However, these gains in net worth have overwhelmingly accrued to the well-to-do while low- to moderate-income folks continue to suffer from poor employment opportunities, stagnant incomes, inadequate retirement savings, and rising costs for everything from food and energy to health care and education.  In other words, the economy hasn’t really improved but the Fed may have created financial asset bubbles.

Last December the Fed began winding down its large scale asset purchases by tapering, or incrementally reducing the amount of purchases over a scheduled period of a year or so. Back in December the Fed was buying $85 billion a month in mortgage backed securities and treasuries; they have now cut that to just $45 billion a month, and by the end of the year they anticipate they will end the large scale asset purchases. This means that demand for treasuries and MBS has, or should have dropped significantly. If there is less demand and the supply stays the same, then prices should fall and bond yields should be moving higher. The exact opposite has been happening; long term bond prices have increased and bond yields have been falling; and the timing of this increase in prices and drop in yields coincides with the start of the Fed taper.

Is there something wrong with the supply/demand equation? Is there invisible demand out there? Well, treasuries are considered a safe haven investment, and if we saw volatility in the stock market, we might expect a move to the safe haven of treasuries. Right now the CBOE Volatility Index known as the VIX, is down. As the 10-year yield touches the 2.4% level, its lowest in nearly a year, the VIX is hovering around 11.5, near its lowest levels since before the financial crisis.

The VIX measures volatility in the US market, so maybe we need to broaden out horizons. Europe is experiencing low-flation, and in some Euro countries the low-flation has turned to deflation; as a consequence, the rates in Europe are very low: German 10 year bonds yield 1.36%, France yields 1.75%, Spain 10 year notes yield 2.86%. In a global market there is something wrong with pricing. Why is the US bond yield higher than the French bond yield? That does not compute.

Of course, one explanation is that foreign investors are looking for a place to park money and if you can get a better yield on US treasuries compared to French bonds, it just makes sense that you wouldn’t buy the French bonds; add in the idea that buying US treasuries serves as an effective hedge against home currency depreciation and treasuries should be attracting money that might be held in emerging market economies.

In general, if economic growth is expected to accelerate, interest rates should rise as well.  The reason for this is fairly straightforward.  Increased demand for goods and services should lead to price increases.  Inflation is one component of "nominal" interest rates.  The other component is called the "real" rate of interest, and it is determined by the demand for money.  As economic growth accelerates, the demand for money should increase as people become more confident in making spending and investment decisions.  Therefore, higher inflation expectations and higher demand for money should lead to higher interest rates in a strengthening economy; but they haven't. Perhaps the weak economy of the Eurozone is holding back rates in the US, or maybe the US economy isn’t as strong as we imagine.

Another consideration has us going back to the supply-demand equation; if supply dries up faster than demand dries up, then that would push prices higher. Remember that the federal deficit has been trimmed to the lowest levels in about 13 years and that means the government isn’t issuing as much new debt. And the housing market has slowed and that means there should be less in the way of mortgage backed securities.

That was certainly the case for the first quarter; the US economy shrank. And there are no real signs of inflation in the US, or at least we didn’t see inflation for quite some time. That may be changing; the April CPI and PPI showed a minor pop in prices; the low interest rate environment has boosted financial asset prices, so stocks and housing prices have moved higher; food prices are also higher but they tend to be overlooked as a weather related aberration, although I doubt that is temporary; the labor market is still weak and despite the unemployment rate dropping to 6.3% there is tremendous slack and little participation and there doesn’t seem to be any wage inflation. The Fed might claim the economy is getting stronger and the Fed might not consider deflation to be a problem, but the bond market seems to be saying the recovery is sick. At least for the Main Street economy.

Further proof today showing American shoppers dialed it back in April. Household purchases fell 0.1%, the first decrease in a year, and following a 1% gain in March; that was the bounce back from the pent up demand of the frozen winter. After adjusting the figure to account for inflation, the news was worse; spending dropped by the most since September 2009 as income growth cooled. Incomes advanced just 0.3% in April, and without pay gains, consumers lack confidence. Consumer sentiment dropped from 84.1 in April to 81.9 in May. What we’re seeing is the failure of trickledown. The stock market may be strong, the well-off may be better off, but it doesn’t trickle down. The economy is never going to recovery without broad based demand, and that will only happen when the labor market gets strong, until then, the Fed is pushing on a string with QE and the Zero Interest Rate Policy.

There are many possible reasons behind the move in bonds, but a big part still has to do with the economy, even with all the subplots of the international markets and the inflation-deflation debate, we get back to the idea that the economy is weak, and the recovery is uneven. The first quarter GDP contraction was certainly weather related but that doesn’t mean the economy will bounce like a quarter on a trampoline. Second quarter GDP should be positive but probably not sizzling hot. I don’t buy that story, and apparently the bond market isn’t buying it either.

Next week’s economic calendar includes the ISM surveys of business activity in the manufacturing and services sector. What will be important to the outlook is what the surveys say about employment, export prospects and inventories. On Wednesday the Fed will release its Beige Book of regional economic reports. The next Fed FOMC meeting is June 17-18. Next Friday is the monthly jobs report; the unemployment rate, the headline number is at 6.3%, but that’s based on a participation rate at 62.8%. If the participation rate moves higher, look for the unemployment rate to jump.

Another big event next week, President Obama on Monday will unveil a plan to cut carbon pollution from power plants and promote cap-and-trade, undertaking the most significant action on climate change in American history. The proposed regulations could cut carbon pollution by as much as 25% from about 1,600 power plants in operation today. Power plants are the country's single biggest source of carbon pollution; responsible for up to 40% of the country's emissions.

The rules, which were drafted by the Environmental Protection Agency and are under review by the White House, are expected to put America on course to meet its international climate goal, and put US diplomats in a better position to leverage climate commitments from big polluters such as China and India. The plan is certain to result in political backlash with critics making doomsday claims about the costs of cutting carbon. Coal mining companies, power plant operators and others are already lining up for legal challenges to the executive action, claiming the approach oversteps the EPA’s authority.

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