- Bonds are becoming riskier as yields are falling.
- Inflation is at 1.2% and very likely to get higher as full employment is approached.
- The FOMC predicts stability which could create a great environment for traders.
On July 6 the Federal Open Market Committee (FOMC) June meeting minutes were released. As they give clear insight into how the controllers of our monetary policy think, it is very important to analyze the minutes in order to better position one’s portfolio and also execute short- and medium-term trades. The FOMC gave a clear indication of their expectations in relation to future GDP growth, unemployment, inflation and its federal funds rate. All of the mentioned indicators will have different effects on various investments.
Summary & Indications for Investors
“Prudent to wait” are three words that summarize the FOMC meeting. For investors this means that you should prepare for anything as the FOMC doesn’t know what will happen.
In more detail, the low treasury yields is what worries the FOMC. As investors shun foreign sovereign debt and repatriate their cash, U.S. yields go down. This decline in U.S. yields is not only caused by global political and economic turmoil—think Europe with BREXIT and Italian banks, and Brazil—but also by the FOMC’s indecision.
Yields went up when the FOMC increased interest rates back in December and forecasted three more increases during 2016, which obviously will not happen. This change in policy has pushed yields down again.
Figure 1: U.S. treasury 10-year yield. Source: Bloomberg.
With consumer price inflation at 1.2% with projections at around 2% in 2017 and a yield of 1.36% on the 10-year note, buying 10-year treasuries doesn’t protect your capital. Such an artificially created situation by the FED is unfair towards savers.
As the price of a bond moves inversely to its yield, the current low yield means that investors have to pay a lot for little. For example, if you invest $100,000 now in 10-year U.S. treasuries and next year the yield climbs up to 2.3% where it was a year ago, your $100,000 investment will become $59,130, which is not a great way to protect your capital, especially if you don’t plan to keep the debt until expiration.
Astute traders might want to grasp the opportunity given by the clear indications of higher inflation which should produce higher interest rates and consequently lower bond values in the medium term by shorting bonds.
On the labor side, the FOMC is worried about the low number of new payrolls added in May as the fall from 5% to the 4.7% unemployment rate was mostly influenced by a large number of people exiting the labor force. The FOMC estimates unemployment to stay in the 4.5% to 5% range in the next three years and in the longer run. This stable forecast is very strange as the unemployment rate has historically never been stable.
Figure 2: Unemployment rate from 1948. Source: FRED.
As the figure above demonstrates, since unemployment has been measured there has never been a period of stable unemployment for a longer period of time except for a one-year period in 1955 and a two-year period in 1965. Perhaps the FOMC is forgetting that the economy works in cycles. Investors should understand that the reach of full employment increases costs for corporations which should finally spur inflation. This again reinforces the above described risk of holding treasury notes and also indicates that investors should look for stocks that will perform well in an environment with higher inflation and higher interest rates. One example is energy stocks as they can raise their prices pretty quickly in relation to inflation and if they have their debt maturing in the distant future with fixed interest rates, even better.
The FOMC’s view on economic growth is a mixed one, again reinforcing the sit and wait strategy. Weakness in the mining sector is continuing, declining corporate earnings and high inventory levels lower business investments that “could portend a broader economic slowdown” according to the FOMC.
On the other hand, the committee is also optimistic due to a turnaround in energy prices and greater optimism in business surveys. So, for the FOMC, pessimism from actual figures like lower business investments, higher inventories and lower corporate earnings is equalized by survey optimism and a turnaround in energy prices. Such statements indicate high risks because even if there was a recession looming, the FOMC isn’t allowed to tell us that because such an admission has the power to influence markets. If the FOMC said that a recession would come in the next year, that recession would begin the same day of the statement and not next year.
Fed governor Daniel Tarullo stated that “This is not an economy that is running hot” and that the Fed has limited tools if the economy slows down as the interest rates are already at their minimum which increases the risks for investors.
To sum it up, the figures below are the FOMC’s forecasts and forecasted ranges for GDP, inflation and unemployment:
Figure 3: FOMC’s forecasts. Source: FED.
As the FOMC forecasts stability on all levels, investors can expect sideways market movements because as soon as negative news like the BREXIT lowers market values, positive news like monetary interventions will push the markets higher again. If things will be as the FOMC forecasts, it will be a heaven for traders. Long term investors will see their current low yields eaten up by inflation, so a portfolio should be rebalanced accordingly.