Category Archives: FOMC

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The Important Insights From The FOMC Minutes No One Is Talking About


  • The FED’s “protect the market at all costs” attitude minimizes the risk of a severe bear market but increases the risk for an inflationary environment.
  • Trade deficits and low productivity are not good signs for the long-term, no matter the positive data from the labor market.
  • Until the focus shifts from central banks to real structural reforms, sluggish GDP growth could easily turn into a recession.

Introduction

There are more important insights that can be gained by going through the FOMC minutes than by just reading the news about an eventual interest rate increase. An interest rate increase of 0.5% won’t change much. It will give the news something to talk about for two weeks and from then onwards it will be business as usual. Structural risks and what the FED is ready to do or not do in the case of turmoil is what will determine our investing returns.

The Patient Needs Stronger Medicine

The FOMC minutes start with a discussion about the implementation of a monetary framework, clearly stating that since the 2009 crisis, heavier intervention is needed to stabilize the markets and the economy. Before the crisis, a few rate cuts or increases and minimal market asset purchases were enough to reach stability. This can be clearly understood by having a look at the FED’s balance sheet. It increased fivefold from 2009 to 2014.

figure 1 fed balance sheet
Figure 1: FED’s total assets. Source: FRED.

 

For investors, this is important because it tells us that the FED will use all the tools at its disposal to keep the economy and markets stable. This minimizes the risks of a severe bear market as capital injections will be immediate, but it also increases the risks for an inflationary environment.

The Economy & Inflation

The economy shows mixed signs. On one hand it is doing very well with the latest jobless claims data at only 262,000, extending the period below 300,000 to 76 weeks which is the longest since the 1970s. On the other, weak manufacturing data, a trade deficit and growth from consumption alone keep the FED from decisively increasing rates.

The unfortunate thing is that adding jobs is easier than solving structural issues. With low productivity and a trade deficit, it is difficult to expect miracles from the U.S. economy in the long term, which again indicates that some international diversification and inflation protection should be welcome in the long term.

Inflation is still only at 1% indicating that something isn’t working as planned. Low interest rates and lots of cheap capital have spurred investments which increases the supply of goods, sending prices down, not up. Such a situation enables the FED to keep rates low and sustain the economy, but nobody knows how long such a situation will last. The FED is just postponing the reach of the 2% inflation target, which is now set for beyond 2018.

The sluggish GDP growth forecast and an economy relying on easy-to-hire jobs and consumer spending indicates that monetary easing did what it can do and now it is time for something else to step in. Structural reforms, lowering student debt and investing in infrastructure might be reasonable ideas, but until the focus is on monetary policy, the risk is high that this slow growth will turn into a recession.

The Situation in Europe

The European central bank released its policy meeting minutes a day after the FED. Europe is still a few years behind the U.S., asset purchases and direct financing programs are the norm but have no influence on inflation or economic growth. Inflation in the EU zone is at 0.8% while industrial production is contracting and GDP growth is below 1%. For the ECB, the good news is that unemployment has decreased from 10.2% to 10.1% and youth unemployment is “only” at 20%.

Similar data clearly indicates that other actions are necessary for the reach of sustainable economic growth. The terrible unemployment rate signals severe structural issues that cannot be amended by monetary policy. At least the situation in the U.S. looks much better after taking a look at Europe.

Conclusion

Everyone expects miracles from central banks, but those miracles only work for a short while. Hopefully structural reforms will enable future economic growth. Until then, we have two situations on our hands as investors.

  • Situation Number 1 – Central banks will intervene at any sign of market and economic weakness with more stimulus, minimizing the risks for long term investments. This means that we can stay long, but we have to be careful to watch for the point in time when the majority of people in the markets understand that monetary policies do not suffice.
  • Situation Number 2 – Global economies are not that healthy, especially in Europe. Severe structural reforms are necessary in order to create real growth, not just financially engineered growth.

The primary conclusion then, is that you can stay long and grasp eventual price declines for rebound trades as central banks state that they will do whatever is necessary to keep things stable. In the longer term, as monetary policy is not working, watch out for the moment when somebody yells: “The emperor is naked.”

 

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The U.S. Dollar: Should You Stick To It Or Diversify Now?


  • The dollar has been positively correlated with stocks for the last 4 years which is unusual.
  • Potential FED interest rate increases don’t make international diversification a great idea right now.
  • Any sign of a U.S. recession should be a good time to think about international diversification with emerging markets.

Introduction

On big news sites like Bloomberg you often come across headlines related to the movement of the U.S. dollar. The headline below is a good example.

figure 1 bloomberg news

Such headlines relay what has been going on in the few hours before publication but are completely irrelevant for investors that aren’t trading pips on forex. This article is going to investigate the longer term relationship between the dollar and stocks, and discuss the best option for maximum return with minimal risk.

Recent Dollar & Stocks Movements

Before 2012, as the dollar strengthened, stocks went down and vice versa. The reason was simple, a strong dollar meant U.S. exports were less competitive and businesses suffered, while a weak dollar made U.S. goods cheaper across the world and increased corporate earnings. Since 2012, however, the story has been a little bit different. The dollar has gotten stronger and stocks have gone higher.

figure 2 fred dollar stocks
Figure 2: U.S. dollar vs. S&P 500. Source: FRED.

The reason behind this is the fact that no matter what we think of the FED, it is the most globally coherent financial institution. In an environment where the European central bank is continuing with stimulus and the Japanese think about printing money for direct spending, the FED is the only institution that contemplates raising interest rates. So the positive correlation between the U.S. dollar and the S&P 500 comes from the relative success of the U.S. economy and the global faith in the U.S. dollar as the only safe currency.

On one hand, the strong dollar lowers corporate revenue. But on the other hand, it also lowers corporate costs, something CEOs never talk about when reporting earnings. As the U.S. has a net trade deficit, the strong U.S. dollar makes everything around the world cheaper and therefore expenses should also be much lower. Don’t forget this in the next earnings season.

Long Term Dollar Strength

The long term perspective is a little bit different than the above. Since 1975, the dollar has slowly but consistently weakened in relation to foreign currencies.

figure 3 long term dollar
Figure 3: Dollar index since 1975. Source: FRED.

The slow decline of the dollar means that global trends are shifting, which is also normal given the development in China and other countries. As the rest of the world is expected to grow at a faster rate than the U.S., the long term trend for the dollar is clearly and slowly downwards. This point is essential for international diversification. We have discussed many times how ChinaIndia and other fast growing emerging markets are essential for healthy diversification.

Forecasts & Economic Factors

In the short to medium term, it looks like the dollar is going to continue to strengthen. If the FED increases interest rates and others continue with their stimulus, the dollar will surge even higher. The most recent FOMC minutes clearly indicate that we could see a rate hike by the end of the year. But, eventually the strength of the dollar will kick back as exports will be more expensive and the trend will turn and continue to follow the declining line seen in figure 3 above.

What To Do

There are two options with currencies. They go up or down and do so for longer periods until the structural influences rebalance on a global scale. With interest rates low and good news from the U.S. economy, the FED will eventually raise interest rates and send the dollar higher. The moment of maximum strength of the U.S. economy and the dollar will be the time to diversify to other currencies but until then, sticking to the dollar is not a bad idea, especially for the majority of our readers who are living in the U.S. If the U.S. economy slows down and the dollar weakens, you will still have most of your assets in your home currency which will not represent a real change to your portfolio. But if you are exposed to other currencies and the dollar gets stronger, you will have to look at losses, which is never pretty.

Conclusion

U.S. investors have the benefit that if the dollar gets weaker, international diversification is just a missed opportunity while if the dollar gets stronger, it was a good idea to stay at home. International investors have to play it differently. With the FED eventually increasing rates, the dollar has no other direction to go than up which is a great diversification play when looking at the stimulus in Europe and Japan which weakens their currencies.

In the long term, it pays to be exposed to the currencies of the countries that are going to grow at a faster pace than the U.S. economy, i.e. emerging markets. We have seen the Chinese Yuan get weaker in the past two years due to some fears about China slowing down, but the longer term trend is clear.

figure 4 cny usd
Figure 4: Chinese Yuan per 1 USD. Source: XE.

With the economy expected to grow at a pace of above 6% in the next 10 years and the Chinese getting richer, there is only one way for their currency, up. Think about international diversification, but only when the dollar strength reaches its structural limits and the U.S. is close to a recession.

 

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Watch Out: The FOMC’s Current Stance Could Impact Your Portfolio in the Long Term


  • 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.

Introduction

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.

Yields

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. yield
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
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 forecasts
Figure 3: FOMC’s forecasts. Source: FED.

Conclusion

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.

 

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An Analysis of and the Implication of the FOMC Minutes


  • An interest rate increase is hanging in the air but no one seems to find enough reasons to pull the trigger.
  • The FOMC expects inflation to be at 2% and interest rates at 2.6% by 2018.
  • Holders of long-term bonds might rethink their positions as interest rate increases could have severe negative repercussions on bond prices.

Introduction 

On May 18 the FED released the minutes of the Federal Open Market Committee (FOMC) meeting held in April. The FOMC decided not to increase interest rates in April which gave a short relief to the markets, but an analysis of the FOMC meeting minutes reveals interesting things because it gives indications on the way of thinking FOMC participants have and hints on potential future interest rate increases. While the goal of the FED is to maintain financial stability and increase the resilience of the financial system to shocks, for an investor it is important to look at the economic trends related to the FOMC’s decisions in order to better assess the risks of their portfolio.

The Minutes in Segments

FED’s Disclaimer

There are several important take-outs from the minutes that are interesting for investors. The minutes start with a big warning—more like a disclaimer—saying that the FOMC can make errors as many of the macro-prudential tools used or available to be used are untested. Untested tools combined with the FOMC’s goal of keeping the economy growing at full employment with stable inflation might be dangerous as it can create imbalances in the financial and economic systems.

Economic Situation

The economic information used by the FOMC that brought it to the decision not to increase interest rates was that labor conditions improved but GDP growth slowed, inflation is still below the target of 2%, payroll employment expanded bringing a 5% unemployment rate, part-time employment remained flat and job openings declined slightly but are still at an elevated level and manufacturing decreased reflecting the appreciation of the dollar. One piece of information that changed since the meeting is new housing starts which were down in March but it picked up in April by 6.6%.

Market Situation

Domestic economic releases had a limited effect on asset prices that, alongside market accommodating FED communications, improved the risk sentiment. Nominal 10-year treasury yields declined, and the volatility index (VIX) decreased while stocks went up even though corporate earnings have been falling.

While the situation in the economy might be looking—and the markets looked—stable before the meeting, the stock markets did not react that well to the minutes, anticipating an increase in interest rates in June. It is interesting to see that the FOMC’s financial market overview is a bit larger than the economic overview which sends a mixed message as it is not clear if the economy or market prices are more important.

Economic Outlook

The FOMC expects GDP growth at a moderately faster pace than potential output supported by consumer spending. The unemployment rate is expected to decline further and to reach the natural rate. Inflation is still expected to rise and reach 2% in 2018 from the current 1%. Participants still expressed concerns over the outlook as the current decrease in domestic spending might decrease due to global economic and financial concerns. Business fixed investments declined but participants had mixed opinions as growth in some districts gives positive inputs.

Policy Decisions

The FED decided not to increase the interest rate as weak readings on spending and production, and below target inflation still create some concerns. Thus they decided that it is prudent to wait. In relation to future rate increases, the FOMC will continuously monitor economic data and make further decisions from there.

Implications of Next Meetings

Since the FOMC meeting in April, positive news came out as new housing starts increased which suggests that an interest rate increase might be around the corner for the June meeting. Bond yields immediately increased and bond prices fell. But the potential interest rate increase has mixed effects for investors. An interest rate increase would indicate an improving economy, but at the same time have severe implications on interest expenses for corporations. Higher interest rates would also mean a stronger dollar which would further affect the already declining exports and manufacturing.

Investors in long term bonds should assess their risks properly as if interest rates increase, bond prices decline to match the increased yields. The US 10-year treasury bond yield is still around three year lows with a yield of 1.86%, but is significantly higher than the low of 1.52% reached in February.

1 figure treasury
Figure 1: US Ten Year treasury note in last 3 years. Source: Wall Street Journal.

If the interest rate increases are moderate, bond holders will lose some money on longer term bond prices but will gain on higher interest payments. But, low interest rates do not give much hope that the coupon payments will be high enough to cover the loss in value as a yield increase of 1 percentage point would decrease the bond value by almost 33% at these levels.

In the longer term, the FOMC expects to set the interest rate at 2.6% by 2018 when inflation is 2% and full employment is reached. According to Goldman Sachs, stock markets tend to drop by 10% when tightening cycles start. Higher interest expenses would further push down corporate earnings and have a negative effect on the stock market.

A potential good diversification and hedge against higher interest rates are banks as they are the ones that profit the most from higher interest rates. Higher interest rates in combination with a better economy should increase mortgage rates so home buyers should not wait much longer as interest rate increases are almost certain, though no one knows when.

Conclusion

The FOMC minutes seem like the weather before a summer storm, and there is a feeling that something is coming but no one knows when. Warren Buffet puts it nicely by saying: “So far, I have been wrong on interest rates. It is so hard for me to believe that you can drop money from a helicopter and not have inflation, but we haven’t.”

It looks like the FOMC is anticipating inflation or having the same disbelieve but hesitating to increase interest rates as the economy has not yet reached its full potential. Such a situation is uncharted territory and therefore it seems that no one knows exactly what is to be done, so a wait-and-see strategy prevails. Perhaps a wait-and-see strategy is the best one also for investing; following Buffett who mentioned several times that he invests no matter what the FED does and that knowing what the FED would do in the next year would not change his investment decisions.