co·nun·drum – noun: A confusing or difficult problem; a question or problem having only a conjectural answer
Back in the last Fed tightening cycle, Alan Greenspan described the refusal of long term rates to follow short rates higher a conundrum, something he couldn’t really explain. Unlike past periods of tightening, long term rates refused to budge higher as the Fed slowly raised the federal funds rate. That thwarted Greenspan’s attempt to tighten credit and probably contributed to the rise in real estate prices. Ben Bernanke, at the time, blamed what he called a global “savings glut” for creating the conundrum. In other words, the problem wasn’t with Fed policy or fiscal policy or anything going on here; it was those darn foreigners buying Treasuries that prevented the bond market from doing what it should and what the Fed expected.
Well, it appears the conundrum is back. I’ve seen the word used more in the last week than since the previous outbreak of conundrum back in 2006. The Fed hasn’t even begun to tighten – if you assume that raising rates is tightening – and already we’re hearing about the conundrum of long term interest rates. The yield on the 10 year Treasury note has fallen roughly 70 basis points (0.70%) since the beginning of the year despite the Fed’s signaling higher rates on the horizon. Now most people, seeing a market not reacting as they expect, might consider the possibility that something was wrong with their strategy. But not the Fed. If markets aren’t reacting the way they think they should, it must be a problem with the markets not their policies.
Let me clear this up for the Fed. There is no conundrum. The bond market is providing solid information about future growth and inflation just as it usually does and Ms. Yellen would be wise to heed the warning that it is sounding loud and clear. It is saying that future growth and/or inflation are not going to measure up to her or the market’s expectations. Back in 2004 when the Fed started hiking rates the bond market said very clearly that future growth was going to disappoint. The nominal 10 Year Treasury note yield did rise some – about 150 basis points versus 450 basis points for the Fed funds rate – but the 10 Year TIPS barely moved. In fact, in March of 2004, 10 Year TIPS yields were down to just 1.4%. Inflation expectations rose only modestly (the movement in the nominal bond) while growth expectations fell (the movement of the TIPS). 10 Year TIPS yields are a proxy for the market’s expectations for future real growth and if you doubt that consider that the annualized growth rate of US real GDP from 2004 to 2013 (10 years later) was 1.47%, almost exactly what the TIPS market predicted 10 years earlier. So, it may have been a conundrum to Greenspan and Bernanke but the bond market pretty much nailed it.
Now, I should stress here that markets are not always right about the future; bond traders don’t have a crystal ball. The bond market is composed of people just like the stock market and they sometimes act just as irrationally as their equity trading cousins (just not as often). In looking at the recent history of the TIPS market one is struck by the signals it has been sending since the crisis of 2008. TIPS yields at the height of the crisis, in November 2008, were predicting 10 year forward real growth expectations of 3% and based on nominal yields at the time, pretty severe deflation. We’ve still got a ways to go before that 10 year period is up, but if that comes true, we would see an acceleration in real growth and a drastic fall into deflation over the next 3 years. I suppose anything is possible but that outcome at present seems highly unlikely. It seems more likely that the emotions of the period overwhelmed good sense even among bond traders.
Today the bond market is predicting 10 year forward annual real GDP growth of just 0.5% and inflation during that time of just 1.85%. With current growth of roughly 2% and inflation running just south of that, achieving those market predictions would mean a pretty severe drop off in growth while inflation remains basically unchanged. It may be that the bond market is wrong about both of those things but if history is any guide, it would be a big mistake for the Fed to ignore the message the bond market is sending. From my perspective, the reaction of the bond market to potentially higher interest rates from the Fed is pretty clear; given its debt load, the global economy can’t handle higher rates from the Fed. The Fed is the world’s central bank and the dollar is the only truly global currency so higher rates here impact the entire world no matter what the PBOC, the ECB or the BOJ choose to believe or do. Easing in Europe or Asia is more likely to impact currency values than real growth.
Interest rates are not the only conundrum at present. There is also the disconnect between the commodity markets, global growth and stock prices. A large chunk of the global economy is in recession or falling toward it. Japan has returned to recession – if you believe 2 consecutive quarters of negative growth is the definition of recession – Europe is on the verge and China is still slowing. If you have had doubts about the angst over weakening Chinese growth, they seem to have answered that last week with a surprise interest rate cut (although there are reasons to believe the cut wasn’t all it was cracked up to be) which central banks don’t generally do unless they are concerned about something. It appears to me, as I warned a few weeks ago, the Chinese are responding to the Japanese Yen devaluation game by at least attempting to match them. The Yuan hasn’t fallen yet but my guess is that the Chinese will discover soon that their currency is a bit higher than they would like and let it drift lower. Don’t be surprised if you start to see more rate cuts in other Asian locales; South Korea cut in October and I’d expect more to come.
The Europeans are also worried about renewed recession and the ECB is talking about doing more although I’ve yet to figure out exactly what with the Germans resistant to anything that even resembles money printing. Nevertheless, stock markets reacted positively to the Chinese rate cuts, the hint of more to come from the ECB and the prospect of Japan’s Abe winning the snap election next month (which would mean, I guess, that the BOJ will be free to continue paying the government’s bills). I can’t help but wonder at what point investors will decide that the need for more monetary stimulus is an admission that previous attempts to “prime the pump” of economic growth have failed. Apparently not yet.
Meanwhile, commodity prices have been signaling weaker growth, falling in a nearly straight line since June. Of course, part of that is due to the rise in the dollar during the same time frame but the CRB index is down quite a bit more than the dollar is up so part of the drop is likely due to expectations of weaker demand in the future. Yes, I know that oil is dropping for all kinds of reasons – shale production, geopolitics, etc. – but the correlation between oil prices and future economic growth is pretty good and shouldn’t be ignored completely. Sentiment toward commodities, particularly gold, is the polar opposite of stocks, about as bearish as I can remember. And, of course, everyone is bullish and long the dollar.
So, to sum up, we have falling growth expectations in the bond markets (it isn’t just US bonds that are signaling lower growth), foreign central banks are cutting rates, commodity prices are falling….and stock prices are rising. Now that is a conundrum if ever there was one. Why in the world would one set of markets be signaling growing concern about growth while one is, if anything, pointing to better – some would say incredible – growth? I must admit that I don’t have an answer for that one unless the only market that is right about the future happens to be the one that everyone is gaga about right now. All I can say for sure is that if the bond market is right, stocks are going to have to adjust to that new reality at some point. When? I have no idea but this market is creating a whole new meaning for the Wall Street term “overbought”.
What does all this mean for investors? Well, I’ve been pondering that for weeks and if one assumes the extremes in sentiment will be reversed – as they always are – then a couple of scenarios emerge. Either US growth expectations will fall or the rest of the world growth expectations will rise but the gap between the two seems likely to converge. Either would be sufficient to wrong foot the dollar bulls and commodity bears. If it is the former – falling US growth expectations – that would also continue to frustrate the bond bears who are nearly as ubiquitous as stock bulls. And I think it goes without saying that the former scenario would also thin the stock bull herd. It would certainly resolve the conundrums we have at present, although probably not in a way the market – or the Fed – expects.
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