Three great charts for you in this edition.
One month after the Federal Reserve announced a second round of bond purchases, this time focused on five year Treasury notes, it is remarkable that yields (which move in the opposite direction of bond prices... and therefore should sink when a buyer the size of Uncle Sam enters the market) have in fact climbed. The chart below traces the up-to-date movement in those five year yields starting from late August when the Federal Reserve first began hinting at another round of buying or quantitative easing.
Notice that the rate on the five year note fell to a hair above 1% (our chart shows rates as a factor of 10) leading into the official Fed announcement but has since risen sharply to over 1.75% and is now above where it stood in late August. Last month we highlighted a Washington Post editorial from Fed Chairman Ben Bernanke that explained the Fed's decision for additional quantitative easing. Top priorities were lower interest rates (thus lower mortgage rates) and higher equity prices. While the stock market has mostly complied with the chairman's wishes the higher yields in the bond market have led to a relative spike in mortgage rates in the last few weeks.
There are a few possible explanations being floated for this action in the bond market. The most optimistic is that improvement seen in a few economic indicators including the ECRI Leading Index and some regional economic reports point towards an uptick in the U.S. economy. We agree that marked improvement in economic activity should lead to higher rates but with the U.S. housing and labor markets as weak as they are we think it is unduly optimistic to expect anything more than moderate growth.
Another possibility is that the market was disappointed in the size of the announced Fed purchase. Ahead of the official decision many analysts were predicting the program to be a $1.0 trillion dollars or more and perhaps the market was disappointed with "only $600 billion". If that were the case the reaction would have been more immediate. This move was not a sudden 'pop' but a steady climb for over a month.
We see it another way: The move up in yields is in part a reaction to the likelihood of a tax deal for 2011 passing in Congress and the lack of enthusiasm from some members of the Federal Reserve for the quantitative easing program. Last month we assumed that the Republican gains in the mid-term election meant little chance of any more fiscal stimulus coming out of Washington. How silly. What we should have assumed is that both parties would push their favored form of stimulus, tax cuts for the Republicans and extended unemployment benefits and payroll tax relief for President Obama. While the tax deal announced between Sen. McConnell and the President seems good policy for current economic conditions, it raises possibilities of higher deficits and inflation- both of which help push up rates.
A final note on the Federal Reserve: One voting member of the Board, Tom Hoenig, has been critical of the Fed's loose monetary policy for most of the year and opposed the $600 billion bond purchase. Richard Fischer, who becomes a voting member next year, has wondered whether the Fed' actions are instead benefiting China and the rest of Asia as "far too many" large corporations told him that "the most effective way to deploy cheap money raised in the current bond markets or in the form of loans from banks, beyond buying in stock or expanding dividends, is to invest it abroad." Barring another crisis it is reasonable to expect less accommodation from the Fed going forward.
Despite November's disappointing jobs report, we feel there have been positive signs from most economic indicators of late and we continue to be moderately optimistic. Three primary areas temper our exhuberance as we head toward a new year.
- Continued sovereign debt problems in Europe. There were 210 days between the announcements of the Greek and Irish bailouts. We expect that it will be a much shorter time period until Portugal's bailout is announced. Bond traders will continue to sell off the weakest member of the EU until they find one that can withstand their assault or we see some country defect from the currency union. We are starting to lean toward the latter as the more probable.
- The continued weakness in the U.S. housing market. Investment in housing is often a driver out of recession because low rates during tough times make it the opportune time to buy. As a result employment in construction tends to lead the recovery in overall employment. In the two previous recessions, construction employment was up 4.0%-5.0% in the twelve months after the peak level of unemployment versus only 1.5%-2.0% gains in overall employment. This time around is a bit different. Construction employment is down nearly 3% since the (hopefully) peak unemployment rate in October 2009. Considering the recent over-building and over-leveraging of housing, the economy will need to find different industries to create employment this time around.
- Finally, while the President and Congress have reached a deal that is stimulative, individual U.S. states generally do not have the option of deficit finance. Over the last month municipal bonds of the most fiscally unsound states have traded down sharply for what is normally a very non-volatile market. The graph below shows the performance of a California muni bond fund since the mid-term elections.
We view this as a realization by investors that a Republican House is unlikely to bail out California, Illinois, or New York. When states dig themselves this deep, any combination of tax increases, budget cuts, and accounting assumptions utilized to pay their debts will impinge on economic activity.
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John O'Meara and Michael Keating