Back to 1994 -Weekly Comment
November 4, 2018
Then he lights every match in an oversized pack,
Lettin’ each one burn down to his
Thick fingers before blowin’ and cursin’ them out. -Sheryl Crow. All I Wanna Do… from 1994
Above are a couple of charts I created, comparing 1994 to 2018. I’ll return to them in a few paragraphs.
We’ve now had a long period of loose conditions, of excess capital in search of yield, of high liquidity and low volatility, and of high asset prices. Things are changing. The Fed may perceive short rates as still leaning toward the accommodative side of the spectrum, but I believe that the market itself is now becoming much less charitable. It’s not a “reach” for yield these days. A few examples: First and most obvious is that stocks had a challenging month in October. Some people think that we just get past this corrective price action and it all goes back to levitating. My reading of markets is that this phase of corrective price action has a long way to run. Much has to do with public versus private behaviour. Apart from stock prices, let’s consider 3 month libor. The Fed hiked on Sept 26. On Friday, Sept 28, 3m libor was just a shade under 2.40. Now it’s just a shade under 2.60, so 20 bps in a bit over a month and there are still 1 ½ months to go before the December quarterly FOMC. That’s a pretty good move, even given near certain expectations of a Fed hike. There is also a Fed meeting next week on the 8th, and the fact that the Fed Effective rate is now exactly equal to Interest on Excess Reserves (IEOR) has some thinking that a tweak could come sooner than later. As another example of tighter conditions, note that ‘real’ rates as expressed by inflation-idexed notes, or tips, have been rising, closing at a new high for the year in both 5’s and 10’s, 1.12% in the former and 1.15% in the latter. Note that the 5yr tip was 12 bps in November 2017, and it’s now 100 bps higher at 1.12%. Maybe that shouldn’t be surprising at all, right? The Fed raised 100 bps over that time frame. So perhaps Powell deserves a pat on the back, raising real rates and keeping inflation expecations more or less anchored. However, my feeling is that capital is becoming more discriminating and is demanding returns and considering costs. Consider the two year treasury yield to the S&P dividend yield. In 2016, the two year yield was 175-200 bps BELOW the dividend yield. Now the 2yr is 95 bps ABOVE the dividend yield (2.91% 2yr vs 1.95% Div yield). TINA? There Is No Alternative? Now there IS an alternative, and it’s risk-free.
After the crisis, the Fed and the government transferred private debt onto the public balance sheet. Now that process is reversing, although the voracious borrowing appetite of the government is accelerating. It’s summed up by the Ghostbusters scene when Drs Venkman and Stantz have been fired by the state university. Ray Stantz to Venkman: “Personally, I liked the university. They gave us money and facilities; we didn’t have to produce anything. You’ve never been out of college. You don’t know what it’s like out there! I’ve WORKED in the private sector. They expect *results*.” The Fed didn’t expect *results* or yield on the balance sheet. They just wanted to force the public into risk investing and take away the fear. Strategies like selling premium to capture those few precious extra basis points came into vogue. Loan covenants evaporated. Well the fear is creeping back. It’s evident in rates, in spreads, in VIX. As pointed out last week, 5 year Credit Default Swaps on high yield are blowing out to new two year highs. The premium sellers needing a couple of extra bps at the margin are gone. As an example of public vs private, the Fed didn’t hedge its MBS holdings, but as these assets are trimmed from the Fed’s balance sheet, they land in private hands that have to worry about pesky considerations like prepayments, etc. Embedded short options need to be hedged.
Which brings us to the top of the page charts again. In 1994, after over a year of FF at the then historic low of 3%, the Fed tightened aggressively to 5.5% by November, and then tacked on the last hike of 50 bps to 6% in February 1995. FF doubled in a bit over a year. As is shown on the top chart, the ten year yield went from 5.57% in Nov 1993 to 7.95% in Nov 1994, a nominal change of about 240 bps. However, in terms of percentage change, which, after all, is how the cash flows are altered, the change in that episode and today’s have nearly been identical. By the end of 1994, tens had topped over 8%. In December, Mexico devalued. The Tequila Crisis. The peso’s value was chopped in half and by 1995 inflation in Mexico hit 50%. The Fed looks back on the rapidity of the 1994 tightening campaign as a policy mistake. As can be seen in the lower chart, US yields tumbled all the way back in the first half of 1995.
A few things are different now. Most notably, Federal Govt debt to GDP was below 70% in 1994, now it’s 104% according to the St Louis Fed. Corporate debt to GDP was around 40% of GDP in 1994, now it’s over 45%. The amount of corporate debt hovering just above junk is at a record percentage. Rate increases now should have a larger effect on cash flows, and let’s face it, it’s now a ‘cash flow’ economy. The Chinese economy wasn’t nearly as large as a percentage of global GDP as it is now. And the amount of US debt currently being auctioned is huge. This week brings 3, 10, and 30 yr sales of $83 billion, with $29 billion of that being new money. There was a time when China was selling us manufactured goods and buying US treasuries in what was referred to as ‘vendor financing’. No more. Trump is currently lighting every match in his oversized pack and letting them burn down to our fingers. This past week, he blew out a couple of matches by making overtures of a deal with China. But next week he will light a few more to keep drama high going into the G20 meeting at month’s end, and of course the midterm elections loom this week.
The question is whether markets will resolve as they did in 1994 with a roundtrip to lower bond yields, or whether conditions have changed to the extent that official actions of intervention have more muted impact as both yields go higher and stocks move lower. By the way, just after bond yields peaked in Nov 1994, SPX bottomed in December just above 440 and proceeded to rally in a nearly straight line to 585, a gain of over 30%. Could it happen again? Well at the end of 1994, stock mkt cap as defined by the Wilshire 5000 to GDP was 61%. Now it’s 139%. I don’t think current valuations allow a 1995-like rally.
My personal bias is that heavy debt and related challenges faced by both the US and countries with large USD debt burdens will make it difficult to gracefully exit the current deterioration. While the Fed looks back at 1994 as a mistake, I don’t think there is any such concern within the institution currently; the finger pointing is coming from Trump. The administration has made every attempt to front load stimulus, but now may have a more difficult time with a divided Congress and less forgiving markets. Despite last month’s plunge in crude oil, broader inflation has taken hold, apparent in Friday’s wage gain of 3.1% yoy. Even if Friday’s wage number was skewed by a low year-ago base, continued gains in payrolls indicate pipeline price pressures. Will the Fed blink? I think markets will force that outcome. First will come a ‘pause’ in rate hikes, if not in March then in June. Then, as the curve steepens, the Fed will decide that a $4 trillion balance sheet actually is EXACTLY the right size, and balance sheet roll-off will end. Finally, a return to QE as interest cost on the Federal debt balloons.
In a sign of what’s to come for the US, consider that Urjit Patel, head of the RBI, offered to resign last week as Modi’s government continues to pressure the central bank to stimulate. At the end of October, RBI deputy governor Viral Acharya, gave a powerful speech in defense of the central bank’s independence, and it pertains not just to India, but to all nations. From the speech (link at bottom):
The second part of the explanation as to why the central bank is separate from the government relates to the observation that much of what the central bank manages or influences – money creation, credit creation, external sector management, and financial stability – involves potential front-loaded benefits to the economy but with the possibility of attendant “tail risk” in the form of back-loaded costs from financial excess or instability.
Governments that do not respect central bank independence will sooner or later incur the wrath of financial markets, ignite economic fire, and come to rue the day they undermined an important regulatory institution. (Sounds a little like Jules Winnfield in another 1994 classic, Pulp Fiction)
OTHER MARKET/TRADE THOUGHTS
Fed Fund spread settlements indicate Fed hike odds. Nov/Jan settled 18.75, plus 1.75 on the week. Given odds of a change in IOER this spread forecasts over 90% odds of a Dec hike. Feb/April settled 17.0, up 1 on the week. May/July settled 13.0, up 2. Friday’s strong payroll report and stock rally off Monday’s spike low helped re-assert a view that the Fed will move quarterly toward neutral.
There is a lot of looseness in the front end of the curve. As mentioned, libor has surged 20 bps since the end of September. 3m libor is just under 2.60% or 97.40 in euro$ futures terms. November ED expires in 2 weeks and settled 97.31, which requires 9 bps of convergence in 2 weeks! Why then, are they selling EDX8 9725 straddle at 5.0 bps? Or the EDZ8 9725 straddle at 9.0 bps? These were the settlement prices vs EDZ8 at 9722.5, which currently has a spread of over 17.5 to 3 month libor.
The other aspect of the curve that’s somewhat interesting is that the one-year euro$ spreads form a bowl from fronts to deferred. For example M9/M0 is +18. One year further out we have inversion, M0/M1 is -3.5 (the lowest spread) then M1/M2 is 0. M2/M3 is +5.5 and M3/M4 is +9.5. If we take the Fed at its word and call the neutral rate approximately 3%, then 2 or 3 more hikes essentially hit target. By summer of 2020, the market indicates no growth (neutral rate stops the economy?) and then recovery by 2022.
| 10/26/2018 | 11/2/2018 | chg | |
| UST 2Y | 280.6 | 291.0 | 10.4 |
| UST 5Y | 290.4 | 303.6 | 13.2 |
| UST 10Y | 307.4 | 321.2 | 13.8 |
| UST 30Y | 331.3 | 345.3 | 14.0 |
| GERM 2Y | -63.0 | -63.0 | 0.0 |
| GERM 10Y | 35.2 | 42.0 | 6.8 |
| JPN 30Y | 85.7 | 87.0 | 1.3 |
| EURO$ Z8/Z9 | 40.0 | 46.5 | 6.5 |
| EURO$ Z9/Z0 | -2.0 | 1.0 | 3.0 |
| EUR | 114.04 | 113.88 | -0.16 |
| CRUDE (1st cont) | 67.59 | 63.14 | -4.45 |
| SPX | 2658.69 | 2723.06 | 64.37 |
| VIX | 24.16 | 19.50 | -4.66 |
https://rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=1066
