Soybeans = Tax Cuts + Spending Bill
Last Week This Morning
- The 10T broke higher to 2.96%
- German bund inched higher to 0.41%
- 2 year Treasury spiked to 2.69%, up 0.10% on the week (bad for caps)
- LIBOR at 2.07%
- SOFR at 1.87%
- GDP on Friday came in at 4.1%, the highest reading since June 2014’s 5.1%
- EU President Juncker met with President Trump and the two released a joint statement that the two leaders will “work together toward zero tariffs, zero non-tariff barriers, and zero subsidies on non-auto industrial goods.”
- Trump indicated he would hold off on auto tariffs, but steel and aluminum would remain.
Soybeans = Tax Cuts + Spending Bill
Strong GDP was the highlight of the data last week, and I had to be reminded that the economy had higher GDP in two separate quarters in 2014 (5.1% and 4.9%). Then oil busted and the economy cooled.
Quarterly GDP calculations also use simple arithmetic to annualize the report – multiply that quarter’s data by 4. So one time events are counted as if they will repeated at the same pace each quarter going forward. For example, China may have stockpiled soybeans ahead of an impending tariff and spike the data. That doesn’t mean they plan on keeping up the pace for the rest of the year, but the GDP print doesn’t know that. And that’s why economists are projecting a decline in GDP in the coming quarters.
The Committee for a Responsible Federal Budget (you don’t even have to Google it because only a governmental-ish entity could come up with such a terrible moniker) projects that 0.6% of GDP was the result tax cuts and the spending bill.
It also projects that 0.6% came from China pre-buying soybeans.
In other words, the exact same amount of GDP from tax cuts and spending bills came from China buying soybeans. One of those is a one time event with offsetting factors in the future. The other dramatically increases the deficit and will keep the record level of debt climbing. Even this state school educated kid can see the difference. Maybe we can plan on quarterly tariff threats to keep pulling forward consumption?
That doesn’t mean it wasn’t a good report, just not the “historic” report touted by the president. Perhaps more importantly than the quarterly report is the yearly GDP data, which came in at 2.8%. That doesn’t sound quite as sexy as a GDP report with a 4 handle, but I would argue it’s more significant. The annual data doesn’t suffer from the one time swings we see in the quarterly data.
FOMC – Wednesday
The Fed isn’t hiking on Wednesday. The market has odds of a hike at 18.6%, which is probably still too high. Meanwhile, the September 26th meeting has odds at 93% (which is probably a little high).
This week’s statement is likely to be intentionally bland given the swirling concerns around tariffs and a flattening yield curve. The Fed will probably acknowledge these factors without spending much time really addressing them. Also, the Fed revised upward a lot of forecasts at the June meeting and is unlikely to convey a further change in sentiment already.
Since the June meeting, the economy has done well – GDP up to 4.1%, Core PCE hit 2.0%, average NFP’s up 30k/mo, manufacturing data strong, etc. In his Congressional testimony two weeks ago, Powell characterized second quarter strength as “considerably stronger” than Q1.
In fact, the Minutes we receive in a few weeks from this meeting will yield more info than the statement this week. In the June minutes, for example, the yield curve flattening was not addressed in the statement but was given considerable time behind closed doors.
For floating rate borrowers, one of the most important topics to monitor is the neutral rate. This is the rate that neither encourages nor restricts growth – think of it as an equilibrium rate.
Recent Fed-speak has put this rate around 2.50% – 3.00%. That doesn’t mean the Fed won’t hike beyond that level (particularly with the economy doing well), but it does suggest each additional hike beyond neutral will become incrementally more challenging to justify. Maybe 3.25% or 3.50% is possible, but 4.00% starts feeling less likely…and 5.00% seems borderline impossible (knock on wood).
Get out your pencil and take notes because this is how this will go down:
- The Fed will reach neutral with another 2 or 3 hikes, which is likely to happen by March 2019.
- LIBOR to 2.65% – 2.85% during this time frame
- If Powell believes GDP is peaking right now, he may believe he needs to squeeze the hikes in faster now and can slow/pause later.
- Once at neutral, the Fed will change its approach and will slow the pace of hikes to avoid the common mistake of hiking too aggressively and pushing us into a recession.
- The Fed may still want to hike, ideally pushing Fed Funds to 3% or 3.25%.
- But if rates are at “neutral”, the Fed can be more cautious with each additional hike and retain flexibility should economic data deteriorate.
By end of March 2019, Fed Funds will be between 2.50% – 3.00%. And the Fed will basically be done hiking with the occasional hike slipped in here or there if they can get away with it.
By the end of March 2020, the band out outcomes really isn’t any wider, just a touch higher – probably 2.75% – 3.25%.
Once rates are at neutral, it will become increasingly difficult for each additional hike. Floating rate borrowers should keep this in mind as they decide how to hedge rising interest rates.
If the Fed rate hike cycle slows, it should allow the long end of the curve to increase. But while Powell is beating the dead horse about how strong the economy is, the markets are jittery the Fed will overdo it and tip us into a recession.
That’s one of the reasons the T10 has refused to climb to 3.50% – fear of an impending slowdown. And the US is still the world’s mattress. When emerging markets turn south, investors pull their money and stash it somewhere safe.
It’s also interesting to note that commercial banks have quietly become one of the biggest buyers of Treasurys as the Fed stepped back from buying bonds.
During QE, we described the Fed as a noneconomic buyer that did not behave like a typical investor. The Fed was going to buy bonds each month, regardless of price/yield. Put the blindfold on and press “buy.” That helped keep a lid on yields, which is exactly what the Fed wanted. Heck, even Chinese and Japanese central banks care a little about the yield.
And as the Fed slowly extricates itself from this process, it suggests upward pressure on yields as every other buyer cares at least a little about the yield, too.
But commercial banks may have stepped into the Fed’s shoes as a buyer at any price. Blindfolded, they’ve been pressing the buy button quite a bit.
Since 2014, Treasury and Agency holdings by commercial banks increased from $1.8T to $2.55T. That’s an increase of $750B during the same time the Fed’s own balance sheet shrunk by $210B.
It’s important to remember that the Federal Reserve is a cartel for the banks. The Fed works for the banks, not for us. While the dual mandate is price stability and full employment, the primary mission is to take care of the banking industry. That’s why the banks were the primary recipients of aid during the crisis. If that trickled down to Main St, great. If not, oh well – at least the banks were safe.
Unlike the Fed, banks are publicly traded institutions with shareholders to answer to. As interest rates climb, bond prices decline and bond holdings lose value. Banks should be taking a bath from their bond buying spree. At a minimum, this suggests they’d slow the pace of purchases. Central banks may not care about losses, but banks should, right?
Hold to Maturity accounts, or HTM, was a new accounting feature added during the crisis that allowed banks to buy bonds without marking to market value changes. No EPS impact. Guess where banks are putting all their Treasury holdings? It’s risk free coupon clipping.
So the Fed turned on the printing presses, gave money to the banks, required huge liquidity requirements, then allowed them to avoid losses on bond holdings. This created a system whereby banks became big buyers of Treasurys at any price, helping to keep a lid on yields.
Couple this with rate hikes, trade war/yield curve inversion fears, and massive front end issuance and we have a recipe for the yield curve flattening we’ve been experiencing.
Not really our area of expertise, but since when has that stopped me from giving an opinion?
Moody’s reported that its Loan Covenant Quality Indicator dropped to an all-time low in Q1. “While the rate of deterioration in covenant quality has slowed, protections remain distressingly weak on average,” said Moody Covenant Officer Derek Gluckman.
I remember the covenant-lite financings from the last boom cycle and the resulting pain during the downturn. In a default, these behave more like equity than secured debt. But when you have massive quantitative easing, the resulting liquidity and spread compression leads to yield reach. I suspect there are a lot of reasons circulating as to why this shouldn’t concern me, but on the surface it has my attention.
Fed meeting on Tuesday and Wednesday, with rate decision Wednesday afternoon.
BofE is expected to raise rates by 0.25% on Thursday.
Tons of data – home sales, PCE, confidence, manufacturing, durable goods, etc.
All culminating with Friday’s job report.
Toss in the typical WH rhetoric and we should have a fun week.