US Bond Market Week In Review: Deconstructing Yellen, Edition

 In Bond Investing

US-bond-marketSubmitted by Hale Stewart via Seeking Alpha.

Fed Chair Yellen gave a very important speech this week. While she focused on domestic economic developments, there was also tremendous focus on international events and their potential negative impact on the US economy – a line of analysis championed by Fed President Brainard. Yellen’s latest speech indicates a far more international approach to monetary policy may be taking hold at the Fed.

Let’s start with Yellen’s assessment of the US economy:

“Readings on the U.S. economy since the turn of the year have been somewhat mixed. On the one hand, many indicators have been quite favorable. The labor market has added an average of almost 230,000 jobs a month over the past three months. In addition, the unemployment rate has edged down further, more people are joining the workforce as the prospects for finding jobs have improved, and the employment-to-population ratio has increased by almost 1/2 percentage point. Consumer spending appears to be expanding at a moderate pace, driven by solid income gains, improved household balance sheets, and the ongoing effects of the increases in wealth and declines in oil prices over the past few years. The housing market continues its gradual recovery, and fiscal policy at all levels of government is now modestly boosting economic activity after exerting a considerable drag in recent years.”

Employment is a clear bright spot for the US. Unemployment is 4.9%; the average duration of unemployment continues to move lower while the employment/population and participation ratio are inching higher. Weak wage gains – especially considering the expansion’s length — indicate slack still exists. But all things being equal, the employment situation is in decent shape. Consumer spending is also a bright spot. Personal consumption expenditures increased 2.4% in 4Q15, and rose .3% in real terms in the latest monthly report. However, consumption may be topping; real retail and food service sales (which are more sensitive to economic effects) stagnated since July.

“On the other hand, manufacturing and net exports have continued to be hard hit by slow global growth and the significant appreciation of the dollar since 2014. These same global developments have also weighed on business investment by limiting firms’ expected sales, thereby reducing their demand for capital goods; partly as a result, recent indicators of capital spending and business sentiment have been lackluster. In addition, business investment has been held down by the collapse in oil prices since late 2014, which is driving an ongoing steep decline in drilling activity. Low oil prices have also resulted in large-scale layoffs in the energy sector and adverse spillovers to output and employment in industries that support energy production.”

The three major manufacturing groups illustrate the industrial slowdown:

0.1 Industrial Produaction

Only non-industrial supplies increased since 2015. Materials (oil) declined last year while final products production stagnated. The weak oil market, strong dollar and weaker overseas economies are clearly hurting the industrial base.

Let’s turn to domestic investment and exports:

0.2. Statistic

The above table is from the BEAs online NIPA accounts. Total investment contracted in 2H15, falling .7% in 3Q15 and 1% in 4Q15. Structural and intellectual property investment declined in 2H15, while equipment added to the slowdown in 4Q15. Finally, goods exports declined in the 2H15, although overall exports only dropped in 4Q15.

 Overall, the above information shows a weakly expanding economy. While the US consumer continues to spend, business investment and exports are subtracting from economic activity. Yellen argues international events are a primary reason for this weakness, and it is those events that have forced the Fed to change their outlook:

“Looking forward however, we have to take into account the potential fallout from recent global economic and financial developments, which have been marked by bouts of turbulence since the turn of the year. For a time, equity prices were down sharply, oil traded at less than $30 per barrel, and many currencies were depreciating against the dollar.Although prices in these markets have since largely returned to where they stood at the start of the year, in other respects economic and financial conditions remain less favorable than they did back at the time of the December FOMC meeting. In particular, foreign economic growth now seems likely to be weaker this year than previously expected, and earnings expectations have declined. By themselves, these developments would tend to restrain U.S. economic activity. But those effects have been at least partially offset by downward revisions to market expectations for the federal funds rate that in turn have put downward pressure on longer-term interest rates, including mortgage rates, thereby helping to support spending. For these reasons, I anticipate that the overall fallout for the U.S. economy from global market developments since the start of the year will most likely belimited, although this assessment is subject to considerable uncertainty.”

This is a fascinating paragraph. Usually, the Fed ignores short-term market gyrations, instead relying on the economy’s general tendency to return to the mean. But the Chinese sell-off that started the year — and its accompanying global fallout – clearly spooked the Fed. One of the reason is it indicates the Chinese economic rebalancing act, may not go as smoothly as desired:

“One concern pertains to the pace of global growth, which is importantly influenced by developments in China. There is a consensus that China’s economy will slow in the coming years as it transitions away from investment toward consumption and from exports toward domestic sources of growth. There is much uncertainty, however, about how smoothly this transition will proceed and about the policy framework in place to manage any financial disruptions that might accompany it.These uncertainties were heightened by market confusion earlier this year over China’s exchange rate policy.”

And there is also the possible negative ramifications from oil prices if they stay too low for too long:

“A second concern relates to the prospects for commodity prices, particularly oil. For the United States, low oil prices, on net, likely will boost spending and economic activity over the next few years because we are still a major oil importer. But the apparent negative reaction of financial markets to recent declines in oil prices may in part reflect market concern that the price of oil was nearing a financial tipping point for some countries and energy firms. In the case of countries reliant on oil exports, the result might be a sharp cutback in government spending; for energy-related firms, it could entail significant financial strains and increased layoffs. In the event oil prices were to fall again, either development could have adverse spillover effects tothe rest of the global economy.”

Again Yellen is focusing on the negative international impact of low oil prices. To that, consider the following:

  1. Oil’s price drop negatively impacted Saudi Arabia’s national budget and several major Saudi companies.
  2. Venezuela – which was an overall mess before oil’s price drop – is hurting more thanks to low oil prices
  3. Russia and Brazil are in a recession.
  4. Global trade was at one of its lowest levels in 2015

Bloomberg offered an excellent summary of Yellen’s speech.

“Fed Chair Janet Yellen’s speech at the Economic Club of New York on Tuesday reinforced that the central bank places a great weight on these market and international variables-and Deutsche Bank AG Chief International Economist Torsten Slok has a chart that shows just how worried the Fed is about the rest of the world.”

 To that, they added this excellent chart:
0.3 Specific words

While the Fed may not know the specific transmission mechanism, they are clearly concerned international weakness will negatively impact the US economy.

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Sergey Sanko
Sergey had started an IncomeClub after years of being an investment advisor for high affluent investors and managing fixed income securities. He is the lead investment advisor representative and holds a Series 65 license. Sergey earned his Executive MBA degree from Antwerp Management School.
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