US Bond Market Week in Review: Is the Fed Getting Inflation Wrong? Edition

Chairperson Yellen offered her assessment of the US economy in a speech to Economic Club of Washington. First, the good news. Growth, while moderate, is still positive, printing at 2%-2.5% for the first three quarters of 2015. And real final domestic purchases were over 3% in the 3Q. This tells us that consumers continue to spend and businesses are investing. Now the bad news:

Foreign economic growth has slowed, damping increases in U.S. exports, and the U.S. dollar has appreciated substantially since the middle of last year,making our exports more expensive and imported goods cheaper.

This weakness also plays into the weaker than desired inflation reading:

The stronger dollar has pushed down the prices of imported goods, placing temporary downward pressure on core inflation

And, despite unemployment rate’s drop to 5%, the labor market still has some slack, as evidenced by the low labor-force participation rate and weak wage growth.

Most importantly, she offered the following projections for growth:

I anticipate continued economic growth at a moderate pace that will be sufficient to generate additional increases in employment, further reductions in the remaining margins of labor market slack, and a rise in inflation to our 2 percent objective. I expect that the fundamental factors supporting domestic spending that I have enumerated today will continue to do so, while the drag from some of the factors that have been weighing on economic growth should begin to lessen next year. Although the economic outlook, as always, is uncertain, I currently see the risks to the outlook for economic activity and the labor market as very close to balanced.

The basis for her projections can be found in the FRBNY DSGE Model Forecast for November. Overall, she argues for continued moderate growth with a slight inflation increase over the next two years. Fed President Lacker agrees with this assessment.

Fed President Evans offers a more dovish view, primarily due to inflation weakness:

Now, I take seriously the view that I should go into every FOMC meeting with an open mind regarding the policy decision. And I will do so in our meeting two weeks from now. Should we raise rates or not? I admit to some nervousness about our upcoming decision. Before raising rates, I would prefer to have more confidence than I do today that inflation is indeed beginning to head higher. Given the current low level of core inflation, some evidence of true upward momentum in actual inflation would bolster my confidence. I am concerned, however, that it could be well into next year before the headwinds from lower energy prices and the stronger dollar dissipate enough so that we begin to see some sustained upward movement in core inflation.

Evans has strong support for his concern. Consider the following data points:

  1. The entire commodity complex is very weak.
  2. Gold is trading near a five year low.
  3. The 10-year TIPS spread is still low.
  4. The ISM reports have reported a large number of commodities declining in price.
  5. Oil traders see an oil glut through 2016 and into 2017.

And for the duration of this expansion, central banks have continually pushed out their inflation projections:

Looking at incoming data, I would say that data are more or less in line with our expectations. But this has to be seen in a context where we had repeatedly overestimated future inflation rates. In the last years, we have repeatedly lengthened the horizon over which we would get back close to 2 percent.

Mechanically updated projections suggest that the risk is present that we may again have to extend this horizon. And even if it's slightly, it's a repetition of a past pattern.

The two Fed camps’ arguments boil down to this: is weak energy the sole reason for low inflation? Or, is weakness across the entire commodity complex to blame? The former is the majority view. However, there is plenty of support for the latter argument – which I believe will wind up being the correct analysis.

News from the lower-rated credits continues to cause concern. Tony Wong at the Invesco Blog offered the following synopsis of the US investment grade, emerging market and junk bond markets (hat tip: Adviser Perspectives)

For most fixed income asset classes, the cycle has continued to advance toward the late cycle phase. Here are some notable highlights of markets in transition:

US investment grade. We see growing signs that US investment grade companies are in the late stages of the credit cycle.

Emerging markets (EM). Another market at an inflection point is EM, where the growth and operating environment is putting pressure on fundamentals, and corporations are managing the downturn with more defensive behavior such as reducing costs, managing down debt and limiting dividend payouts to shareholders.

High yield corporates. We are also monitoring the conditions of high yield corporates. We believe this asset class is marching towards late cycle phase,with financial conservatism fading and looming restructurings in parts of the commodity complex.

David Schawel, CFA made the same observation at the CFA Institute’s blog. Largely as a result of the weak energy sector, the junk bond market is seeing the highest level of distressed securities since 2009. And now the Chinese bond market is witnessing some levels of “froth.” And downgrades are hitting a post-crisis high:

More than $1tn in US corporate debt has been downgraded this year as defaults climb to post-crisis highs, underlining investor fears that the credit cycle has entered its final innings.

The figures, which will be lifted by downgrades on Wednesday evening that stripped four of the largest US banks of coveted A level ratings, have unnerved credit investors already skittish from a pop in volatility and sharp swings in bond prices.

Analysts with Standard & Poor’s, Moody’s and Fitch expect default rates to increase over the next 12 months, an inopportune time for Federal Reserve policymakers, who are expected to begin to tighten monetary policy in the coming weeks.

Overall, this is beginning to be a concerning development.

© Hale Stewart

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