US Bond Market Week in Review: Why The Fed Is About to Make A Mistake In Raising Rates

The consensus is the Fed will raise rates at their next meeting. The latest employment report all but baked this into the cake. However, I’m not so sure this is a good idea. First, there are three economic indicators – industrial production, corporate profits and bond yields – that signal we’re closer to the end of an expansion then the beginning. A rate hike in this environment may do more harm than good by adding additional counter-stimulus to the economy. Second, I believe the Fed mis-understands the current inflation dynamic. The hawks argue low oil prices are the primary reason for low inflation. However, I believe the ending of the commodity super-cycle is the real reason for weak inflation. If this is correct, low prices will persist for a longer period of time.

Industrial Production

Industrial production is one of four components of the Conference Board’s Coincident Economic Indicators. However, it has only been strongly positive in one of the last six months:

The problem started in the 1H13, when new orders for durable goods stopped rising. Save for a very large spike in mid-2014, this statistic has stalled at the 240,000 level since.

Next, industrial production peaked in December 2014 and has moved sideways since:

Thanks to the strong dollar and weaker emerging economies, new export orders for industrial goods are also weak:

And in the latest ISM manufacturing report, new orders dropped below 50, indicating manufacturing weakness is more widespread than just the oil sector:

The latest anecdotal comments from the ISM manufacturing report highlight the basic problems:

  • "The oil and gas industry is realizing that [the] ‘low’ oil prices are now the new reality with expectations to continue at this level for some time." (Petroleum & Coal Products)
  • "Still seeing deflation in raw materials." (Chemical Products)
  • "Bookings and new orders are lower than expected." (Computer & Electronic Products)
  • "Automotive remains strong." (Fabricated Metal Products)
  • "Business is still good." (Transportation Equipment)
  • "Downturn in China and European markets are negatively affecting our business." (Machinery)
  • "Strong dollar is slowing our sales to China as they can buy in Europe." (Primary Metals)
  • "Medical device continues to be strong." (Miscellaneous Manufacturing)
  • "Incoming orders have leveled off from the summer." (Furniture & Related Products)
  • "Month-over-month conditions are stable." (Food, Beverage & Tobacco Products)

The weak oil and gas market, strong dollar and weak emerging economies continue to weaken the sector. None of these factors is going away any time soon. Oil recently hit a seven year low, the dollar is strong thanks to the Fed rate hike and emerging economics are being hit by China’s slowdown.

Bond Yields

Over the last several weeks, I’ve noted that CCC and BBB bond yields have widened. In the case of CCC, the sell-off has been significant. As I previously noted:

There are several reasons for these developments. First, thanks to low oil prices, there’s been an increase in oil company defaults:

A slide in oil and commodity prices has weighed on smaller energy producers, primarily in the US, as big Opec producers continue pumping crude to maintain market share. In the US, about three-fifths of defaults in 2015 have been among energy and natural resources businesses, including Midstates Petroleum, SandRidge Energy and Patriot Coal.

But this isn’t the only sector hurting; weakness is rising overall:

After six years of easy-money central-bank policies kept over-leveraged companies afloat and left scant opportunities for traders who profit off the market’s scrap heaps, a rout in commodities prices in 2014 presented what had seemed like a perfect chance to buy again. Instead, those prices only declined further this year, causing the debt of everyone from oil drillers to coal miners to fall deeper into distress. As the losses intensified, gun-shy investors pulled back from almost anything that smacked of risk, spreading the losses to industries from retail to technology.

Perhaps the biggest potential problem is companies have allocated most of their newly acquired indebtedness to share buybacks:

Lower-rated credits are the bond market’s canary in the coalmine; they are the first group to sell-off at the end of an expansion. This is why the BAA yield is a long leading indicator.

Corporate Profits

From Bloomberg

Profits from S&P 500 companies have fallen by about $25 billion in the first three quarters of this year, and a further drop is expected before the end of 2015 as energy companies battle with lower oil prices and a sharp rally in the dollar hits exporters.

However, corporate profits have been growing slowly for a few years:

Also consider this chart from Ryan Detrick:

There are a number of reasons cited for this drop: weaker overseas markets, the strong dollar and weakness in the oil sector. Regardless of the reason, it appears corporations have having a difficult time increasing gross revenue. Corporate profits are also a long-leading indicator.

The nature of inflation’s weakness.

I wrote about this several weeks ago and am reprinting that article:

Several Fed President’s gave speeches this week. But the speeches offered by St. Louis President Bullard and Chicago Fed President Evans highlight the different perspectives held by the members of the open market committee. St. Louis President Bullard framed his discussion of the economy through the prism of “five questions,” for which he provided the italicized

1. What are the chances of a hard landing in China? The probability of a hard landing in China is no higher today than it was earlier this year.
2. Have U.S. financial market stress indicators worsened substantially? Financial stress today in the U.S. is not particularly high compared to the last five years.
3. Has the U.S. labor market returned to normal? U.S. labor markets have largely normalized.
4. What will the headline inflation rate be once the effects of the oil price shock dissipate? Oil price stabilization likely implies headline inflation will return to 2 percent in the U.S.
5. Will the U.S. dollar continue to gain value against rival currencies? Global policy divergence has already been priced into foreign exchange valuations.

Bullard’s analysis is somewhat superficial as there are strong rebuttals to several conclusions. Financial stress may be increasing for two interrelated reasons. First, as a result of Dodd-Frank, financial intermediaries are no longer inventorying corporate bonds, instead acting as brokers between buyers and sellers. This could be a problem if the market experiences a liquidity event. And the market may be closer to just that problem. CCC yields widened considerably over the last year, thanks to weakness in the oil sector. Baa yields recently joined them:

The Moody’s Baa index is just shy of the peak of 5.58 per cent in August 2013 near the end of the “taper tantrum”, when yields rose sharply as investors anticipated that the Fed would start winding down its asset purchases.

As for employment, if the sole metric used was the unemployment rate, one could argue the economy reached full employment. But broader measures of labor utilization such as U-6, labor force participation rate and people employed part-time for economic reasons still show high levels of slack, which weak wage growth confirms. Finally, Bullard argues oil is the primary reason for the drop in CPI. But according to the latest IEA estimate, demand and supply won’t be in balance until 2020, implying weak oil prices for an extended period of time.

But as Fed President Evans points out below, there is weakness over the entire commodities complex.

Chicago Fed President Evans offered a more nuanced outlook in his speech:

So what are these inflation risks? With prospects of slower growth in China and other emerging market economies, low energy and import prices could exert downward pressure on inflation longer than most anticipate.That’s a risk. In addition, while many survey-based measures of long-term inflation expectations have been relatively stable in recent years, we shouldn’t take them as confirmation that our 2 percent target is assured. In fact,some survey measures of inflation expectations have ticked down in the past year and a half. Furthermore, measures of inflation compensation derived from financial markets have moved quite low in recent months.These could reflect either lower expectations of inflation or a heightened concern over the nature of the economic conditions that will be associated with low inflation. Adding to my unease is anecdotal evidence: I talk to a wide range of business contacts, and virtually none of them are mentioning rising inflationary or cost pressures. No one is planning for higher inflation. My contacts just don’t expect it.

Evan’s observations assume the effects of the commodity super-cycle slowdown are broader than simply the drop in oil prices. Commodity markets are confirming this analysis; there is currently a broad sell-off in the oil, metals and agricultural markets as shown in this chart from Bloomberg:

The story observes:

The index is made up of 33 different underlying commodity futures that can be put together into different subgroups. Three important ones are Brent crude oil (which in turn represents other liquid fuels like West Texas Intermediate crude and gasoline), crops and industrial metals. Altogether, they represent 70 percent of the index and offer a rough barometer of economic and industrial health: how much people are burning, eating and hammering.

All three are down in price so far this month compared to October, as is the index overall. That is rare: Looked at monthly since the start of 1991, it has only happened 15 percent of the time, clustered mostly around three periods: the Asian crisis of the late 1990s, the global financial crisis, and the past year or so.

Evans also notes the strong dollar’s impact; because commodities are priced in dollars, a higher dollar means lower commodity prices. And not just for oil, but the entire complex. This trend will only accelerate if the Fed raises rates. In summation, Evans, like Fed President Brainard, offers a nuanced and complex mix of events that he argues will keep inflation weak for a prolonged period of time.

I believe Brainard and Evans are correct.


There is just enough weakness in two of the long-leading indicators and one coincident indicator to, at minimum, give the Fed pause. And the drop in the entire commodity complex as a direct result of Chinese rebalancing is the primary reason for weak inflation. In that case, a rate hike will add to deflationary pressure: the dollar will rise, adding downward pressure to all commodity prices. It is for these reasons that I believe a rate hike in the current environment is a mistake.

© Hale Stewart

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