by Neil Azous, Chief Investment Officer
- Federal Reserve – Our Track Record
- Our Approach to the Federal Reserve is Model Driven
- What Is Our Super-Forecasting Model Saying Currently?
- FOMC Meetings: March and April Only
- FOMC Meetings: March, April, June, July
- Economic Data Already Starting to Deteriorate
- Force Majeure Causes Near-Term Interest Rate Cuts
- What Does This Mean for Portfolio Construction?
- A Deep Dive into China…How We Are Thinking About It
Federal Reserve – Our Track Record
This is the track record of our posts regarding the Federal Reserve (“Fed”) easing cycle.
In our September 5, 2018, post “Yield Curve Inversion – What Does It Mean For Your Portfolio Right Now,” we said the Fed’s last interest rate hike for the cycle would be in December 2018. The roadmap we laid out advocated that the Fed would start cutting interest rates as soon as the summer of 2019.
Outcome: The last interest rate hike for the cycle was December 2018. The first interest rate cut was in July 2019.
In our February 19, 2019, post “The New Narrative For Lower Interest Rates,” we doubled-down on that view, reiterating that the US fixed income market continued to communicate that the Fed will likely be cutting interest rates by the end of the summer.
In our May 31, 2019 post “Fed Cutting Cycle – Our View Is Crystallized,” we illustrated that the US fixed income market was providing another key signal – when the cutting cycle will start (i.e., next three months) and end (i.e., Q4 2020-Q1 2021).
Outcome: The Fed cut interest rates at the July and September FOMC meetings.
In our September 25, 2019, post “Fed Cutting Cycle – The Next Evolution,” we provided supporting information that the mid-cycle adjustment was a false narrative, and the Fed was embarking on an easing cycle that should last well into 2020.
Outcome: The Fed cut interest rates at the October FOMC meeting.
After a brief pause, we believe there is the distinct possibility the Fed is set to restart cutting interest rates by June, if not sooner.
Our Approach to the Federal Reserve is Model Driven
We do not believe in “speech whispering” – that is, adopting a sympathetic view of the motives, needs, and desires of the Fed based on psychology. Nor do we place much value on predictive software that analyzes communications centered on how many times a word is used. Finally, we run far away from think tanks with former “Fed Insiders.” Why? Because these inputs are either qualitative or cannot be applied to an investment process. Instead, to remove human emotion and increase the odds of repeatability, we are model-driven. Specifically, we use probabilistic outcomes to guide portfolio construction.
It is important to know what the market anticipates happening in the future relative to current expectations. For example, a forecast of a Treasury yield is meaningless unless we know what that expectation is relative to the market’s, and how realistic it is that the path may evolve between now and then.
Using our super-forecasting model, we can recreate various scenarios that are priced into the US interest rate market. The ability to recreate the expectations embedded in the US Treasury yield curve with precision is a very powerful tool to determine the direction of interest rates, either higher or lower. Those conclusions are a critical component for our asset allocation decisions.
What Is Our Super-Forecasting Model Saying Currently?
The next four FOMC meetings are on March 18th, April 29th, June 10th, and July 29th.
Our super-forecasting model is saying the Fed will cut interest rates at least once between now and July. However, it is also revealing that the cut is backloaded during the period.
This is important to recognize because a shift to the cut being frontloaded during the period has significant ramifications for how much further interest rates could fall.
FOMC Meetings: March and April Only
The illustration shows the unconditional probabilities of an interest rate move “AT” a certain meeting.
The key takeaways for the March and April FOMC meetings are:
- The unconditional probability of an interest rate cut at the March FOMC meeting is in the mid-single digits.
- Note, this Wednesday will mark the four-week threshold leading up to the meeting. Historically, if the probability of a move is not at least 30% when that four-week threshold is reached, the Fed will not cut interest rates at that meeting as the outcome becomes binary – its either 0% or 100%.
- The unconditional probability of an interest rate cut at the April FOMC meeting is 24% or skewed towards more interest rate cuts building after the Fed skips acting at the March meeting.
- An interest rate cut is not front-loaded; the higher probabilities of a cut are in June or July.
FOMC Meetings: March, April, June, July
Next, what does our model output when you include the June and July FOMC meetings? It considers four potential outcomes, the probability of each outcome, and the reaction to that outcome in interest rates terms:
The key takeaways for all four meetings are:
- The market probability that the Fed remains on hold is 41%. Conversely, there is a 59% chance that the Fed cuts one or more times by the summer.
- If the Fed remains on hold until July, US Treasury yields likely to remain rangebound but with a bias back up towards the middle-to-higher end of this year’s range.
- If the Fed cuts interest rates once by July, US Treasury yields have incremental downside.
- If the Fed cuts interest rates two or three times by July, US Treasury yields will drop substantially.
- This outcome is now the most asymmetric.
Question: Now that our model has recreated the scenario analysis, the key question is what increases the odds of more than one cut by June/July, including increasing the probability of the first cut at the March/April FOMC?
Answer: The Fed declaring Force majeure on the pause in the interest rate cutting cycle because of China’s growth concerns.
Force Majeure Causes Near-Term Interest Rate Cuts
There is a historical precedent of the Fed using Chinese turbulence to justify a policy shift. Leading up to the September 2015 FOMC meeting, the market was priced for the Fed to raise interest rates. Following a surprise devaluation of the Chinese yuan in the prior month, Fed Chair, Janet Yellen, made comments that U.S. interest rates were kept on hold over concerns of China’s slowdown. From the September 2015 Fed statement, the following sentence was added to address the U-turn in the Committees thinking:
Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.
If the economic data deteriorates, we believe the Fed could declare Force majeure on the pause in the interest rate cutting cycle. Depending on the speed and degree of the deterioration, it could force the Fed’s hand to cut interest rates at the March or April FOMC meeting, which would lead to the bond market pricing in multiple cuts by July.
Force majeure – meaning “superior force” [China] and also known as “chance occurrence, unavoidable accident” [Coronavirus] – is a common clause in contracts that essentially frees both parties from liability or obligation [Phase 1 of trade deal] when an extraordinary event or circumstance beyond the control of the parties such as a war, strike, riot, crime, [deflation] or an event described by the legal term act of God (hurricane, flood, earthquake, volcanic eruption, etc.), prevents one or both parties from fulfilling their obligations [inflation] under the contract.
Economic Data Already Starting to Deteriorate
The first global data with insight into economic activity in February is now being released. For the first time, investors and the Fed can judge the initial economic fallout from the Coronavirus.
So far, the data is weaker than expected in Asia and Europe. Also, Apple Inc. (symbol: AAPL), warned Monday it may fail to meet this quarter’s sales guidance because of slower production and weaker demand.
Note, the data being released only captures the early stages of the virus’ impact. Therefore, the market has yet to discount that the results for the next period, when they are released in the second half of March, will be significantly worse because it covers the “guts” of the growth shock.
What Does This Mean for Portfolio Construction?
If the bond market begins to discount a larger fallout from the Coronavirus, instruments linked to US Treasury yields are not done going up in price.
If the Fed remains on hold until the summer because the rebound in China is faster than expected, and yields rise incrementally back up to the higher end of this year’s range, the total return of a fixed income holding will likely still be positive.
Our favored expression to capture any potential interest rate cuts from the Fed remains fixed income closed-end funds – they stand to benefit from either stable or lower financing costs.
A Deep Dive into China…How We Are Thinking About It
The following section is a detailed analysis of the current psychology regarding China.
Starting Point: This is the starting point for any discussion regarding China currently. There is no precedent for this virus. Past episodes of SARS, MERS, Ebola, etc. are no longer considered viable inputs to a model. Instead, because this is an “unknown unknown,” we must think in the abstract. Below are several color-coded examples. The conclusion is the same in each – that is, it’s bad.
Delayed Recovery: China accounts for 1/3rd of global growth and is the arbiter of the international cycle through four key channels – commodities, capital goods, integrated supply chains, and tourism. The prospect of a global recovery before the virus outbreak was low. The economic data was not confirming a synchronous upward recovery – all that happened was that growth stopped going down after 18 months. Despite a resolution last December, the trade war caused harm for a year and a half. China was understating growth during the SARS outbreak at the beginning of the century; it has been overstating growth over the last two years. Now, it is probable that China will report its first negative quarter of growth in over 30 years when it releases first-quarter official data. The majority of stimulus to offset this has not been implemented. China is holding back announcing it until the country reopens for business as it makes little sense to publicize it when the country is closed. A lack of pick-up already in the high-frequency data challenges assumptions that Chinese factories will quickly reopen. China is attempting to ramp up economic activity while containing the Coronavirus. That is hard to achieve simultaneously. They can’t have their cake and eat it too. This suggests growth forecasts will need to be revised downward again for the third time in as many weeks. A full return to normal for the “workshop of the world” is not expected now until early-March at best, which all but guarantees a recession in the first quarter even if China intentionally fails to report it. It is not too early to dismiss a “V-shaped” recovery in Q2 2020 and replace it with a “U” or “L” outcome in 2H 2020.
Temporary Disruption vs. Lasting Impact: It is one thing for a winter storm in the US to temporarily disrupt economic activity but something altogether different regarding death and martial law. Meaning, when it snows, you have the option to risk driving your all-wheel automobile to work. Conversely, when there is a virus and a military lockdown in China, your choice is potentially dying from illness or spending time in prison when leaving your residence. In a temporary dislocation, like a winter storm, economic activity continues, albeit at a slower pace. It is also given a free pass by investors because it has snowed since the dawn of time each winter. During these bouts, the narrative is always about a v-shaped recovery. In China’s case, 90% of foot-traffic has come to a grinding halt for almost three weeks, and it cannot be determined when normalcy will return. Lost manufacturing sales will not be easily regained like following a weather-related event where the rebuild effort following insurance claims and emergency government aid increases demand and activity. Sales from services during this period are permanently lost.
Banking System: A major delineation between a temporary and systemic issue is if it impacts the banking system. The losses to the banking system will be uneven. China compelled banks to lower interest rates and extend repayment options in the most impacted locations. Also, China will likely cover large banks with strong political ties. Conversely, the impact on smaller banks could be large and asymmetric. The default rate for private loans before the outbreak was in double digits. Once the country reopens, the damage to small bank balance sheets should be more severe without the protection of the Government, including the possibility of bank runs.
Behavioral Response: Prior to the outbreak of the Coronavirus, China’s questionable behavior on multiple fronts was being exposed with a more negative connotation then existed previously. Unfair trade, human rights abuse, Hong Kong, etc. all have faced increased scrutiny on the global stage. The notion that this event originated as a biomedical mishap, not from a human being exposed to an animal host, only adds to these concerns. We highlight this because the secondary effects, such as the behavioral response, also have a significant impact on the new level and durability of growth. Here is what we mean in practicality. For companies that import Chinese goods and are still struggling from the trade war, is this event the last straw to move their supply chain? For locals, what if it takes longer to return to key urban centers? Or, what if the consumer borrows less to buy real estate? The list could go on but expect behavioral psychology to weigh on growth at the margin.
If you are interested in learning more about how we use our Federal Reserve model to take advantage of lower interest rates in a portfolio or make asset allocation decisions, please call us at 203-539-6067 or email us at email@example.com.
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