The 2020 Rewards vs. Risks

These are the most unique of times. From articles of impeachment being sent to the Senate to the signing of the Phase 1 deal with China: we are witnessing history in the making. The House Speaker seized her moment this week, and shortly thereafter so too our President. We’ve really never seen anything like this. And the hope is we never do again. 

We always revert to markets. This week’s signing of the Phase 1 trade deal was a very symbolic event for both the United States and China. Whether you agree, disagree, like or not: This is the first President over decades and multiple parties to bring China to the table.

And now the difficult part for the markets: What does it really mean for the economy and Fed? And what the Fed means for the market in 2020 will be more difficult than last year to determine.

THE REWARDS

2019 was filled with a plethora of central bank liquidity. A ton. And clearly short term the Fed has been forced to step in for unanticipated events with the balance sheet expansion. In the end, we do believe economic outcomes matter this year. And thus far the data is coming in very strong in the United States.

US Housing Starts (2000-2020)

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Risk assets are off to a good start in 2020. We spent time toward the end of 2019 offering reasons why the backdrop for 2020 was a good one despite enormous returns for calendar year 2019.

But when you factor in the late 2018 market corrections across both equities and credit, things look good but less stellar. In other words, much of 2019 was spent recovering losses from 2018 (the Pivot).

S&P Chart 2018/2019

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In general, lots of questions this week about the short term momentum in risk assets across both equities and credit.

We Offer Some Thoughts

1) Multiple trade deals in place now: Much of 2018 and all of 2019 was about global trade. Clearly the largest negative for the market. Yet, risk assets were supported by extreme global central bank liquidity. This year we have central bank liquidity AND the potential for a much better trade scenario. 

2) Central banks are still friendly. The backdrop for liquidity heading into 2020 is still strong. That may change along the way in 2020, but for now it’s a positive force. 

3) The Fed is firmly on hold. And additionally, with forward guidance linked to the inflation outlook, investors are feeling confident of a long pause. The notion of the Fed letting inflation run above its target has the market thinking “lower for longer”. 

4) There is little yield and plenty of cash. The backdrop of flat to negative global yields is still a factor. This is impacting not only fixed income but also equities with dividend yields in equities in many cases higher than credit. 

5) The US data looks solid to start the year. The data across the board lately (retail sales, housing, employment) all looks good. Yesterday we had a very big jump in the Philly Fed manufacturing number and now expectations for a follow through with the ISM numbers. 

6) The Fed has been expanding its balance sheet. At a little over 4.1 Trillion, the Fed’s balance sheet is not that far from the post-crisis high. Granted, a good chunk of the increase was related to the hiccup in the funding markets, yet nonetheless the effective funds rate has been trading toward the lower end of the Fed’s 1.5-1.75% band and liquidity abundant.

S&P Versus The Fed’s Balance Sheet

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THE RISKS

It’s early in the year, but for now the markets have been able to shrug off some geopolitical risk and continue its march from 2019.

It’s interesting when looking at this year and potential risk factors though:

And we see two right now: The 2020 Election and the Fed

1) The 2020 election. Not only the outcome, but the emergence of a Democratic candidate with policies to the extreme of the current administration. Remember, Donald Trump was highly unlikely in 2016. We live in strange times.

2) The Fed: Should risk assets continue to move to extremes, a shift in tone from the Fed. We don’t expect the Fed to tighten anytime soon, but Dallas Fed Kaplan’s comments on the balance sheet this week should be noted. We’ve highlighted. This is not today’s trade but it’s on our radar and should be for investors too in our view.

Dallas Fed President Kaplan caught our eye this week. It’s interesting to us because in the Fall of 2018, it was a Powell interview with the Dallas Fed in which we first picked up on cracks in Powell’s stance on a continued move higher with the Fed Funds rate. The rest is history. 

This week, Kaplan issued a warning on the Fed’s balance sheet expansion. Not so much about the past, but the most recent move since September and the ensuing move in risk assets. We feel it’s worth noting. 

Kaplan this week: 

1) Kaplan: “Investors have perception bar is high for future hikes”

AmeriVet: Yes they do. Forward guidance on inflation (sustained and substantially above 2%). Market based indicators have turned lower. 

CNY- White DXY- Orange CT10- Green PCE- Purple CPI- Red

The last time the divide (PCE/CPI) was this wide was 2016. And a period we continue to revert back to. The convergence came in 2017 (lower), following a period of USD strength, extreme Yuan weakness and another bout of all-time lows in 10-year yields.

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2) Kaplan: “Recent moves gave investors (Funds rate AND balance sheet) “green light” to buy risky assets”

AmeriVet: see chart below

S&P, Fed’s Balance Sheet, CDS IG Index, 10-year UST and Gold (1990-2020)

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3) Kaplan: “Important we have a plan to wind down balance sheet”

AmeriVet: Fed hasn’t had a plan since the Fall of 2018 when it was moving in the wrong direction on the Fed Funds rate. 

The Fed’s in a bind. No market based solutions and too much supply from D.C. Simply swapping TOMO for POMO is not a plan. And the message on the balance sheet moves have not been forceful enough.

Fed’s Balance Sheet, S&P, Outstanding Treasury Debt and Debt to GDP

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In our interview with Fox last week, we indicated we thought the Fed’s work this year would be more to do with the balance sheet than the official rate (outright levels). Yet, once in a “good place” where the Fed has intimated it is (policy rate), the ample reserve framework matters in keeping the Fed Funds rate within its band and behaving appropriately. This, in conjunction with fine tuning its inflation posture relative to policy, will be the key themes of 2020 in our view. And also risk factors to the move in risk assets as we price to the most dovish of scenarios.

Central Bank policies globally have been the biggest and most influential factor with risk assets over the past 10 years. Rest assured there has already, and will continue to be, much chatter about the Fed and its balance sheet as we move forward in 2020. In a world of muted growth and inflation it will matter and especially where valuations sit across asset classes. 

At the top of the chain of the central bank policies: negative interest rate policies. Which, aside from the foreign markets, are having clear spillover with risk assets in the US. Of late, we have noted the correlation between risk assets and the Fed’s balance sheet expansion since September. It’s very high. And when relationships continue to get distorted there can be poor investment decisions made.

Our gut is telling us that the Fed will be increasingly under pressure (risk assets even higher) to fine tune the message on:

1) Ample Reserve (balance sheet)

2) Inflation: Substantial and Sustained. And what metric.

US RATES

The US rate market remains firmly within its range on the longer end of the curve. And with volatility on the move lower. In the end, tariffs are a winner for Treasury volatility and with a Fed on hold and the trade war subsiding, the price action has been muted.

ICE BOA Move Index (weighted average of Treasury implied volatility)

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We have been expressing our view regarding the yield curve (2/10): very directional. And with the Treasury Department announcing the reintroduction of the 20-year bond, the curve is steepening a bit today. Makes sense: the Fed is likely to keep reserve purchases further in the curve (not QE), while the Treasury will add long end duration. Even still, the yield curve similar to absolute levels is well within recent ranges.

Announcement from Treasury Department from last night:

https://home.treasury.gov/news/press-releases/sm878

The discussion about issuing longer dated paper is certainly not a new one. Globally we’ve seen the emergence of 50 and 100-year paper with rates low and the demand for yield high. In the US, the discussion of the same has been ongoing through multiple administrations. 

The decision seems sensible relative to some of the global issuance. The Treasury is always cognizant of liquidity, consistency and stability of auctions. From that perspective clearly a safer bet for Mnuchin. 20 year paper also fills a nice duration gap, and can be valued more seamlessly on the curve than 50 or 100-years.

From an absolute rate basis, US yields are still very attractive and the demand for US long end paper is strong. Additionally, corporate issuers will find the addition of 20-year paper more attractive than benchmarks beyond 30-years for potential future deals.

Have a great weekend!