Fed Sees No 2019 Hike, Plans September End to Asset Drawdown (Big, Bad Jay!)

“Big Bad Jay” Powell today announced today that there would be no more rate cuts in 2019 and balance sheet shrinking would halt in September.

Federal Reserve officials scaled back their projected interest-rate increases this year to zero and said they would end the drawdown of central bank bond holdings in September sending benchmark Treasury yields to the lowest level in more than a year and bolstering market bets on a rate cut in 2019.

The median rate projection of Fed officials compared with two hikes in the December forecasts, which spooked investors at the time. In its statement following a two-day meeting in Washington, the Federal Open Market Committee repeated January language that it will be “patient” amid “global economic and financial developments and muted inflation pressures.”

“Patient means that we see no need to rush to judgment,” Fed Chairman Jerome Powell said in a press conference after Wednesday’s decision. “It may be some time before the outlook for jobs and inflation calls clearly for a change in policy.”

The Fed’s signal that it will keep interest rates on hold for the full year reflects concerns that economic growth is slowing, lower energy prices are weighing on inflation and risks from abroad are dimming the outlook. The projections go further than the one-hike forecast analysis.

Here is today’s FOMC Dot Plot.

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Here is yesterday’s FOMC Dots Plot.

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On the announcement, 10-year US T-Notes yields dropped 7+ basis points.

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And the 2-year and 5-year Treasury Note yields are BELOW The Fed Funds Target Rate!

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Dot Plot Fever! Fed’s Dot Plot Detached From Market Pricing (Target Rate CUT More Likely Than Rate Increase)

The Federal Reserve may be suffering from “Dot Plot Fever.”

The Fed may need to lower the expected path of rate hikes (the “dot plot”) to satisfy equity markets, which appear to be pricing for less-hawkish monetary policy in the coming year. The S&P 500’s current multiple of about 18.5x trailing EPS implies slightly less than one 25-bp hike through the next 12 months, based on our fair-value model. Bond markets, measured by OIS and fed funds futures prices, appear to be expecting no change in the latter over that time.

If the Fed reduces expectations in-line with bond markets, equity markets would likely get a significant boost. Our fair-value model suggests the current level of two-year yield and yield-curve spread imply a market multiple closer to 20x.

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The financial market isn’t expecting any target rate increases, but a rate cut is in play for Q4 2019 and Q1 2020.

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Inflation, as measured by the US Federal Government, is rising and at its highest level in several years. But the 2-year Treasury Note yield continues to slide.

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The Fall And Rise Of Subprime Borrowers For Fannie Mae And Freddie Mac

Of course, non-bank lenders were the major participants in the subprime borrower / ALT-A fiasco of the mid 2000s. But both Fannie Mae and Freddie Mac did purchase mortgages to meet affordable housing goals and that included mortgage loans to borrowers with credit scores considered “subprime.” That is, FICO scores of 660 or lower.

In terms of volume, Freddie Mac had more subprime borrowers in 2005, but Fannie Mae has had higher subprime borrower’s mortgages since 2007 with a large peak in 2008.

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But as home prices rise and housing is progressively more unaffordable to the average American, the GSEs are under pressure to soften credit standards.

Yes, subprime borrower share of Fannie and Freddie fell, then rose again.

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Shilling: A Recession Is Coming, And Maybe a Bear Market, Too (Equities Normally Drop About 21% When The Economy Contract)

Shilling has an interesting Gary Shilling piece on Bloomberg on impending recessions and stock market declines. With a great photo of a bear waving!

The recessionary indicators are numerous. Tighter monetary policy by the Federal Reserve that the central bank now worries it may have overdone. The near-inversion in the Treasury yield curve. The swoon in stocks at the end of last year. Weaker housing activity. Soft consumer spending. The tiny 20,000 increase in February payrolls, compared to the 223,000 monthly average gain last year. Then there are the effects of the deteriorating European economies and decelerating growth in China as well as President Donald Trump’s ongoing trade war with that country.

There is, of course, a small chance of a soft landing such as in the mid-1990s. At that time, the Fed ended its interest-rate hiking cycle and cut the federal funds rate with no ensuing recession. By my count, the other 12 times the central bank restricted credit in the post-World War II era, a recession resulted.

It’s also possible that the current economic softening is temporary, but a revival would bring more Fed restraint. Policy makers want higher rates in order to have significant room to cut in the next recession, and the current 2.25 percent to 2.50 percent range doesn’t give them much leeway. The Fed also dislikes investors’ zeal for riskier assets, from hedge funds to private equity and leveraged loans, to say nothing of that rankest of rank speculations, Bitcoin. With a resumption in economic growth, a tight credit-induced recession would be postponed until 2020.

“Recession” conjures up specters of 2007-2009, the most severe business downturn since the 1930s in which the S&P 500 Index plunged 57 percent from its peak to its trough. The Fed raised its target rate from 1 percent in June 2004 to 5.25 percent in June 2006, but the main event was the financial crisis spawned by the collapse in the vastly-inflated subprime mortgage market.

Similarly, the central bank increased its policy rate from 4.75 percent in June 1999 to 6.5 percent in May 2000. Still, the mild 2001 recession that followed was principally driven by the collapse in the late 1990s dot-com bubble that pushed the tech-laden Nasdaq Composite Index down by a whopping 78 percent.

The 1973-1975 recession, the second deepest since the 1930s, resulted from the collapse in the early 1970s inflation hedge buying of excess inventories. That deflated the S&P 500 by 48.2 percent. The federal funds rate hike from 9 percent in February 1974 to 13 percent in July of that year was a minor contributor.

The remaining eight post-World War II recessions were not the result of major financial or economic excesses, but just the normal late economic cycle business and investor overconfidence. The average drop in the S&P 500 was 21.2 percent.

At present, I don’t see any major economic or financial bubbles that are just begging to be pricked. The only possibilities are excess debt among U.S. nonfinancial corporations and the heavy borrowing in dollars by emerging-market economies in the face of a rising greenback. Housing never fully recovered from the subprime mortgage debacle. The financial sector is still deleveraging in the wake of the financial crisis. Consumer debt remains substantial but well off its 2008 peak in relation to household income.

Consequently, the recession I foresee will probably be accompanied by about an average drop in stock prices. The S&P 500 fell 19.6 percent from Oct. 3 to Dec. 24, but the recovery since has almost eliminated that loss. A normal recession-related decline of 21.2 percent – meeting the definition of a bear market – from that Oct. 3 top would take it to 2,305, down about 18 percent from Friday’s close, but not much below the Christmas Eve low of 2,351.

Now here is an interesting chart from BofAML showing global equity returns over global IG bonds and The Fed Funds rate. For the moment, Global Equities/Global IG bond (total returns) are rising with The Fed rate increases. Interesting.

Exhibit-1 BofAML

BofAML’s chart does not support Shilling’s thesis. But it is because the BofAML chart focuses solely on The US Federal Reserve at a time where other major Central Banks are NOT tightening.

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Deutsche Bank + Commerzbank = Ogre Zombie Bank (Nothing Plus Nothing = Nothing)

What do you get when you merge German zombie Deutsche Bank and zombie Commerzbank? An ogre zombie bank!

Or as Billy Preston almost sang, “Nothing Plus Nothing Equals Nothing.”

Both Deutsche Bank and Commerzbank are trading at under $10 or 10 Euros per share. This is down from over $100 per share for Deutsche Bank in the 2000s and Commerzbank was trading at over 200 Euros as well. How the once mighty have fallen.

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Earning per share for Deutsche Bank have plummeted despite efforts to revamp their business model.

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The same goes for Commerzbank.

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While Commerzbank hasn’t issued any contingent collateral (CoCo) bonds, Deutsche Bank has issued 4 CoCo bonds. Here is the 6% CoCo bond. The good news? Both CDS and the yield to maturity (YTM) have been declining in 2019, likely reflecting the expected merger of the two.

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The downside? Merging two large zombie banks creates an “Ogre Zombie” bank. One that the ECB and German government cannot permit to fail.

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An Occurrence At The Federal Reserve: Increased SMART Money & Equity Volatility, Crushed Bond Volatility

Ambrose Bierce wrote a short story about a man being hanged during the American Civil War and what went through his mind in his final moments. It is called “An Occurrence At Owl Creek Bridge.” Hauntingly similar to today’s plight: overoptimistic expectations before being hung, then …. snap.

In summary., Ben Bernanke and The Federal Reserve entered the markets in 2008 in force. The Fed Funds Target rate was raised once during President Obama’s two terms as President, but eight times since President Trump’s election as President. Plus, The Fed’s Quantitative Tightening (in terms of its balance sheet) begin in earnest in 2019.

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Once The Fed hurled its monetary weight at the economy in 2008, the stock market had an amazing run. but since The Fed started to raise rates and began their balance sheet unwind, the S&P 500 index has increased in volatility as has the SMART Money Flow Index.

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The bond market volatility indices have gotten crushed by central banks.

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On the real estate front, equity REITs, like the small cap Russell equity indices, seemed to be benefit greatly from The Fed’s Zero Interest Rate Policy and QE. Mortgage REITs, on the other hand, kind of died with the financial crisis and never recovered. The RCA CPPI commercial real estate index too off like a missile.

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Like in the Ambrose Bierce short story “An Occurrence At Owl Creek Bridge,” The Fed and other central banks are quitting any attempts at rate normalization (for fear that they might hear that dreaded “snap” at the end of the monetary rope].

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Did The Federal Reserve Kill Off 10-Year Swaption Volatility? (Lowest Since 2005)

10-year Swaption volatility has sunk to the lowest level since 2005. Did The Federal Reserve provide too much liquidity for too long, effectively drowning bond volatility?

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The Fed’s lingering Target Rate near zero and its three rounds of asset purchases helped kill of bond volatiilty. And with rising Fed Target rate and balance sheet unwind (removing liquidity from markets) has pushed bond volatility to 2006-2007 levels.

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So, the answer is … YES!

(Vol has been) shot through the heart and The Fed’s to blame! The Fed gives central banks a.bad name.

Wipeout! US Department Store Sales Hit A New Record Low Since 1992 (Retail REIT And CMBS Alert!)

The US Commerce Department reported that Department stores are a “wipeout.”

E-commerce is wiping out brick and mortar stores are a rapid rate.

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At the same time, e-commerce sales are rising rapidly.

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It’s not the end of the world for bricks and mortar shopping. Consumers still eat at out at restaurants, use fitness clubs, bars, etc. But it does cause a rethinking of retail REIT and CMBS valuation and growth projections.

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MOVE 3-month Option Volatility Index Hits All-time Low (Bond Market Bernanke’d!)

The Merrill Lynch Option Volatility Estimate 3-Month has just hit an all-time low.

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The MOVE index is a yield curve weighted index of the normalized implied volatility on 3-month Treasury options. It is the weighted average of volatilities on the CT2, CT5, CT10, and CT30.

Even since Fed Chair Ben Bernanke started ZIRP and QE in 2008, continued by Janet Yellen, interest rate volatility has subsided to an all-time low under current Chairman Powell.

Not a great time for volatility traders!

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