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The Never Ending Fed Merry Go Round

The bulls have been watching the stock market rise without many corrections over the past seven

years. In fact, the market has not had a significant decline since this bull market started in March

of 2009. Clearly, the reason for such an extended equity rise was due to the Fed pumping in

enormous amounts of money into the financial system. In doing so, U.S. monetary policy has

distorted and inflated the price of stocks, bonds and anything else that trades, including precious

art, residential and commercial real estate. In other words, the market is not the economy.

This nonsensical monetary stimulation policy was not limited to the U.S. The rest of the world

followed the U.S. as well as Japan, who has been doing a similar monetary policy for the past 27

years with virtually no success. As we have noted in prior articles, the Bank of Japan has just

recently decided to use negative interest rates to stimulate their economy. Negative interest rates

are also being used by the European Central Bank in order to boost a stagnating European

economy. In China, though rates are not negative, the People’s Bank of China (PBOC) has

“doubled down” and added huge amounts of debt over the past seven years. In fact, the

government debt has grown to 243% of GDP over the last seven years. But, as noted time and

time in this space, none of this has worked in stimulating real economic growth in the U.S. or

around the world.

As frequent readers have heard from me (maybe too many times), I have been extremely critical

of Central Banks and their “experimental” policies and the “unintended consequences” that

may occur from these policies. Consider the following “unintended consequences” of the Fed’s

“experiments:”

Debt is future consumption denied. Bringing future demand forward by lowering interest

rates to zero just digs a gigantic hole in future demand. Funny thing, the future eventually

becomes the present, and instead of a brief recession of low demand we get an extended

recession of weak demand and over-indebted households and enterprises. Sound familiar?

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Enabling and sponsoring massive systemic speculation is reckless and destructive. Capital is no longer allocated on productive returns (i.e. real investment), but on the

speculative gains to be reaped with the Fed's free money for Wall Street. You would have

thought the bubble building central bankers would have realized this by now.

Buying assets to artificially prop up markets completely distorts the markets' ability to

price assets based on real returns and real risk. If you have not already noticed, we no

longer have free capital markets. Rather, the 12 people in the Eccles building are planning

the markets/economy and the winners and losers. (Reminds me of the USSR Politburo).

As James Grant so perfectly and succinctly summarized:

“Future citizens will reflect on this so-called PhD standard (that runs the world) with the

following realization:

"My generation gave former tenured economics professors discretionary authority to

fabricate money and to fix interest rates... We put the cart of asset prices before the horse

of enterprise… We entertained the fantasy that high asset prices made for prosperity,

rather than the other way around.”

Let’s cut to the chase. The Fed's entire policy boils down to a tsunami of debt. The whole point

of ultra-low interest rates is obviously to induce households to borrow and spend, and thereby

trigger a virtuous cycle of rising demand, increasing production, more jobs and income and even

more consumer spending. That’s Keynes 101.

But it is not working. In the U.S. we have now had 90 straight months of virtually zero interest

rates and the Fed’s balance sheet has been expanded by $3.5 trillion. No one would or could

argue that these policies are NOT extreme!

And what are the fruits of these extreme policies? We are now in month 83 of the

WEAKEST ECONOMIC recovery EVER in the storied history of the U.S. And household

income is still 5% below its level in the fall of 2007. Sadly, there are still 45 million people on

food stamps – one out of every seven Americans. But yes, the stock market is trading close to

all-time record highs.

So something doesn’t add up to put it kindly. The truth is the Fed’s entire radical regime of ZIRP

and QE has not “stimulated” the struggling main street economy. Instead, it has showered Wall

Street speculators with trillions of windfall gains.

“Monetary stimulus is a one-time parlor trick. It only works when there is business and

household balance sheet space left to leverage, thereby permitting spending derived from

current production and income in the manner of Say’s Law to be boosted with spending

derived from incremental borrowings.

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Under conditions of peak debt, therefore, the Keynesian credit magic ceases to

‘stimulate’ the main street economy. Instead, it never leaves the canyons of Wall Street,

where it cycles in an incendiary spiral of leveraged speculation and the

systematic inflation of financial assets.” – David Stockman (Former OMB Director)

The Story of Three Bubbles

One way to observe the effects of Fed-induced yield seeking speculation is to look at the graph

below, which shows household net worth (wealth) as a percent of personal disposable

income. If history is any guide, the graph deserves special attention because of what it seems to

imply for the markets and economy going forward.

The Story of Three Bubbles

Let’s review the three Fed induced bubbles since 2000.

Bubble #1: Household net worth as a percent of disposable income increased dramatically in the

mid-1990s. The first rise in household wealth ended because of the bursting of what is known as

the Dot.com bubble. Its collapse precipitated the 2000 recession.

Bubble #2: Household wealth as a percent of disposable income rose quickly, increasing by

125% from 2002 to 2006 only to collapse again precipitating the 2007 – 2009 Great Recession.

With the helping hand of the Alan Greenspan’s Federal Reserve, the large increase in household

wealth was largely driven by rising equity prices and an equally large and, as it turned out,

unsustainable rise in house prices. Not surprisingly, house prices and household net worth both

peaked in 2006.

Bubble #3: Once again, household net worth has increased dramatically. Since the end of 2012 it

has increasing by nearly 100% to 640% of disposable income. This is scary; not just because

it is an incredibly large rise in wealth in a short period of time, but because we all know what

followed in the past two bubble cycles. The bubble burst with very bad consequences for the real

economy.

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Now, an optimist could argue that a high value of financial assets relative to disposable income

is actually a good thing. They might say that rising financial assets reflects increased saving by

households. Unfortunately (as shown below), since 2000 saving as a fraction of household

income has plunged to half the savings rate observed in the previous half-century. Americans are

saving less not more! A realist would state that the elevated (artificial) level of financial

assets reflects extreme valuations, not an increase in the rate of savings or investment. Thank you Ben and Janet!

Savings has Fallen!

Life after QE

“We frontloaded a tremendous market rally to create a wealth effect... The Federal Reserve is

a giant weapon that has no ammunition left.” – Former Dallas Fed President Richard Fisher

If you have attended a CFO roundtable or a webinar over the past 12 months, one of the slides I

frequently show is the correlation between Quantitative Easing (QE) and stock market (S&P

500) performance. As you can quickly glean from the following graph (courtesy of Merrill

Lynch), when QE programs (QE1, QE2, Operation Twist and QE3) were in effect the stock

market rose steadily, but

when the QE programs

stopped a funny thing

happened. The stock market

went down.

The long term results tell the

story. During QE operations,

equity markets rose a

cumulative 176% from

December 2008 through

October 2014.

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And when the QE programs were halted (even for brief periods – see “gray” shaded areas) the

equity markets declined a cumulative 55% over the same periods! In other words, once the

steroids are removed the market traded to economic reality.

Academics often say a correlation is not necessarily causation, but to this spectator it tells me

everything I need to know about why the market is where it is today. To be blunt, the stock

market is where it is today because of the Fed’s reckless “bubble building” monetary policies

designed to create a wealth effect and stimulate consumption.

As shown in the following graph, despite a couple of 10% downdrafts, without the Feds ‘pixie

dust’ the S&P50 has remained virtually unchanged over the past 18 months since the Fed ended

QE3 in October 2014. Also, unlike the QE era, the past 18 months were punctuated with sharp

volatile slides. As you can glean from the graph below, equities peaked in December, ahead of

the Fed’s initial liftoff in its short-term rate target to the current 0.25% to 0.5%. But equities

declined after global markets swooned, along with the strong dollar, falling oil, and other

commodities, and the widening of credit spreads. Then, when Fed officials began to back off

from calls for as many as four rate hikes this year, risk markets rallied from their February lows.

More recently, the blue chips have ebbed and flowed like the tide unable to reach new highs.

The Equity Markets are Addicted to QE

The Never Ending Fed Merry Go Round

Importantly, recessions are not the driver of financial markets, but it is the market that ultimately

drives recessions. This is why the Federal Reserve is so focused on keeping asset prices elevated

in order to mitigate a loss of consumer confidence and consumption, which would push the

economy into a recession.

Because of this, the Fed will have a difficult time in reversing their extremely loose monetary

policy. Every time they have tried to reverse it, the stock market drops, and now they are scared

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to death of trying to raise rates again after the decline the market took in January, not long after

the first rate hike in December.

Yet, the Fed minutes last week highlighted a committee that continues to want to raise rates

whenever they can push it through. However, what normally happens after such hawkishness in

the current environment is either the data doesn't ever quite get there for them to pull the trigger

or the global market takes fright by enough for them to have to postpone their plan. I'm not sure

this time is any different. (See diagram below.)

With that said – the probability of a June hike has moved from 4% to 32% after the Federal Open

Market Committee minutes. Fed funds futures contracts further out in the year have also seen a

reasonable re-pricing. The probability of a July move is now up to 47% from 28% just prior to

the minutes and 19% on Monday, while a move by December has gone from 56% at the start of

the week to 65% on Tuesday and to 75% post meeting.

While it’s encouraging that the Federal Reserve wants to get out of “the Japanese trap” of the

“addiction to free money,” the timing is far from ideal: Another rate hike at the same time U.S.

growth is running below 2%, corporate earnings are falling, manufacturing is flat-lining, and

valuations for both bonds and stocks are still very overvalued is a potentially toxic mix.

The Never Ending Fed Merry Go Round

If the Fed decides to raise rates at this time, while most other central banks continue their

stimulus plans, the results could be disastrous. If the Fed does move this year, it could drive short

term rates higher, the U.S. dollar higher and the stock market lower.

Fed Threatens Rate Hike

Markets Tank

Fed Delays Hike

Markets Recover

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If I am correct, and the stock market drops sharply after the first hike, I suspect they will make

the first hike the last hike for the year. In fact, if they really fear the market as much as I think

they do, they could even go back to QE-4. But, in my opinion, if they do the investors will not

continue to be the Fed’s flunkies any longer and the market will still fall sharply knowing there

is no way out of this mess.

The Flattening Yield Curve

Last week, Bloomberg noted the two-year yield rose, stating that it “surged 13 basis points this

week, the biggest climb since the week ended November 6. The 10-year note yield rose 14 basis

points this week, also the most since November.” Oh My! It’s pretty amazing that the biggest

weekly bond selloff in half a year is a measly 14 basis points. The yield on the long bond rose a

trivial three basis points.

Remember: 2016 was the year when, in the aftermath of the Fed's first tightening cycle in a

decade, the yield curve was supposed to not only rise substantially, but also steepen, providing a

much needed boost to net interest margins (NIMs) credit unions and banks. That has not

happened, and as a result of the Fed's relent (according to which the Fed will no longer hike four

times in 2016, but at least two, and according to the market zero), yields have tumbled on the

long end of the yield curve as the yield curve has steadily flattened.

In fact, flattening has been the operative condition going all the way back to late 2013. In

particular, the spread between the two-year and 10-year Treasury has dipped to its lowest level

since 2007 and is presently trading in the mid-90 basis points range. Given that a curve

narrower than 100 basis points has correctly signaled three out of the past four recessions;

it is fair to pay attention to what ‘Mr. Market’ thinks.

Flat Yield Curve Portends Slow Growth

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The actual yield curve action is recessionary-looking. If the economy was truly strengthening,

the long end of the curve would be rising far faster than the short end as more hikes get priced in.

If the Fed manages to get in a couple hikes (I am still extremely skeptical), the already

compressed yield curve is likely to get flatter and flatter.

And a flat yield curve is not conducive to increased bank lending or bank profits.

In addition to rates, equities, currencies and commodities have been the most impacted by the

Fed's recently hawkish rhetoric. The Dow has seen several 100+ point days, both up and down

over the past week. Oil has shown encouraging signs, rising 8% over the past week, although its

gains have not translated to other commodities.

Most important, I have often cited the stronger U.S. dollar as one of the biggest challenges facing

the Fed. In addition to its role in trade, the U.S. dollar also affects emerging markets sovereigns

and corporates (which issue debt in US Dollars) with tightening credit conditions in the US

having an immediate impact on their local economies. The bottom line is the Fed drives the

dollar; the dollar doesn’t drive the Fed. If the Fed hikes aggressively, the dollar will rise and all

markets (commodities, equities and bonds) will adjust accordingly.

The Last Resort

At present, there is about $39 trillion of outstanding G10 government debt. Negative yielding

debt accounts for 35% ($9 trillion) of all G10 debt. On the other hand, the U.S. accounts for

almost 60% of all positive-yielding debt and 89% of the positive yielding debt which has a

maturity of less than one year. Also, U.S. debt accounts for 74% of the positive yielding G10

debt in the one- to five-year sector.

Thus, given that the U.S. dollar denominated debt is still extremely attractive vs. most high grade

sovereign debt; I expect an increase in demand from foreign investors that are seeking refuge

from a negative rate environment. This trend would be further strengthened with a rising dollar.

In other words, the U.S. is truly the last resort. The world cannot essentially find yield anywhere

else.

Where are they supposed to turn? Long story short, Treasury rates are not going up any time

soon with the one caveat that the Fed goes rogue and raises rates much more aggressively than

the market has priced in.

Election 2016

As poll after poll indicates “the Donald” continues to gain ground on Hillary. The Trump

campaign will need to convince more independents to come to his side by the fall. The key to

this is can Trump convince those unhappy Sanders supporters that Clinton is nothing but the

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status quo, figuring that they don't want to see her in office? In other words, a vote for Trump

would at least be a vote for an outsider who will not be afraid to shake things up.

The Silver Lining

At any rate, we now have our candidates for the Democratic and Republican parties. I personally

expect that as the Democrats continue to turn on its own party members; Trump will enjoy a nice

gain in support at least from many Sanders supporters who are irate that they are not being heard

over the ever important "Superdelegate" voices that Hillary covets so much. And of course,

Trump isn't wasting any time adding fuel to that fire.

Superdelegates

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Market Outlook and Portfolio Strategy

With the economy now more than 83 month into an expansion, which is long by historical

standards (average recoveries last 61 months), the question for you to answer is:

Are we closer to an economic recession or a continued expansion?

Your answer should have a significant impact on your investment outlook as financial markets

tend to lose roughly 30%-40% on average during recessionary periods. However, with margin

debt at record levels, revenues and earnings deteriorating and interest rate spreads narrowing,

this is hardly a normal market environment within which we are currently invested.

Let’s take a step back. Given the plethora of commentary strongly suggesting that the U.S.

economy is nowhere near recession, I thought it was time to revisit some key economic themes

as the backdrop against expectations for stronger economic growth, rising inflationary pressures

and an increase in interest rates and expectations.

This is how I see the macro landscape:

1. U.S. growth continues to slow. Remember it’s the “rate of change” not the absolute level

of growth that matters. And growth has been trending lower. Nominal GDP growth could

slow to a 2.5 - 2.8% range for the year. The slower pace in nominal GDP would continue

the 2014-15 pattern, when the rate of rise in nominal GDP decelerated from 3.9% to 3.1%.

2. U.S. consumption and employment growth slowing are more important to the Fed than

CPI. At +2% year-over-year, the latest jobless claims report was the first year-over-year

acceleration to positive since 2012. Prior to 2012, you’d have to go back to 2007 to find

the last time claims were rising.

3. Long term yields have declined significantly year-to-date, and the Treasury 10s-2s spread

compressing to new cycle lows is not exactly a bullish indicator. The resulting flattening

of the yield curve sends a signal of slowing economic growth, Michael Darda, chief

economist and market strategist at MKM Partners, points out. Fed officials appear to

believe the opposite, which is contrary to 160 years of data, he observes. Who’s right?

Mr. Market or the Fed?

4. U.S. inflation is reflating from deflationary lows – that’s not to be confused with a

breakout of hyperinflation. Slow top line growth suggests that spurts in inflation will

simply reduce real GDP growth and thus be transitory in nature.

5. If the Fed raises rates (June) into this slow-down, they’ll be the catalyst for a stronger U.S.

dollar and deflation (lower yields) again.

In conclusion, if Yellen and Co. hikes for the sake of hiking, she’ll truly prove that she’s not

politically tied to the Democrat party. Then again, she’ll probably blow up the commodity, stock,

and bond markets all at once right before the election.

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Over the next few months there will likely be increased uncertainty surrounding Fed policy and

VOLATILITY will remain HIGHER than NORMAL. And undoubtedly, there could be sharp

moves higher and lower. Our recommendation in dealing with this increased volatility is to

capitalize on periods of weakness (rising rates). Buy the dips. Try to avoid chasing short term

rallies.

Overall, from a longer term perspective, we advocate a fully invested profile consistent within

the risk appropriate framework of each credit union. Maintaining an “agnostic interest rate”

ladder strategy remains a simple yet prudent approach to investing in today’s new normal

environment.

In terms of sectors we continue to favor being on the “yield side of the trade” by diversifying

into select high quality, short duration bank notes. As we have highlighted for quite some

time, banknotes currently provide a significant yield and income advantage over comparable

short duration Agency bullets. Over the past two months, we have seen increased interest in

banknotes from credit unions and we expect that trend to continue as credit unions diversify their

investment portfolios with the ultimate goal of optimizing income.

Credit unions open to active management (sector rotation or security swaps) may want to explore

swapping out of short Agency bullets (booking gains) and investing proceeds in comparable

duration banknotes. Finally, floating rate bank notes are also quite attractive for those credit

unions that are concerned that rates will be rising or have balance sheet risk exposure to rising

rates. It should be noted that bank notes, unlike many floaters, do not have CAPs. As such, the

floating rate will adjust as the benchmark (LIBOR, T-Bills) rate rises.

Bank Note Yields vs. Agency Notes

Bank Notes Agency Bullet Yield Pick-Up

1Year 1.18% 0.69 % 0.49%

2Year 1.56 0.85 0.71

3Year 1.88 0.98 0.90

4Year 2.13 1.10 1.03

5Year 2.36 1.35 1.01

For more information on bank notes please click here for an article on Bank Note article and/or

contact your Institutional Fixed Income Representative.

In terms of relative value, please click here for the Relative Value Analysis.

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More Information

For more information about credit union investment strategy, portfolio allocation and security

selection, please contact the author at tom.slefinger@balancesheetsolutions.org or (800) 782-

2431, ext. 2753.

Tom Slefinger, Senior Vice President, Director of Institutional Fixed Income Sales, and

Registered Representative of ISI, has more than 30 years of fixed income portfolio management

experience. He has developed and successfully managed various high profile domestic and

global fixed income mutual funds. Tom has extensive expertise in trading and managing virtually

all types of domestic and foreign fixed income securities, foreign exchange and derivatives in

institutional environments.

At Balance Sheet Solutions, Tom is responsible for developing and managing operations associated

with institutional fixed income sales. In addition to providing strategic direction, Tom is heavily

involved in analyzing portfolios, developing investment portfolio strategies and identifying

appropriate sectors and securities with the ultimate goal of optimizing investment portfolio

performance at the credit union level.

Information contained herein is prepared by ISI Registered Representatives for general circulation and is distributed for general

information only. This information does not consider the specific investment objectives, financial situations or particular needs of

any specific individual or organization that may receive this report. Neither the information nor any opinion expressed constitutes

an offer, or an invitation to make an offer, to buy or sell any securities. All opinions, prices, and yields contained herein are

subject to change without notice. Investors should understand that statements regarding future prospects might not be realized.

Please contact Balance Sheet Solutions to discuss your specific situation and objectives.