Economy

Highlights Duration: The Fed will need to see further significant tightening in broad indexes of financial conditions before backing away from its +25 bps per quarter rate hike pace. With only 54 bps of rate hikes priced into the curve for the next 12 months, investors should maintain below-benchmark portfolio duration. Credit Spreads: A likely deceleration in U.S. economic growth during the next few quarters is a near-term risk for credit spreads, while waning demand for C&I loans could signal that the market's default outlook is too benign. We see a high risk of spread widening during the next few months, and would advocate only a neutral allocation to spread product on a 6-12 month horizon. TIPS: Breakeven inflation rates remain low because investors are much less fearful of high inflation than in the past. This will change over time as inflation continues to print near the Fed's target and expectations slowly shift to price more two-way risk into the inflation market. Remain overweight TIPS versus nominal Treasuries on a 6-12 month investment horizon. Feature More Pain Required Fed Chairman Jerome Powell spoke at the Dallas Fed last week, amidst some expectation that he might try to assuage financial market concerns about the pace of monetary tightening. Instead, the Chairman struck a balanced tone that the market took as slightly dovish. A rate hike next month remains fully discounted, but investors are now split on whether the Fed will move again in March (Chart 1). The April 2019 fed funds futures contract implies a funds rate of 2.525% by next April, just barely above the lower-end of the 2.5% - 2.75% target band consistent with two more rate hikes. Chart 1Markets Doubt The Gradual Pace Of Hikes Chairman Powell's remarks did not alter our view of the Fed's reaction function, which we expect will result in continued quarterly rate hikes until a preponderance of evidence is consistent with a significant slow-down in U.S. economic activity. As we discussed in last week's report, it is highly likely that the combination of a waning fiscal impulse and a stronger U.S. dollar will cause U.S. growth to slow during the next few quarters.1 What remains uncertain is whether the slow-down will be severe enough for the Fed to pause its +25 bps per quarter tightening cycle. With only 54 bps of rate hikes priced into the yield curve for the next 12 months, we are inclined to maintain below-benchmark portfolio duration on a 6-12 month investment horizon. However, we do not anticipate a significant move higher in yields during the next few months. We also think credit spreads can widen further in the near-term as growth slows, and we recommend only a neutral allocation to spread product versus Treasuries on a 6-12 month horizon, given the less attractive risk/reward trade-off in corporate credit. Another reason to get defensive on credit spreads before increasing portfolio duration is that further spread widening and tighter financial conditions are likely a necessary pre-condition for the Fed to slow its pace of rate hikes. Chairman Powell noted last week that financial conditions are an important input to the Fed's assessment of future economic growth, and also stressed that the Fed takes a broad view of financial conditions - encompassing not just the stock market but also the level of rates, credit spreads and other factors. With that in mind, we observe that there has been very little tightening in broad indexes of financial conditions during the past few months. In fact, the Chicago Fed's National Financial Conditions Index shows that financial conditions remain far more accommodative than when the Fed started hiking rates in December 2015 (Chart 2). Chart 2More Pain Needed For The Fed To Pause We conclude that much more financial market pain will be required before the Fed takes a dovish turn. As such, we are inclined to get more defensive with respect to credit, but to remain bearish on rates for now. Last week's release of the Fed's Senior Loan Officer Survey provided one more negative datapoint for corporate credit. While banks continue to ease standards on commercial & industrial loans, respondents reported that demand for such loans waned during the past three months (Chart 3). If the demand slow-down continues, then lending standards will eventually start to tighten and we will see more corporate defaults. For now, the slow-down in loan demand is a tentative signal that could be reversed next quarter, but it bears close monitoring as a potential warning that we are moving into the late stages of the credit cycle. Stay tuned. Chart 3Tighter Lending Standards Ahead? Bottom Line: U.S. economic growth will decelerate from a high level during the next few quarters, but the Fed will need to see further significant tightening in broad indexes of financial conditions before backing away from its +25 bps per quarter rate hike pace. Investors should get more defensive on credit spreads, but maintain below-benchmark duration. Stick With TIPS We have been recommending overweight positions in TIPS versus nominal Treasuries for some time, targeting a range of 2.3% to 2.5% for both the 10-year and 5-year/5-year forward TIPS breakeven inflation rates. This range is consistent with prior periods when core inflation was well-anchored around the Fed's target.2 This recommendation suffered a set-back last week when long-maturity breakevens finally capitulated to the trend in other financial market indicators that have been pointing to weakness in global demand for several months (Chart 4). In fact, for most of this year falling commodity prices and a strengthening dollar have been signaling that global demand is on the decline. But until last week, TIPS breakevens had mostly bucked the trend. Chart 4Held Down By Global Demand The reason is that long-maturity TIPS breakeven inflation rates remain under the influence of two competing forces. Signals of waning global demand on the one hand, and rapidly rising U.S. inflation on the other. Last December, the 12-month rate of change in core PCE inflation stood at 1.64%. As of September it stands at 1.97%, within a hair of the Fed's 2% target. Likewise, year-over-year core CPI inflation has increased from 1.76% as of last December to 2.15% as of October. Survey measures of realized and expected price changes have similarly strengthened (Chart 5). Chart 5Pulled Up By U.S. Inflation The combination of strong U.S. inflation and waning global growth has left long-dated breakevens relatively trendless for most of the year. And although we think year-over-year U.S. core inflation will flatten-off during the next few months (see Box), we would remain overweight TIPS versus nominal Treasuries on a 6-12 month investment horizon. BOX Core Inflation: Grappling With Base Effects Year-over-year core CPI inflation was 2.15% in October, down slightly from 2.17% in September. Meanwhile, our Base Effects Indicator ticked up from 3 to 4 but it remains below the critical 5.5 level (Chart 6). Chart 6Expect Year-Over-Year Core CPI To Flatten-Off In our Weekly Report from September 4, 2018, we showed that when our Base Effects Indicator - an indicator derived from near-term rates of change in core CPI - is below 5.5, 12-month core inflation is much more likely to fall than rise during the next six months. While pipeline inflation measures and the tightness of the labor market both suggest that the uptrend in core inflation will remain intact, we expect that year-over-year core inflation will flatten-off during the next six months, at levels close to the Fed's target. Our view is that as long as inflation remains sufficiently close to the Fed's target, over time, investors will start to price two-way risk back into the inflation market. It simply takes time for expectations to fully adapt to the new economic reality. Expectations Are Slow To Adapt To illustrate why we remain optimistic that TIPS breakevens have further upside, we created what we call our Adaptive Expectations Model of the 10-year breakeven rate (Chart 7). The model combines both forward-looking and backward-looking measures of inflation, and is premised on the idea that investors are slow to fully adapt their expectations to a changing environment. Chart 7Adaptive Expectations Model For example, even though core inflation is now close to the Fed's target on a 12-month rate of change basis, investors remain scarred by the past decade when it was stubbornly low. The long period of low inflation makes it much more difficult for investors to believe that the regime is finally shifting. Our Adaptive Expectations Model includes three variables: The 120-month rate of change in core CPI inflation (annualized) The 12-month rate of change in headline CPI inflation The New York Fed's Underlying Inflation Gauge (full data set measure) The 120-month rate of change is included to capture the impact from investors' long memories when it comes to inflation. The 12-month rate of change is included to capture the more recent trend in prices and the New York Fed's Underlying Inflation Gauge is included to provide a forward-looking measure of inflationary pressures in the economy. Notice in Table 1 that the 120-month rate of change in core CPI carries much greater importance in our model than the other two variables. Table 1Adaptive Expectations Model Regression Output (2003 To Present) Turning back to Chart 7, we see that the current 10-year TIPS breakeven inflation rate is more or less in line with our model's fair value. We also see that two of the model's three variables (12-month headline CPI and the Underlying Inflation Gauge) have returned to pre-crisis levels. It is only the 120-month rate of change in core CPI that is preventing breakevens from reaching our target range. In other words, even though inflation is more or less back to target levels, investors still doubt whether we have transitioned out of the prior low-inflation regime. The Fear Of High Inflation Is Missing Digging further into the data, we see that the real difference between today and the pre-crisis period is that investors are now much less worried about significantly higher inflation. A break-down of individual responses from the Survey of Professional Forecasters shows that, as in 2004, most forecasters think inflation will average between 2.01% and 2.5% during the next 10 years. But today, only 7% of forecasters think inflation will average above 2.51%. In 2004, 32% of forecasters thought inflation would average above 2.51% over the next 10 years (Chart 8). Chart 8High Inflation Is Less Of A Worry This assessment of likely inflation outcomes is backed-up by the economic data. The St. Louis Fed's Price Pressures Measure is a macro model designed to output the probability that inflation falls into different ranges over the next year.3 Here again, we see that the probability of inflation being between 1.5% and 2.5% is similar to its pre-crisis level, but the probability of inflation exceeding 2.5% is much lower (Chart 9). Chart 9Price Pressures Even looking at only the post-crisis period shows that it is the upper-tail of the inflation expectations distribution that is lagging. The Fed's Survey of Primary Dealers has been asking respondents to place probabilities on different long-run inflation outcomes since 2011. Chart 10 shows how the most recent responses - from September - compare to the post-2011 range. It shows that respondents are more certain than at any time since 2011 that inflation will be between 2.01% and 2.5% on average during the next 10 years, but are also more doubtful that inflation will be 2.51% or higher. Chart 10Primary Dealer Inflation Expectations Bottom Line: Even though 12-month inflation has more or less returned to the Fed's target, long-maturity TIPS breakeven inflation rates remain below levels that have been historically consistent with that target. Breakevens remain low because investors are much less fearful of elevated inflation (> 2.5%) than in the past. This will change over time as inflation continues to print near the Fed's target and expectations slowly adapt to the new regime. Remain overweight TIPS versus nominal Treasuries on a 6-12 month horizon. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, "The Sweet Spot On The Yield Curve", dated November 13, 2018, available at usbs.bcaresearch.com 2 For details on how we arrive at that range please see U.S. Bond Strategy Weekly Report, "The Two-Stage Bear Market In Bonds", dated February 20, 2018, available at usbs.bcaresearch.com 3 https://research.stlouisfed.org/publications/economic-synopses/2015/11/06/introducing-the-st-louis-fed-price-pressures-measure/   Fixed Income Sector Performance Recommended Portfolio Specification

Special Report

Highlights U.S. housing's immediate past will not repeat, ... : It is understandable that investors who lived through the financial crisis are acutely sensitive to any sign of trouble in housing, but none of the factors that helped precipitate the crisis are in place now. ... and its older history will only rhyme: Home construction slowdowns have a good record of signaling recessions, but residential investment's steadily waning share of GDP has chipped away at its influence. The current housing soft patch is not over, but it's unlikely to get much worse, ... : The rapid rise in mortgage rates sharply reduced affordability, but it still remains at a very comfortable level relative to history. Inventories of new and existing homes are very low, and the pace of new construction continues to run slightly behind household formation. Most importantly for the expansion, there were no construction excesses in this cycle that need to be worked off. ... so we don't think it's sending any broader signal about the economy: A tiny contraction in residential investment is not a harbinger of recession, nor is it an indication that monetary policy is already tight. Feature Desynchronization has been the name of the game in 2018. The U.S. economy, already ahead of its peers in putting the crisis in its rear-view mirror, has gotten an additional fillip from the fiscal stimulus package. Global growth, on the other hand, has been slipping. As Fed chair Jay Powell put it last week, the rest of the world is "gradual[ly] chipping away" at the U.S., but there "is not a terrible slowdown" in the global ex-U.S. economy. Global conditions have not slowed enough to get the Fed to interrupt its tightening campaign, but signs of softness outside of the U.S.'s borders have been popping up like mushrooms after the rain. With disappointments having been few and far between in the U.S., any pockets of weakness that do appear attract immediate attention. Against this backdrop, the slowing in housing - residential investment has now contracted for three consecutive quarters - is making some investors a little uneasy. We have spent a good deal of time within BCA debating housing's recent softness, its outlook, and its implications for financial assets and the economy, and clients are increasingly inquiring about our views. Housing's Recent Past Housing is top of mind for many investors because it was at the center of the financial crisis. Residential mortgages were ground zero of the credit bubble that systemically threatened the banking system. Wobbles in housing bring back unpleasant memories of the searing trauma that unfolded just ten years ago. With the dot-com mania and the financial crisis having occurred just a decade apart, the financial media, and many strategists, analysts and investors are on high alert for the next crash. The concerns are understandable, but conditions today are nearly the polar opposite of conditions in 2005 and 2006. There is nothing even remotely bubble-like about the current housing market. The critical weakness back then was the shunning of time-tested underwriting standards, as revealed by the homeownership rate. An average of just over 64% of households owned their own homes for the first three decades of the ownership series in a remarkably steady pattern,1 but a steady debauching of standards pushed the rate to above 69% at its peak (Chart 1, top panel). Chart 1Too-Easy Lending Standards ... The homeownership rate was built on a foundation of increasingly unserviceable mortgages (Chart 1, bottom panel). Prices surged (Chart 2, top panel), flippers flooded the market, and homebuilders ramped up production to meet the ensuing demand (Chart 2, second panel). When the music stopped, the housing market was left with unprecedentedly large inventories of unsold homes (Chart 2, third panel); the banking system's primary source of collateral was poised to suffer a body blow; and a hiring surge that played out over a decade and a half was unwound in just two years (Chart 2, bottom panel). Chart 2... Made Housing Unstable Housing In The Current Cycle Current conditions are much more stable. The homeownership rate is back to its time-tested levels. New housing supply has generally undershot the smoothed trend in household formations ever since the crisis ended (Chart 3, top panel). Inventories are strikingly low when adjusted for the overall size of the housing stock (Chart 3, middle panel). The vacancy rate is low (Chart 3, bottom panel), and there is no construction employment cliff. Most importantly from a stability perspective, the Basel III/Dodd-Frank regulatory framework makes it very difficult to replicate the reckless credit conditions that enabled the housing bubble. This cycle has been devoid of housing excesses. Chart 3Plenty Of Room For More Homes A broader historical context reveals that housing has been exerting steadily less influence on the economy across the entire postwar era. We have a good deal of sympathy for the argument that the postwar business cycle has been a consumption cycle, largely led by housing,2 but it's possible that the crisis marked housing's last hurrah as a driver of recessions. Residential investment's share of GDP exploded when pent-up demand was released upon the return of servicemen and women needing homes for their burgeoning families (Chart 4). The construction of the interstate system, and the network of subsidiary roads that sprang up to connect to it, facilitated the creation of the suburbs, and Levittown-style tract housing communities had to be built from scratch to meet the demand. Chart 4The Incredible Shrinking Impact Of Housing Activity The baby boom kept demand for more, and larger, houses going strong. Once grown themselves, the baby boomers helped keep household formation growth flush. The baby boomers are now net sellers, however, and will be at an increasing rate across the next couple of decades. The time trend of residential investment's share of GDP is stark, and demographics are poised to keep it going as long as the baby boomers are divesting their holdings. The bottom line is that we do not think housing is the business cycle this time around. It is a highly cyclical part of the economy, and its fluctuations will still be felt, but its influence on the overall economy has been steadily waning for 70 years, and it is not currently in a position to exert a powerful drag. It would be overstating matters to say that housing booms cause recessions, but they've been observed at the scene of the crime in every recession of the last 60 years except for the dot-com bust. In this cycle, the barely visible white area above the trend line in Chart 4 is nowhere near large enough to give rise to a big swing below the trend line, and inspire a patch of gray shading on its own. The ratio of housing starts to the existing stock of homes (Chart 5) reinforces the message of residential investment's declining contribution to overall output. The United States has been augmenting and/or replacing the existing stock of homes at a steadily diminishing rate for 60 years. Assuming that the rate of obsolescence has remained roughly constant, it seems that there has simply been less to build once the suburban frontier was settled. Even against the declining time trend, however, residential construction activity in this cycle has not revived enough to require a correction. Chart 5Tinkering Around The Edges We attribute the current softness to the backup in mortgage rates over the last twelve months. 100 basis points may not seem like the end of the world, but the rise in interest rates has been sudden, and it is entirely plausible to think that it has sent some marginal first-time buyers to the sidelines. The Housing Affordability Index is way below its 2013 peak, but remains quite high relative to its pre-ZIRP history (Chart 6, top panel). The sudden drop in the index has been a function of mortgage payments (Chart 6, second panel) as sudden moves almost always are - the median home price (Chart 6, third panel) and the median income series (Chart 6, bottom panel) are much less variable. Chart 6Mortgage Rates Drive Affordability We expect that rates will go still higher, but our bond strategists don't think it will happen any time soon. They see rates consolidating for a while as the economy digests the sharp move higher, and favorable year-over-year comparisons cool off inflation's upward momentum over the coming months. Our above-consensus view on the terminal fed funds rate is not housing friendly. Housing will have to contend with ongoing bond-market headwinds, but we don't expect another move of this magnitude will recur in such a concentrated time frame. Bottom Line: Housing may face a headwind from higher rates for at least another year, but a big drop-off in activity is not in the cards. There are no current cycle excesses that need to be unwound, and housing has become too small a part of the economy to induce a recession on its own. Housing Demand And The Fed Funds Rate Cycle The notion that mortgage rates are to blame for the housing soft patch raises some questions about our assessment of the monetary policy backdrop. Is it possible that a funds rate that's proximally related to a slowdown in housing demand is not impacting consumer demand for other goods or services, or corporate demand? Could there be multiple equilibrium fed funds rates? If not, is the housing soft patch a sign that the economy is actually in Phase II of the cycle, and not Phase I? We are unperturbed by the three-quarter contraction in residential investment, which one has to squint to see (Chart 7). We do not believe that housing demand has reached an inflection point; we simply think that prospective monthly mortgage payments have moved so fast that some buyers have temporarily stepped aside. Given that buying a home still looks quite inviting by the historical standards of the affordability index, conditions are not yet restrictive. Ex-the ZIRP era, the index had not exceeded 140 for more than three decades (Chart 6, top panel). If homes are still affordable relative to history, then housing would seem to support our equilibrium fed funds rate model's assessment that monetary policy remains accommodative. Chart 7Not Much Of A Downturn Yet We view the state of policy as binary for the economy as a whole, even if some activity is necessarily more rate-sensitive. While some marginal investment projects cease to generate positive prospective net present value any time interest rates rise, encouraging or discouraging activity is a universal condition. The broader investment-relevant question is whether or not our assessment that the fed funds rate cycle has not yet transited from Phase I to Phase II is correct (Chart 8). If the economy is still in Phase I, and will remain there for a year, our constructive take on the economy and financial markets still applies. If it's shifted to Phase II, however, the empirical record says investors should be paring back risk. Chart 8The Fed Funds Rate Cycle The preponderance of evidence supports the idea that we remain in Phase I. Real-time measures of activity remain robust. Credit performance remains very good, so banks are still eager lenders. Employment is surging, and a follow-up dose of fiscal stimulus in 2019 should keep all the plates spinning for another year. As macro investors, and students of cycles, we are as eager as anyone to recognize the inflection point as swiftly as possible, but the data series we follow do not indicate that it is approaching. We continue to abide by our equilibrium fed funds rate model's benign conclusion. Investment Implications Although housing's direct impact on GDP has steadily waned, it remains an important part of the economy, given how it feeds into several other elements of consumer demand. Three consecutive quarters of contraction in residential investment are worthy of notice, but such a run has occurred before without provoking a recession, and the contraction to date has been awfully modest in any event. We do not view the slowdown as the beginning of the end for the expansion. We also do not view it as a sign that monetary policy is tighter than we originally judged. We expect that the ongoing surprise over the rest of this cycle will be that the neutral fed funds rate is considerably higher than the market consensus expects. We therefore think that investors should continue to maintain benchmark exposure to risk assets while remaining underweight Treasuries and holding all bond exposure below benchmark duration. Since we think the expansion remains in place, supported by accommodative monetary policy, we view the recurring mini-scares provoked by data points like housing's soft patch as potential opportunities to put our cash overweight to work. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Over the 120 quarters through the end of 1994, a mean 64.3% of households owned a home, with a standard deviation of 0.6%. Only 22% of the quarterly observations were more than a standard deviation away from the mean, as opposed to the 32% predicted by the normal distribution. 2 Leamer, Edward E., "Housing IS the Business Cycle," NBER Working Paper No. 13428, September 2007. http://www.nber.org/papers/w13428