Fed, Bonds & Interest Rates

Ben White had this to say about Fed appointments last week in his Politico “Morning Money” column:

“FED TALK – Look for the vice chair nomination to come fairly soon. Mohamed El-Erian remains in the mix but could also be a candidate for the New York Fed. John Taylor sounds like a no-go for vice chair. The White House is looking for a hard-core economist for the vice chair slot, given that with Jay Powell, Randy Quarles, and Michelle Bowman for the community banker slot, Brainard would be the only remaining economist.

“The White House could also look to fill all the remaining slots after Chair Yellen leaves, bringing the Fed board up to its full seven and giving President Trump a massive imprint on the make-up of the nation’s central bank.” (https://www.politico.com/newsletters/morning-money/2017/11/22/murkowski-looks-like-a-yes-on-taxes-030978)

My colleague Bob Eisenbeis has just written on this subject. Bob’s distinguished career has included serving at the Fed under five different chairmen. Here is the link to his recent missive: http://www.cumber.com/chair-yellen-resigns/.

What do we know?

A year from now the central bank of the United States – the lender of last resort to the US banking system and therefore to the world – will be a very different assemblage of folks than we have been accustomed to. Ten years of QE 1-2-3 and near-ZIRP are over.

What else do we know?

The last ten years of financial tailwinds are giving way to headwinds. Note that one may sail forward against a headwind by tacking back and forth. The process is slow and requires hard work. That is different from the ease of movement experienced with a tailwind.

The US federal deficit ran high for the last ten years, and aggregate US debt under three presidents has increased by nearly $11 trillion in a decade. Meanwhile, the interest expense line item in the federal budget has been flat as interest rates remained low and US debt service was refinanced at low rates. That tailwind is over.

The tax reform bill will raise the authorization to borrow and to add $1.5 trillion to the deficit. This is incremental to existing deficit projections which are already rising.  The total interest bill will be rising. The total debt-to-GDP ratio is headed for 100% with the tax reform bill addition, a level that reminds us of the end of World War II.

In its early stages, trouble in financial markets appears in places where credit and lending issues can be seen and measured. That is where to look for warnings. A partial list of such places follows, along with some stellar observations by Chris Whalen.

Chris has penned an essay on the Fed and on a bright yellow flag. He asks, “Q. Besides stocks, what asset class has benefitted the most from the radical monetary policies of the Federal Open Market Committee? A: Multifamily real estate. And what asset class most worries federal bank regulators today? Same answer.”

See https://t.co/4XvERiw8du for the discussion. We thank Chris for permission to share this with our readers. To subscribe to Chris’s The Institutional Risk Analyst, please email your request to info@rcwhalen.com.

There are other places to worry about credit risk, too. Credit card delinquencies have started to rise. High Yield spreads are very low by historical standards but are recently starting to widen.  Private equity financing of commercial real estate shows trouble spots. Note that twice as many retail spaces closed as opened in the last report period. Note empty mall and highway retail space. Note the secondary effects of these changes on employment and on city, county, and school board tax receipts.

Finally, we have the credit risk around the hot topic of Bitcoin, with its wild price fluctuations. New buyers of crypto and crypto derivatives emerge every day. Some are leveraging; thus credit risk is added to speculative risk.

Even outgoing Fed Chair Janet Yellen admits that too much QE for too long with a ZIRP can lead to difficulty.

We are in the post-Thanksgiving to New Year’s period, which is traditionally upbeat. We encourage you to enjoy the season – but when you ring the bell, we advise you not to drop it on your foot.

Our Cumberland US stock market ETF portfolios are now overweight the smaller and mid-cap area. Our overweight of Tech has been reduced.

Our bond accounts emphasize higher-quality credit, and we are not chasing the high-yield space.

We expect a tax reform bill to pass both houses of Congress and to be signed into law. Political leaders are desperate to produce it, so they will do anything to make a deal and get an “aye” vote.

Next year portends rising volatility and massive political swings of sentiment as we run up to the midterm elections.

Current polling suggests that the Democrats may capture the House majority and thus chair all House committees. An impeachment bill is likely if they prevail.

2018 promises to be an interesting year.

David R. Kotok
Chairman and Chief Investment Officer
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