Fed staff research anchors subtle shift that could lead rates higher

Reuters Wednesday August 29, 2018 18:42
Excerpt of: Fed staff research anchors subtle shift that could lead rates higher
by Howard Schneider

WASHINGTON  – The U.S. Federal Reserve should be ready to lift interest rates for a longer period or even more quickly than currently expected to insure against a jump in inflation in a U.S. economy operating in the vicinity of full employment.

That is the message that has been percolating up from senior central bank staff economists to policymakers including Fed Chair Jerome Powell in research that has helped inform a subtle shift in how Powell plans to steer policy amid growing uncertainty about concepts such as full employment and the neutral level of interest rates.

Powell on Friday signaled he was wary of how accurately the Fed can estimate some of the variables that are important to the U.S. central bank’s models of the economy, including the level of full employment and the “neutral” rate of interest, and was thus hesitant to be guided strictly by how they interact.

“A skeptic would say that the models aren’t working – and this is what Powell is indirectly saying,” Robert Eisenbeis, chief monetary economist with Cumberland Advisors, wrote this week. “His answer is to fall back on risk management,” or weighing the cost of a mistake in either direction and choosing the less costly option.

Read the full article at Reuters.com




It’s in the Stars

As is the custom for Fed chairs, Chairman Powell provided the kickoff address to the Kansas City Fed’s annual Jackson Hole symposium, broadly attended by many of the world’s central bankers.

For those who are unfamiliar with the conference, the papers presented are generally conceptual economic policy documents with a distinctly longer-run, bigger-picture focus rather than a discussion and assessment of currently policy. In that vein, Chairman Powell provided an interesting and thoughtful discussion of the problems that he and the Fed face in setting policy going forward.

Some commentators on the speech focused on missing elements such as Powell’s failure to mention trade and tariff issues or the changing role that international economic integration has on the policy environment of changing policy regimes. These factors are clearly important but weren’t central to Chairman Powell’s thought piece, which really focused on the more abstract conceptual framework upon which the Fed’s current policy is depends.

Before discussing that framework however, Powell first provided a brief, but obligatory, overview of the current economic situation. It proved to be just a restatement of what was noted in the FOMC’s July/August policy statement and subsequent minutes. He noted that growth is strengthening, unemployment is at a 30-year low, and inflation is at the 2% objective. There was nothing new or noteworthy here.

Then Chairman Powell then turned to the more interesting part of the speech – interesting in part because it appears that he is revealing his own discomfort with the current policy framework. He first poses two disparate questions that observers and critics might ask any FOMC participant today, questions that encapsulate the policy conundrum the FOMC now faces. The questions are paraphrased below:

(1) With unemployment so low, why isn’t the FOMC tightening policy faster to head off potential overheating and a rise in inflation?

(2) Or, with inflation so low, why is the Fed tightening, thereby risking higher unemployment and a recession?

The first question is rooted in a Phillips-curve view of the world in which tight labor markets inevitably lead to inflation, while the second question ignores evidence on the lags of monetary policy and reflects the view that inflation isn’t a problem until it is. Powell has structured these questions as a policy problem of balancing two risks: the risk of being behind the curve versus the risk of being too aggressive.

Against this set of policy questions, Powell then goes on in a clear but oblique way to discuss how economists are currently framing policy in terms of (a) the desired rate of inflation, and (b) the two abstract concepts of the natural rate of unemployment and the natural rate of interest. Economists have dubbed the natural rate of unemployment u-star (u*) and defined it as the rate of unemployment that would prevail in an economy growing at its potential, where people would be unemployed only due to friction and structural reasons – that is, unemployed due to skill mismatches, mobility problems, or lack of information. The natural rate of real interest or r-star (r*) is the real rate that would exist in an economy operating at full employment and growing at its long-run potential.

Powell then proposes the simple, effective analogy that policy is like trying to navigate by the stars (u* and r*), where the course of policy is dictated by inferior instruments (ie. models) in which action depends upon the direction and magnitude of the deviations of actual unemployment from u* and of the estimated real rate of interest from r*. But the problem is that neither of the two stars nor the potential rate of growth of the economy are known with any degree of certainty.[1] Thus it is hard for policy makers to know exactly where the economy currently stands in terms of these conceptual anchors. The problem is doubly difficult because the anchors also have moved over time.[2] It is also important to note at this point in the discussion that Powell omits any mention of the policy tools that the FOMC has in its tool kit or how they are linked to changes in the deviations of the actual economy from u*, r*, or potential growth.

So, if policy makers don’t know exactly where the economy lies relative to these key variables, what are they to do? Put another way, a skeptic would say that the models aren’t working – and this is what Powell is indirectly saying. So, in the face of this conundrum, what does a practical policy maker like Chairman Powell do? His answer is to fall back on risk management, which says go slowly, be observant, and be prepared to act. In the current economic environment of steady growth, low inflation, and low unemployment, this means the FOMC should continue with gradual tightening, since policy is still accommodative, but be prepared to change if inflation and, importantly, inflation expectations change.

Overall, this was a speech that was clear, honest, and pragmatic. Some might have wanted more, especially since stargazing isn’t working too well, but Powell has laid out clearly what the conceptual problems are and how the Fed is proceeding.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


[1] Indeed, the error bands around estimates of these parameters are quite wide.
[2] As an aside, this is part of the reason that President Bullard of the St Louis Fed has argued that regime shifts make policy formulation and forecasting very difficult.


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

Sign up for our FREE Cumberland Market Commentaries

Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




From the Maine Outpost: The Corporate Bond Market – A Frog in Boiling Water?

By Jeanine Prezioso

Federal Reserve monetary policy and its anticipated effects – in addition to the debate over who caught the largest salmon or smallmouth bass – was one of the many discussions bandied about in the northeast Maine woods earlier this month at Camp Kotok, an annual gathering of economists, pundits and investment professionals hosted by Cumberland Advisors’ David Kotok.

From the Maine Outpost- The Corporate Bond Market - A Frog in Boiling Water - by Jeanine Prezioso

Trade wars and a slowdown in the U.S. economy are ubiquitous market concerns, but one focus was the corporate bond market, which is largely in unchartered territory, emerging from a hazy decade of cheap credit.

The amount of high-yield debt sits at record levels relative to the total, while global risks are rising. Credit spreads have widened from the beginning of the year. In the week following the Camp Kotok, Turkey’s currency crisis and uncertainty over U.S. trade policies further weighed on markets.

“You’ve had 10 years of financial valium of low interest rates,” said Kotok, Chairman and Chief Investment Officer of Cumberland. “The risk in credit is rising and the nature of spread widening is underway and that will deal a blow to high yield and to corporates.”

Continue reading at LinkedIn Pulse: https://www.linkedin.com/pulse/from-maine-outpost-corporate-bond-market-frog-boiling-prezioso/




Market milestone: This is the longest bull run in history

Excerpt from “Market milestone: This is the longest bull run in history” by

Cumberland-Advisors-David-Kotok-In-The-News

“While this bull market and economic recovery may very well be old,” LPL Financial strategists wrote to clients, “we see few signs that suggest an end is near.”

David Kotok, chairman and chief investment officer of Cumberland Advisors, agrees. He believes that strong corporate profits could lift the S&P 500 to 3,000 before the end of the decade.

But the economic expansion, already the second-longest in history, also faces threats from tariffs and inflation.

An escalation of the trade war between the United States and China could derail global growth while causing headaches for the Federal Reserve.

“If the trade war does not ratchet down,” Kotok said, “the Fed will have to fight more inflation with slower rates of growth. Therein lies a stewpot of risk.”

Read the full article at CNN Money.


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

Sign up for our FREE Cumberland Market Commentaries

Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




Fed’s solo act faces tremors in Turkey and a slower Europe

Excerpt from “Fed’s solo act faces tremors in Turkey and a slower Europe”

Cumberland-Advisors-David-Kotok-In-The-News

The Turkish lira’s slide has little in common with the Thai baht devaluation in the late 1990s that preceded a larger crisis in emerging markets, or to the debt problems in Greece that raised the spectacle of the euro zone breaking apart. Both events raised direct risks to U.S. growth and financial stability and reshaped Fed policy in real time.

But Turkey’s problems, say some analysts, are another piece of evidence that the world is not as trouble free as it has seemed over the last year and a half. Over that period Fed officials, including some of those most hesitant to raise interest rates, spoke of economic “tailwinds” that let them lift rates in five of the last six quarters.

There are many other emerging markets, including Turkey, Iran, Russia India, Argentina, China, Chile and South Africa, that are “sitting on a ticking time bomb of U.S. dollar-denominated debt,” according to David Kotok, Cumberland Advisors chairman. In addition growth risks have rekindled in China; Europe’s suddenly poorer outlook could mean weaker world demand; and to top it all off the threat of a slide in global trade has been magnified by the Trump administration’s tariff threats.

Read the full article at One America News Network – OANN.com.


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

Sign up for our FREE Cumberland Market Commentaries

Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




How Good Can It Get?

Friday’s GDP release showing growth at 4.1% is clearly positive news. Consumer spending contributed 2.7 percentage points to growth, followed by fixed investment (0.94 percentage point largely offset by a negative 1.0 percentage point contribution from inventories) and a 1.06 percentage point contribution from net exports.Market Commentary - Cumberland Advisors - GDP 4.1 How Good Can It GetIf we factor this growth figure together with a PCE inflation now at 2.3%, a strong job market (230K jobs were created in June), and unemployment at 4%, the FOMC now appears to have a strong case to make another rate hike, even though the next meeting, on July 31–August 1, is not one where new projections will be offered or a press conference scheduled.

Naysayers will argue that this growth rate can’t continue and that 4.1% is clearly above potential. For example, exports are up, and some have suggested that the surge has occurred because companies anticipate looming tariffs. The administration, on the other hand, is arguing that we haven’t seen anything yet when it comes to growth. Well, the question is, can 4.1% be repeated the next couple of quarters? First, let’s look at a bit of history. The chart below shows the quarterly real GDP growth rate (annualized) since 2005 – before the financial crisis and the period following the crisis, when we have seen slow productivity growth.

Over that period there have only been 6 out of 50 quarters where growth has been over 4% (four at slightly over 4% and two at 5% or more). In nearly each case, the following quarter was in many instances about 2%, and growth continued to stay well below 4% for many quarters thereafter. Only one exception exists when growth was over 5% (Q1 2014) followed by growth over 4% (Q2 2014) the next quarter.

One of the reasons for a reduction in the rate of growth following a strong quarter during the 2005-2018 Q2 period is the fact that potential growth is actually much less and 4%, and people argue that this remains the case going forward. The Congressional Budget Office, for example, puts potential growth at 2.3%.

How might we rationalize that number? The two key determinants of potential GDP growth are the rate of growth of productivity and rate of growth of the labor force. Abstracting from sophisticated analytical techniques, productivity growth from 2007 through Q3 2016 was about 1.1% (1). BLS employment projections suggest that the labor force will grow about 0.6% over the next 10 years or so. Add those two numbers together, and we get a sustainable growth rate of slightly less than 2%. Now, if the positive economy brings more people into the labor force – i.e., the participation rate increases – and the investment stimulated by the tax cut continues, then we may see potential GDP about where the CBO has it. But the prospect for large, sustainable increases in GDP growth is at this point problematic.

So, while the Q2 GDP number is extraordinary and the economy is basically strong, we are not likely to see a continuation of such robust growth, especially if the tariff and trade wars continue. Furthermore, the FOMC is going to be focused on inflation, which is now running 16% above its 2% target rate.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


(1) See https://www.bls.gov/opub/btn/volume-6/below-trend-the-us-productivity-slowdown-since-the-great-recession.htm.


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

Sign up for our FREE Cumberland Market Commentaries

Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




Fed Independence

In the wake of the turmoil in Washington, DC, over his performance in Helsinki, President Trump also took a sideswipe at the Federal Reserve, criticizing the FOMC’s recent efforts to normalize policy.

He argued that raising rates threatens the expansion and on top of it has contributed to the rise in the value of the dollar, just when the euro was shrinking, the effect of which is to further disadvantage US producers.

Most presidents – though not all – have understood that Fed independence ensures separation from the Treasury and serves as a check on fiscal excesses. When a central bank takes orders from the fiscal side of government, history shows that inflation and economic decline soon follow. Witness the German inflation of the Weimar Republic, the 1992–1994 experience in Yugoslavia, the 1990 experience in Peru when inflation doubled every 13 days, the persistent problems in Venezuela, and the hyperinflation of Zimbabwe, just to name a few.

There have been many times in the past when presidents expressed frustration with Federal Reserve actions, but those criticisms lacked teeth when it came to actually affecting the Fed’s conduct of monetary policy. One noteworthy period when there was a cozy relationship between Fed leadership and the president was during the chairmanship of Arthur Burns. Burns steered policy in such a way to accommodate the fiscal interests of President Nixon, and the result was stagflation in the 1970s and a disastrous experiment with wage and price controls. We experienced an unprecedented inflation that took courageous action by then-Chairman Paul Volcker to break the back of inflation at the cost of a recession, thus proving that the lack of independence represents a severe threat to economic stability and prosperity. Similarly, President George H. W. Bush blamed the Fed for not cutting rates, and that reluctance to act he alleged cost him the election.

Interestingly, the issue of independence came up last week, on Wednesday, in two entirely different contexts and different venues, in both instances during hearings by the House Financial Services Committee. The first occurred during Chairman Powell’s semiannual testimony on monetary policy before the full House Financial Services Committee, when Congressman Hensarling suggested that the size of the Fed’s balance sheet in itself might pose a threat to its independence because of the temptation on the part of Congress to induce or cause the Fed to purchase private sector assets. As evidence he also referenced the fact that raiding the Fed’s balance sheet has already taken place. Two examples he gave were the use of Fed resources to fund the Consumer Financial Protection Bureau and the deployment of some of the Fed’s surplus to fund the Highway Bill. While Congressman Hensarling’s concern is valid, neither congressional action was related to the size of the Fed’s balance sheet per se. The Fed doesn’t act like a private bank, attracting deposits and then making loans. Rather, it purchases assets – in the present case Treasuries and mortgage-backed securities (MBS) – by simply creating reserves. That is, it purchases assets and pays for them with high-powered money – which ends up as reserves on commercial bank balance sheets.

The real threat is simply that Congress has viewed the Fed more and more as a piggy bank whose resources can be tapped to fund pet projects, seemly at zero cost to the budget. This temptation has been stoked, in part, by the Fed’s willingness to purchase newly issued MBS – which in this case were liabilities of another set of now-government entities, Freddie and Fannie, which are in conservatorship and whose liabilities are effectively guaranteed by the Treasury.

If Congressman Hensarling and his colleagues are truly interested in protecting the independence of the Fed, to counter this trend they should restrict the Fed’s asset purchases to US Treasury obligations – except in extreme emergencies, such as envisioned in the Dodd-Frank Act – and encourage the rundown of the Fed’s holdings of MBS as soon as feasible.

The second time the issue of Fed independence was implicitly raised was in an entirely different context during a hearing on digital currencies that took place that same Wednesday before the House Financial Services Subcommittee on Monetary Policy and Trade. The discussion was wide-ranging, but some participants argued that if digital currencies proved to be a more efficient means of payments than cash, then such currencies should be made legal tender. Furthermore, the Fed should get into the retail digital currency business. But what was lost in their brainstorming was the logical implication of the Fed’s getting into retail payments. Fedcoins, by virtue of the government’s backing, would likely dominate private sector digital currencies and would surely supplant demand deposits as a component of payments as well. However, the advent of Fedcoins would also imply a huge increase in the Fed’s balance sheet on the liability side, an increase that would have to be balanced with assets – presumably Treasuries. But banks rely upon demand deposits to fund their lending activities; and to the extent that this funding source was significantly reduced or disappeared, then banking as we know it would also be adversely impacted. The political fallout from this disruption would be large, and we do not know what implications such a change would have for financial stability or the implementation of monetary policy. Worst case is that the Fed would be dragged into consumer lending. So the role of digital currencies in the US economy is, as of this writing, not clear; nor is the structure of Bitcoin and similar currencies as anonymous or safe as proponents would have us believe [1].

The threats to Fed independence from the legislative branch have a long history. Congressman Wright Patman (in Congress from 1929–1976) was longtime chairman of what was then the House Committee on Banking, Finance, and Urban Affairs [2]. A populist, he favored low interest rates and continually threatened to subject the Fed to appropriations and/or audit [3]. His main concern was that the Fed was too independent and lacked transparency in its operations and decision-making [4]. Remember, during that period the Fed did not reveal its decisions, nor did it produce meeting minutes. Furthermore, Fed chairmen and governors made only infrequent appearances before Congress.

Patman’s crusade was picked up by Henry Gonzales, another Texan, who rose to the chairmanship of the House Banking Committee in 1989, and who vigorously sought to make the Fed more accountable [5]. Under Gonzales it was revealed that the Fed kept secret minutes of its meetings, destroyed many meeting records, and concealed information on a fleet of airplanes it operated, just to mention a few examples of covert Fed actions [6]. Gonzales even initiated an unsuccessful proceeding to impeach Fed Chairman Paul Volcker. Under Gonzales’ tenure the Fed began publishing minutes of its meetings.

So attacks on the Fed from both the executive and legislative branches of government are real but have mainly succeeded – appropriately so – in making the Fed’s decision process more transparent. But those efforts have had minimal influence on actually policy decisions. The president may not appreciate that the Fed is a creature of Congress and not the executive branch, and that he has little or no power to force either the chairman of the Board of Governors or the FOMC to do his bidding. Nor can he fire them.

How will the Fed respond to these recent pressures? Some have speculated that attempts to influence the Fed will cause the Fed to overreact and accelerate its tightening policy just to demonstrate its independence. If the past is any guide, however, there is little evidence that the Fed has deviated from what it deems to be the appropriate policy path just to stick it to its critics. While most of the FOMC participants and governors are relatively new to the table, the best guess is that Fed’s culture and history will provide them with the backbone to steady the course and not bow to outside political pressures. The bigger risk is that the economy could weaken sufficiently towards the end of this year to cause a change in policy, especially if this slowdown occurs before the election. A backtrack on policy in that economic scenario would pose a formidable communications challenge for the Fed – to explain the change while not appearing to be bowing to outside pressure, especially from a president who is likely to claim credit for the change in policy. This is where the real short-term threat to Fed independence will come from. Over the longer run, however, the real threats may come from a Congress tempted to look for cheap financing for projects, and we can only hope there that the true issues are understood.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


[1] Anyone who doubts this assertion should just read the recent indictment handed down by the Justice Department in the case of 12 Russians accused of meddling in the US 2016 election. See https://www.vox.com/2018/7/13/17568806/mueller-russia-intelligence-indictment-full-text.
[2] I concentrate here on the period after the 1951 Treasury-Fed Accord and after the Fed stopped pegging interest rates, a policy instituted during WWII that made the Fed effectively subservient to the Treasury.
[3] Having been at the Board of Governors during part of Patman’s tenure in Congress, I can attest to the fact that the mere threat of appropriations or an audit instilled more financial discipline in the Fed’s operations than could be observed in agencies that were subject to appropriations and audit.
[4] See Harrison, William B., “Annals of a Crusade: Wright Patman and the Federal Reserve System,” American Journal of Economics and Sociology, Vol. 40, No. 3, July 1981.
[5] The Committee’s name has changed several times, so for simplicity it is simply referred to as the House Banking Committee.
[6] See history.house.gov/People/Detail/13906.


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

Sign up for our FREE Cumberland Market Commentaries

Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




Trump pressures the Fed

Excerpt from Politico article, Trump pressures the Fed:

Cumberland-Advisors-David-Kotok-In-The-News

Politico’s Morning Money just happened to be sitting down with one of the top executives on Wall Street on Thursday just as President Trump’s interview with CNBC appeared in which Trump criticized the Federal Reserve for raising interest rates, fulfilling the fears of many who thought it was always just a matter of time before exactly this happened. The executive expressed exasperation and suggested that Fed Chair Jay Powell should issue a statement in response reiterating the Fed’s independence and intention to continue on its current path regardless of any political pressure.

WALL STREET REACT — Cumberland Advisor’s David Kotok emails: “Why meddle? Why overturn decades of central bank independence? Why stir up a pot after the Fed spent 37 years getting from double-digit interest rates (1981) and double digit inflation (1970s) to present day 2% level. The poet George Santayana penned a message for this erstwhile President, Donald J. Trump. ‘Those who forget their history are condemned to repeat it.’”

Continue reading other comments here: POLITICO


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

Sign up for our FREE Cumberland Market Commentaries

Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




Minute By Minute

The FOMC June minutes were released this past week, along with the Committee’s most recent predictions as detailed in its Summary of Economic Projections (SEPs).

Although the press gave attention to the Committee’s views on the implications that the tariffs soon to be implemented might have for growth, in reality the minutes devoted only a couple of sentences to concerns that district contacts had about tariffs. Specifically, “… many District contacts expressed concern about the possible adverse effects of tariffs and other proposed trade restrictions, both domestically and abroad, on future investment activity; contacts in some Districts indicated that plans for capital spending had been scaled back or postponed as a result of uncertainty over trade policy.” Potential impacts on steel, aluminum, and agricultural prices and exports were noted.

While the minutes were largely unremarkable overall, there were a couple of points of emphasis that were different and potentially interesting. For example, the manager of the Open Market Desk pointed out that paydowns and maturing MBS were likely to fall short of the caps that had been established (the max for MBS being $20 billion per month), indicating that reinvestment in MBS was likely to be unnecessary and implying that shrinkage of the MBS segment of the System Open Market Account portfolio would be less than planned. Indeed, as of the end of June, the shrinkage of the aggregate portfolio was about $22 billion short of target, and at the present pace the shortfall will be much greater by the end of July.  Having said that, paydowns could, depending upon what happens to rates, again exceed the target reductions in MBS. So as a contingency, the Desk staff proposed continuing to make small MBS purchases to maintain operational readiness should redemptions exceed the targets and purchases again become necessary.

Additionally, the Committee appeared to have spent considerable time discussing the strength of labor markets and the implications that had for potential wage increases. As for risks, the Committee again noted policy uncertainty, especially with respect to trade policy and the negative implications for investment and business sentiment.

The most interesting discussion, however, in the entire set of minutes was the attention that was paid to the flattening of the yield curve and what, if any, signal that trend may have as a harbinger of a future recession. Several factors in addition to the tightening of policy were seen as possible contributors, including a reduction in the longer-run equilibrium rate of interest, lower inflation expectations, and a lower term premium, in part related to central bank asset purchases. Views appeared to be mixed and relatively split between those who felt that the above factors reduce the meaningfulness of a flattened term structure as an indicator of recession probabilities and those who felt that the flattening curve is still a useful indicator. Staff apparently presented research looking at the usefulness of measures of the spread between the current and expected federal funds rate derived from futures markets as predictors of recessions. In general, the System has continually devoted attention to yield-curve inversions as predictors of recessions, and the general conclusion is that a negative yield curve has led all but one recession since 1955, with a lag of between 6 and 24 months.[1] Bauer and Mertens’ most recent work shows two key things. First, while inversions may signal an increase in the probability of a recession, at the critical threshold of a zero spread, the probability of a recession 12 months ahead is still only 24%.[2] They also note that as of February 2018 the estimated probability based upon the spread that existed at that time was still only 11%, which they viewed as “… comfortably below the critical threshold….”

As for the risks to the economy associated with the potential trade war initiated by the US, it is interesting to look at statistics on US and China trade relative to the size of their respective economies. Current estimates suggest that China’s GDP is about $12.2 trillion, while that of the US is about $19.4 trillion.[3] Of that, US exports of $1.4 trillion are about 7% of US GDP, and imports of $2.4 trillion are about 12.4% of US GDP. Trade is much more important to China than it is to the US. Chinese exports are 17.2% of GDP, and imports (which historically have consisted of raw materials and intermediate inputs to their exports) are about 15.6% of GDP.

US trade with China, especially the deficit, has gotten a lot of attention. However, US exports to China are less than 1% of US GDP, and imports are about 2.5% of GDP. As of this writing, the administration has imposed tariffs on about $35 billion of US China imports, or about 0.2% of US GDP. While these appear to be small numbers, the impacts on certain US industries in many parts of the country, such as soybean farmers in the Midwest, are critically important to their well-being. Unfortunately, what the present approach to trade implies is picking winners and losers who bear the brunt of attempts to rationalize international trade policies, but is based upon the faulty logic that the US must have bi-lateral trade balances  with each of our trading partners.[4]  The political fallout from the coming trade war will be significant, but the immediate worry is not the overall economic impact, which by most measures is small.  Rather the more significant effects will be the impacts that tariffs may have on market psychology and business investment attitudes and decision-making. The emotional impacts may drown the real economic impacts.

Robert Eisenbeis, Ph.D.
Vice Chairman & Chief Monetary Economist
Email | Bio


[1] As but a small snapshot see: Bauer, Michael D., and Glenn D. Rudebusch. 2016. “Why Are Long-Term Interest Rates So Low?” FRBSF Economic Letter 2016-36 (December 5); Berge, Travis J., and Oscar Jorda. 2011. “Evaluating the Classification of Economic Activity into Recessions and Expansions.” American Economic Journal: Macroeconomics 3(2), pp. 246–277; Estrella, Arturo, and Frederic S. Mishkin. 1997. “The Predictive Power of the Term Structure of Interest Rates in Europe and the United States: Implications for the European Central Bank.” European Economic Review 41(7), pp. 1,375–1,401; Mertens, Thomas, Patrick Shultz, and Michael Tubbs. 2018. “Valuation Ratios for Households and Businesses.” FRBSF Economic Letter 2018-01 (January 8); and Rudebusch, Glenn D., and John C. Williams. 2009. “Forecasting Recessions: The Puzzle of the Enduring Power of the Yield Curve.” Journal of Business and Economic Statistics 27(4), pp. 492–503.
[2] See Bauer, Michael D. and Thomas Mertens, “Economic Forecasts with the Yield Curve,” FRBSF Economic Letter, March 5, 2018. https://www.frbsf.org/economic-research/publications/economic-letter/2018/march/economic-forecasts-with-yield-curve/
[3] https://tradingeconomics.com/china/gdp; https://tradingeconomics.com/united-states/gdp
[4] Alan Blinder has a useful discussion of what we know about trade balances in WSJ July 9, 2018.

Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

Sign up for our FREE Cumberland Market Commentaries

Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




Fed & Rates

My colleague Bob Eisenbeis recently described the improved communications from the Fed and offered his current thoughts on Fed policy. His post-Fed-meeting notes are here: http://www.cumber.com/the-fed-decides/.

Today we want to take a longer view of interest rates and offer some observations on what lies ahead. I write this after the FOMC June meeting and after I was fortunate to participate in a panel at the Benchmark Rates Forum New York 2018. That June 7th meeting brought together major players from around the world for sequential presentations about the coming changes in short-term interest rates and about the replacement for LIBOR. I thank Alexandre Ripley for inviting me to speak at this prestigious gathering. And I also thank KPMG, Bloomberg, and Latham & Watkins for sponsoring the day-long event.

Market Commentary - Cumberland Advisors - Interest Rates

One major forecast of shorter-term interest rates has suggested what rates will be in December 2019. The year-and-a-half time frame is not so long, but that forecast required considerable effort to develop a rationale behind each item. Let me extract and comment on what is a substantial, 60-plus-page document.

The forecast projects the upper end of the fed funds band to be 3.50% by December 2019. Remember that the fed funds rate-setting mechanism now operates with a high/low band for the FOMC target. The forecast calls for the lower end of the band to be 3.25%, which is also the expected RRP rate. This is the rate that is thought to reflect the use of repo, which is an alternative form of short-term interest rate cash management for those institutions that may not have direct access to the Federal Reserve. So the forecast target range is 3.25% to 3.50% at the end of 2019.

Interest that the Fed will pay on excess reserve deposits (IOER) is projected at 3.45%. This is 5 basis points lower than the upper band and is the extension of a new Fed policy that was announced at the June meeting. The Fed is trying to keep the fed funds rate within the targeted band. It faced a problem in that the FF rate was pushing against the upper end of the band for a variety of reasons. So the Fed raised the band by 25 basis points but raised the IOER rate by only 20 basis points. The 2019 forecast sees that policy decision continuing for the next year and a half.

The forecaster then estimated the rest of the short-term interest rates as follows. Treasury bills and related collateral would trade at 3.40%. SOFR (secured overnight funding rate) would trade at 3.35%. That would put 1-month LIBOR at 3.60% and 3-month LIBOR at 3.75%. The spread between LIBOR and the overnight indexed swap (OIS) is expected to be 30 basis points, and this estimate assumes that no shocks or credit problems rock the banking system and that LIBOR is fully functional.

Let’s think about what interest rates in the marketplace would look like if this forecast turns out to be correct.

As an investor, your cash equivalent options should be somewhere in the neighborhood of 3% or slightly lower. That is a major change from the last 10 years. We believe that is a rate high enough to change investor behavior and to restore the holding of some cash reserves by those investors who have been seeking to do so.

What can we expect for intermediate and longer-term rates if this forecast is correct? Here is where things get really difficult.

If the short-term and overnight SOFR is yielding 3.35%, is it reasonable to expect the intermediate and longer-term riskless US Treasury note and bond to yield less. That would mean an inverted yield curve, and that outcome is hard to see if there is a growing US economy. If there is a recession, it is hard to see how the Fed would have raised rates high enough to meet the forecast expectations.

So either we have to disagree with this forecast, or we have to raise the expectation for the 10-year Treasury yield to reach somewhere around 4%. We can quickly see what that figure does to mortgage interest rates and corporate bond rates and also to municipal bonds rates, although they are not likely to respond as much as corporate rates will.

Other forces are also at work and will influence the Fed. What happens to the unemployment rate over the next year and a half, and what happens to the inflation rate? The former is headed lower to about 3.5%, while the latter is headed higher. Are they on a collision course?

And lastly, what will be the impact when the European Central Bank starts to move away from its negative-rate targets and tapers its bond-buying program? And let’s not ignore the expanding US federal deficit and the Fed’s policy of shrinking the size of its asset holdings by allowing maturity and not replacing federally backed debt instruments. There is also the nascent trend of the Social Security Trust Fund’s rolling over, which means a transfer to the market to absorb the change. It isn’t much now, but it will be a growing force over time if the Congress doesn’t remedy the Social Security funding formula. Since Congress is usually reactive and requires a crisis to act, we are not sanguine about an early fix to Social Security.

Cumberland now uses a barbell strategy in its actively managed bond accounts. It does so for a very important reason. The strategy allows bond management to proceed when there are headwinds facing the bond market. Barbells are called for now. Ladders are likely to underperform. That is true for both taxable and tax-free bond accounts. And credit quality surveillance is a critical and ongoing need.

The next two years are going to be interesting and challenging.

We wish all our US readers a Happy July 4th celebration.

David R. Kotok
Chairman & Chief Investment Officer
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

Sign up for our FREE Cumberland Market Commentaries

Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.