Cumberland Advisors Market Commentary – Interest Rates and Yield Curve Control, Part 1

“The Trimmed Mean PCE inflation rate is an alternative measure of core inflation in the price index for personal consumption expenditures (PCE). It is calculated by staff at the Dallas Fed, using data from the Bureau of Economic Analysis (BEA).” Through June 2020, “The Trimmed Mean PCE inflation rate over the 12 months ending in June was 1.8 percent. According to the BEA, the overall [June] PCE inflation rate was 0.8 percent on a 12-month basis and the inflation rate for PCE excluding food and energy was 0.9 percent on a 12-month basis.” (“Trimmed Mean PCE Inflation Rate,” https://www.dallasfed.org/research/pce)

Market Commentary - Cumberland Advisors - Interest Rates and Yield Curve Control, Part 1

The annualized one-month trimmed mean PCE inflation rate was 2.8% in January and plummeted to 1.1% in March; April was 1.3%; May was 1.5%; June was 1.7%. Note the steady increase of PCE inflation over the last four months. Using the trimmed mean PCE as the inflation measure of choice, we can conclude that the entire Treasury yield curve is now trading at negative REAL interest rates. We will have more on this later in this series (today is part 1).

In our view this is an important series to follow. Reason: Fed Chair Powell has publicly mentioned that he follows it. In simple terms the idea of trimmed mean inflation is to discard the very volatile items in the inflation statistics and thus narrow the estimate of inflation to the price changes of the majority of items in the center of the distribution. In Powell’s words, “It cuts off the big movements on the upside and the downside, looks at the mean movements of inflation on the various product categories and service categories.” (“Just when you got used to core inflation, Powell talks up another measure – ‘trimmed mean’,” MarketWatch, https://www.marketwatch.com/amp/story/just-when-you-got-used-to-core-inflation-powell-talks-up-another-measure-trimmed-mean-2019-05-01)

In my experience, the concept of trimmed mean has been controversial, with advocates (including me) facing off against detractors. Readers may want to look at all historical series that estimate rates of inflation. That’s what I do. Together they help me assess the rate of changes in prices.

The trimmed mean inflation estimation method originated, along with the trimmed mean CPI, in pioneering work done at the Cleveland Fed by Steve Cecchetti (now professor of global finance at Brandeis International Business School) and carried forward by Mike Bryan (now vice president and senior economist at the Atlanta Fed). Here is a link to the Cleveland Fed’s trimmed mean CPI monthly report: https://www.clevelandfed.org/our-research/indicators-and-data/median-cpi.aspx.

(Bryan and Cecchetti and their colleagues produced a wealth of research on inflation measurement when they were in Cleveland and since. Here is another of their seminal papers: “Measuring Core Inflation,” https://www.clevelandfed.org/newsroom-and-events/publications/working-papers/working-papers-archives/1993-working-papers/wp-9304-measuring-core-inflation.aspx.)

I’ve had occasion to participate on panels with Steve and Mike and respectfully hope I can articulate this concept in simple layman’s terms for our readers. The statistical method to optimize the “trimming” is, however, complex.

We believe that the trimmed mean estimation process has become extremely important during this very volatile pandemic period. We can see that volatility by examining the reports from the Dallas Fed and Cleveland Fed. I personally review them in detail every month as they are released.

Normally the various measures of inflation track closely with one another. We would expect that in normal times. But these are not normal times. That is why the trimmed mean process is important.

The trimmed mean estimation tells us that inflation bottomed coincidentally with the March–April plummet in the US and global economies. For the US, the sensitive (monthly and annualized) numbers suggest that inflation is gradually reappearing. We believe these early signs must be respected.

The implication is that US interest rates are nearing or have reached a bottom. We will have more to say about that as this series on rates and yield curve controls is published.

At Cumberland, we are using a barbell approach now in our managed bond accounts. The degree of barbell shifting and the structure of the barbells is a topic for a technical conversation that can be held with a number of folks in Cumberland’s fixed-income division. The trimmed mean methodology suggests that the fierce deflation pressures from the pandemic ended in March, coinciding with the bottoming of the economy and the March 23rd bottom in the US stock market. Readers, please note that is an early and not yet confirmed assertion. It will be a year before we have sufficient data to verify this assertion.

Also, note that at Cumberland we are portfolio managers, and our job is to assess and respond to changes in trends and in risk. Inflation shifting is an extremely important item for the performance of both bonds and stocks. That is why we are so focused on it. We’re working on part 2 of this series now.

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


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Cumberland Advisors Market Commentary – Coronavirus Infects Bond Yields

Cumberland Advisors - Coronavirus Infects Bond Yields

The turmoil and volatility in the equity markets is also greatly affecting bond markets, with both taxable and tax-free yields shifting down sharply.

 

You can see the dramatic drop in yields this year, particularly in US Treasury yields, with the very large drop in the past month as the coronavirus outbreak has moved almost all other news to the sidelines. It has sent both the 30-year and 10-year US Treasury yields to record low levels, with the 10-year cruising through the past record low of 1.35% set in July of 2016 and the 30-year bond yield blowing through the 1.95% record set in August of 2019 when US Treasury yields gapped down in sympathy with European and Japanese yields. Time and time again, we see the flight into US Treasuries almost regardless of yield.

 

Whenever there is a crisis, perceived or real, Treasuries are the go-to investment. We see the various dips in yields in the past 25 years: the Thai Bhat currency crisis of 1998, the downdraft following 9/11, the fallout after the Lehman bankruptcy, the drop in confidence following the Greek crisis of 2010, the drop in yields in 2016 following Brexit, and now the coronavirus. In all these cases there were, of course, other supporting factors. The past year was seeing drops in yields as US yields came down in sympathy with foreign yields.

Muni yields also have dropped – not nearly as much as US Treasuries, but this is a common occurrence when flights to quality happen. Nothing stays up. Credit spreads widen as the move to Treasuries exacerbates.

“One is the Loneliest Number”

Song, Three Dog Night, 1969, lyrics by Harry Nilsson

The Federal Reserve cut the fed funds target rate by 50 basis points on March 3rd, to a 1–1.25% range from a 1.50–1.75% range. The 10-year Treasury bond yield plunged on March 3rd, with the bond moving from 1.17 down to below 1%. It is at 0.96% as we write this piece. The only thing that is a positive is the fact that it is a positive yield. This compares to a 10-year German government bond yield of -0.641, and a 10-year Japanese government bond yield of -0.148. We would expect to see some fiscal stimulus here as well, particularly if the crisis worsens. This stimulus could include moving ahead with an infrastructure program that the administration has NOT pushed so far in this presidential term. And you may see this on the state level as well, particularly since most states are in good fiscal shape from the economy, which has been strong until this crisis.

How to manage this?

From a big-picture standpoint, we saw the negative yields in Europe and Japan go positive as we went into fall 2019. There seemed to be growing recognition that negative rates were effectively “pushing on a string” and that they were not helpful to financial institutions. The Fed’s action on March 3rd is probably not the last one. The dramatic drop in yields occurred AFTER the virus finally showed up in the US. And we don’t know the economic effects yet. We do know there is a large multiplier effect from this pandemic. Think about restaurants and hotels with far fewer patrons. They lay off workers, who then don’t spend money, etc. Sporting events, meetings, rallies, concerts, and other gatherings get cancelled or reduced, and a subsequent multiplier effect drop in economic activity results. On the muni front, we worry about regional hospitals POSSIBLY being overwhelmed. We worry about a drop in economic activity that affects things everything from sales tax receipts to turnpike revenues. Drop in demand is already affecting airports, landing fees, and vendor revenues at airports. Port authorities will see reduced tonnage of shipments. My colleague Patricia Healy has written on this: https://www.cumber.com/cumberland-advisors-market-commentary-covid-19-and-municipal-credit-quality/).From a bond portfolio management standpoint, the US coronavirus outbreak means two things.

First, emphasize quality of holdings. We don’t know the duration of this crisis, but we do know that credit-spread widening is almost always a byproduct of this type of event.

Two, keep a barbell structure; that is, keep both longer and shorter positions – longer to capture some positive yield while we work through the crisis and shorter to take advantage of the eventual rise in yields. When does that happen? We don’t know. But, in our experience, yields that have dropped sharply, as is the case now, usually rebound at some point.

 

This graph captures the 10-year US Treasury yield and the trailing 12-month CORE CPI for the past 20 years. Prior to 2000 we had some incidences of this – mostly around 1979 when inflation was booming and the bond markets were disbelievers, and then during the stagflation of 1974–1975. We have seen this phenomenon for the third time in nine years now. In general, the duration of these periods is a year to a year and a half. The situation reverses in one of three ways – either a rise in yields or a rollover in inflation or a combination of both. CORE inflation recently hit 2.5%. Certainly, inflation will slow down if the economy backtracks. But if the virus crisis is short-lived, the economy should be able to get back on track. Going into the COVID-19 crisis, the economy was in very good shape, with 3.5% unemployment, still-low inflation, and real GDP growth in 2019 of well over 2% (nominal 4%).

We hope and pray for all during this time. But, speaking from a bond portfolio standpoint, we note that defensiveness is called for.

John R. Mousseau, CFA
President, Chief Executive Officer & Director of Fixed Income
Email | Bio

Tom Patterson
Fixed Income Research Assistant


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Cumberland Advisors Market Commentary – 2019: Bonds Roar Back

2019 saw bond yields turn around from their climb in 2018 and move lower. Since the Federal Reserve changed their language last December to being accommodative and data-driven, we have seen yields across the board come down a lot.

2019 Bonds Roar Back

There is no question that this drop in yields was driven, in large part, by what were low or negative yields in Europe and Japan. The 10-year Treasury started the year at 2.70% and ended the year at 1.90% after making a low in early September at 1.45%.

The drop in Treasuries in the latter part of the summer was dramatic. We saw the 10-year Treasury move from a 2% yield to 1.50% in the space of two weeks as US yields moved to catch up on the downside with European and Japanese yields.

Muni yields also saw a significant drop in the year, with 10-year AAA muni yields moving from 2.28% to 1.44% and 30-year AAA munis moving from 3.02% to 2.09%. The drop in muni/Treasury yield ratios was impressive, with the 10-year yield ratio moving from 84% to 76%; but just as impressive was the 30-year muni ratio/Treasury’s moving from 100% to 88%.

What are some of the takeaways?

* The flattening Treasury yield curve – which was such a source of concern in the summer – unflattened. As we have written, we never saw the flattening curve as much of a concern, because it was accompanied by long yields falling as opposed to short-term yields being jacked up by the Fed. Indeed, the Treasury yield spread between the 2-years and 10-year has risen from a minus 5 basis points in late summer to 26 basis points currently.

* Inflation has remained steady. Core inflation began the year at 2.2%. The trailing twelve-month is 2.3% as of November. This means that the 10-year bond REAL yield went from +50 basis points to -40 basis points currently. We know that negative REAL yields generally don’t last. They didn’t last in 2016, and we don’t think they’ll last now. Election years tend to be volatile in that regard.

10yr US Treasury Yield vs Core CPI

* The muni story was impressive. Not only did ratios drop, but muni supply ended up an impressive $424 billion after 2018’s $338 billion. The increase really came from two sources. Issuers took advantage of low rates just to sell new money, locking in almost historically low long rates. But we also saw a phenomenon that wasn’t being considered in the higher interest-rate environment of 2018. That is, issuers used the taxable bond market to advance refund older higher-coupon debt, to the tune of $70 billion taxable issuance in 2019. The 2017 tax bill took away tax-exempt advance refundings. However, with the drop in rates, many issuers could issue taxable paper and refund bonds that might have had 4.5%+ original yields and 2–3 years left to call dates. The cost savings on out years more than make up for the negative interest-rate differential between taxable muni rates and Treasury rates.

* Demand continued to be voracious for munis in high-tax states such as California, New York, and New Jersey. The 2017 tax bill eliminated deductions for state income taxes and local property taxes, so there are few places other than munis from which to get a tax-free income flow. Also, bond fund inflows were dramatically higher than in 2018. We expect this demand to continue, although shorter-term tax-free yields are very expensive – look at the end of the year shorter-maturity ratios in the mid-60 percentiles!

* The terrific stock market of 2019 (S&P up 31%) bolstered municipal pensions. But the lower interest rates will hurt discounted liabilities as well as assumed returns going forward.

As we move into 2020, the negative real yields in Treasuries are causing us to play defense in bonds. That means a continuation of a barbell strategy, with some longer paper offset by shorter defensive structures. Given that the Federal Reserve cut the fed funds target three times in 2019 (the rate now sits at a target range of 1.50–1.75), we feel the Fed will play a pat hand for the most part in 2020, in part because they want to see what the effects of their rate cuts are and also because, in an ideal world, they would like to stay out of the political fracas.

Presidential election years are always interesting and usually volatile. We will keep everyone informed.

John R. Mousseau, CFA
President, Chief Executive Officer & Director of Fixed Income
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.

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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.




The Danger of Rising Bond Yields, and the Opportunities

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

The Danger of Rising Bond Yields, and the Opportunities

Excerpt below:

The 10-year Treasury note was yielding 3.24% in midafternoon trading on Wednesday, just below the seven-year high reached Monday, when the 10-year Treasury yield hit 3.25%, buoyed by Friday’s unemployment report showing the jobless rate at its lowest level in 49 years. By day’s end the 10-year Treasury yield had retreated to 3.19%, below the 3.21% close on Tuesday, but the major U.S. stock market indexes were off more than 3% from the previous close.

Traders cited rising Treasury yields, escalating U.S. trade war with China and a recent IMF warning on global growth, including U.S. growth, for the decline, which was led by large-cap tech stocks like Apple and Google.

“Markets are repricing risks,” says David Kotok, chief investment officer at Cumberland Advisors. “Bottom line, rates have to go higher to really zonk markets, but markets are now starting to realize that there is an upward trend in interest rates, that there there is some rising, accelerating inflation, and that the Fed is being placed between a rock and a hard place by Trump because they have to contend with the growing effects of the Trump-Navarro trade war.” Peter Navarro is one of the top trade advisors in the administration.

Kotok notes that investors can now collect 5% yield on federally guaranteed mortgage-backed securities, 4%-plus yield on very high grade tax-free bonds, and 2% on cash equivalents. And with expectations that yields may go even higher, based in part on the Fed signaling more rate hikes this year and next, some bond buyers are stepping to the sidelines while other bondholders and stockholders “don’t need a lot of encouragement to sell on the heels of huge bull markets in both for many years.”

Read full article here: www.ThinkAdvisor.com