Covenant Weekly Market Synopsis as of September 23, 2016

September 26, 2016

Buy, buy, buy… a lot of investors were pushing the buy button last week as risk assets, safe haven assets and inflation-sensitive assets (precious metals and commodities) all increased in price. Perhaps it was the generally supportive message from central bankers…. Whatever the reason, investors were ebullient last week. Global equities rose better than 2%, while large cap domestic equities increased by 1.2% and small cap stocks by 2.5%.  Investors also snapped up US Treasuries (moving the yield on the UST 10-year down to 1.62%, yields move inversely with bond prices) which even at 1.6% offer a substantially juicier yield than most other developed market fixed income instruments offering a yield of near, or less than, zero. The price of crude oil also moved higher as rumors circulated that OPEC members might agree to limit production at today’s meeting in Algeria. We’ve seen this movie before, so OPEC will remain guilty until proven otherwise about supporting a higher price for oil. At about $45 per barrel, WTI Crude is smack in the middle of the $40 – $50 trading range it has maintained over the last three months.

For a more detailed view of weekly, month-to-date and year-to-date asset class performance, please click here.


A tale of two banks: Last Wednesday was a central bank doubleheader as both the Bank of Japan (BOJ) and the Federal Reserve Open Market Committee (FOMC) held meetings on the same day. Neither bank did much on the surface, but looking deeper one can deduce that the central bankers are beginning to bump up against the limits that monetary policy can have on engendering real economic growth.

As you likely know the FOMC did not raise interest rates last week. However, the accompanying FOMC statement was rather hawkish, indicating the committee would like to increase interest rates in the near term. If the economic data holds up, odds favor the Fed moving rates higher by 0.25% at their December meeting. What may be of more importance is that the FOMC’s forward guidance on interest rates is falling faster than ever now, which is in effect a form of monetary policy easing relative to previous forecasts. The chart below compares the FOMC’s projection of the path of the Fed Funds Rate from June of this year and then updated as of their meeting last week.



Source: BCA Research

The first observation to make in this chart is that the FOMC continues to move their forward expectations lower, the downward shift in the forecasts from June (blue dotted line) to September (black solid line) is just the latest example. The second observation is that the market has continually forecast a Fed Funds rate anchored at much lower levels than the FOMC’s forecast. Incidentally, the market’s forecast of lower interest rates is a tacit forecast of slower economic growth because the market is seeing that the Fed will not need to raise rates to slow an overheating economy. As it turns out, the market has been far more accurate in forecasting future interest rates (and economic growth) than the FOMC. If past is prologue, which we currently believe to be the case, the FOMC’s interest rate forecasts will continue to converge with the market forecasts and the theme of “lower for longer” will remain intact, even if the Fed does move rates up at their December confab.

The Bank of Japan left its short-term target rate unchanged at -0.1%, but committed to target a 0% interest rate for its 10-year bond (which is currently trading with a slightly negative yield) and to allow inflation to exceed 2%. The BOJ’s goal is to create a positive yield in longer dated 30-year and 40-year bonds, which will incent banks to lend and increase overall economic activity. A positive sloping yield curve will also provide pensions and insurance companies with investment opportunities to fund their obligations. The BOJ is clearly struggling to pull Japan’s economy out of its multi-decade slump, having experimented with zero interest rates, quantitative easing, qualitative easing (verbally setting interest rate targets), and negative interest rates.

Bottom Line: The Fed is likely to raise rates in the short term, but rates will be lower in the long term and Japan will target higher rates to increase economic growth (typically higher rates act as a governor to growth). If you are still with me here, but you are confused, welcome to the club. The most powerful bankers in the world are sending conflicting messages, experimenting with novel monetary policies and have little economic growth to show for it. This series of events and unsatisfactory outcomes have not been lost on the market, which is assigning ever lower credibility to central bank forecasts.


Economic Wrap-up: Housing starts declined by 5.8% in August (vs. expectations of -1.7%), but not too much should be read into this number. Heavy rains in the southern states had a negative impact on starts, while other regions saw gains in both permits and starts. Moreover, the NAHB homebuilder sentiment index rose from 59 to 65 in September, indicating confidence amongst homebuilders heading into the Fall. Existing home sales also declined in August (by -0.9%), but here again this is not an indication of a lack of demand for housing. Rather a low supply level of existing homes (which fell from 4.7 months to 4.6 months of housing) are constraining turnover of the housing inventory.


Be well and Godspeed,