Monday Market Review May 26, 2020
Economic news remained dreary, with expected poor results for home sales, leading economic indicators, and manufacturing—although there appear to see some signs of marginal improvement in sentiment for the latter.
U.S. and foreign equity markets rose as investors looked ahead to progress on a Covid vaccine, and continued extreme stimulus measures in the meantime, while emerging markets were less positively affected, due to deteriorating U.S.-China relations. Bonds were mixed as rates rose, yet corporate credit spreads tightened. Commodities gained as the price of crude oil and natural gas spiked last week with hope for stronger demand sooner than later.
Question of the Week
Are negative interest rates again being considered as a viable option for the U.S.?
With U.S. short-term interest rates again reaching the zero bound (fed funds rate of 0.00-0.25%), debate has surfaced again about moving the target range further—to below-zero territory. Several developed nations, mostly in Europe, moved down this path years ago, and now remain entrenched in it, with global slowing causing central banks to continue down an easing path. This is despite apparent regrets by some about doing so, due to the lack of effectiveness. (Reversing that stance by bringing rates back above zero would amount to a ‘tightening’ of monetary policy, and counterintuitive to current policy goals, especially in the depths of current Covid-battered conditions.) As recently as last week, the Bank of England reversed a prior stance, and is again reviewing the possibility of negative rates.
It might be helpful to provide a summary on what negative rates actually represent. In normal economic transactions involving debt, borrowers pay interest to lenders for the use of their funds. The ‘lender’ of money can refer to a variety of roles: bank depositor/savings account owner, institution offering a mortgage, or buyer of a bond. The latter relates to the commercial paper of a money market fund, corporate debenture, U.S. treasury bond, and others. In addition to macro factors at the time like inflation, the rate of interest charged includes two components: term risk, which compensates the lender based on the time period of the loan (why long rates are usually higher than short-term rates); and credit risk, to offset the chances of not being paid back. Due to these risks being taken by the lender, a positive rate has historically made economic sense. Otherwise, why lend?
In more extreme cases, a ‘zero’ rate situation can surface. In periods of severe economic distress, for instance, car manufacturers have offered 0% rate loans to some qualifying consumers, since the need to sell vehicles outweighs the benefit of any interest to be earned on loans. Although there’s usually more to it, that’s a trade-off they’re willing to make for potentially higher sales numbers. On the investor side and on a larger scale, zero or near-zero rates (such as for short-term U.S. treasury bills) may be attractive for buyers of bonds with no other options for placement of ‘safe’ assets (e.g. FDIC insurance is limited to $250,000). There, a return of principal is far preferable to risking loss elsewhere. A zero-rate situation was often assumed to be the natural boundary for how low rates could go, to preserve these natural economic incentives.
A negative rate implies the opposite logic. On one side, the lender would shove money at the borrower—in fact, paying them to take it. Many consumers would love a negative rate mortgage, in one popular example, but the risk-return tradeoff for a loan underwriter makes little sense over the long-term. (Note: there was a case of at least one bank in Denmark attempting this, although it had to be assumed money was being made elsewhere, though fees, etc.) The only true negative rates implemented have been by several sovereign governments in Europe and Japan as extreme government monetary policy stimulus. This was seen as easing even ‘beyond zero’, except that the logistical ramifications were quite different. In those nations, the pool of buyers for such bonds is often driven by requirement, such as pension funds, investors in foreign bond index funds, or by investors with such a need for safety or liquidity that paying a premium to own negative-rate securities was worth the trade-off. This market quirk has happened a few times in U.S. treasury bill markets, where the demand for safety has pushed the auction price over the $100 par value; under the assumption you receive only par back at maturity, the yield to maturity morphs into a negative rate. Those are normally self-correcting situations.
Some economic models, such as during the Great Recession and more recently with Covid, have spit out results calling for negative central bank policy rates. This is a natural extension of the 0% level not being ‘accommodating enough’, so the model keeps moving in the easing direction. This explains the policy appeal on the surface by these central banks. However, there are problems over the medium- to long-term with actually implementing negative rates. They have not been shown to be regularly effective in stimulating economies. When looking at this holistically, if buyers won’t purchase goods being financed at a zero interest rate (and/or due to other hang-ups in the lending system, like borrower quality), they haven’t been likely to do so at a negative rate, either. Liquidity in the system has been identified as a greater problem than demand for borrowing during these times, which sub-zero rates won’t help. Moreover, negative rates play havoc on the longer-term operations of certain institutions, specifically banks and insurance companies. Banks operate on the principle of ‘borrow low, lend high’—earning a net interest margin on the spread between rates for loans (assets) and rates paid to depositors (liabilities). This spread will naturally vary with time, but inverting the relationship makes banks unprofitable, and less viable. This isn’t sustainable for very long in an economy reliant on a healthy financial system. Negative rates would also have negative consequences for money market mutual funds, which are a very large part of the financial system, since they’re considered ‘cash-like’ and ‘default-free’ for many investors (despite the disclosures always stating otherwise). These funds had enough problems with viability under a period of post-financial crisis zero rates, when fees were included.
On a consumer level, low interest rates for savers and conservative investors have been difficult enough, but negative rates—implying savers would be charged a fee to preserve the status of safe assets—could be a catalyst for different economic behavior. We’re naturally incented to seek assets that provide payment of some sort, and avoid those that don’t. While part of a central bank’s incentive for negative rates would be to push these savers out on the risk spectrum by buying securities, etc. instead, it could backfire by incenting behavior such as hoarding cash (earning no interest is better than paying fees), or moving to alternative assets such as foreign currencies, or precious metals. Regressive hoarding behavior like this runs counter to the Fed’s goals of increasing economic activity and investment, so would not be a preferred outcome.
There are ways to provide negative-rate like stimulus, though, without an outright negative short-term policy rate. Quantitative easing, which has now been re-accelerated, is the purchase of treasury and agency mortgage bonds by the government. The new artificial demand pushes prices up and yields down, so has the effect of lowering rates below their natural level. Long-term rates are less likely to go down to zero, due to embedded long-term inflation expectations, but such QE allows more targeted policy at key points in the yield curve. The 5- and 10-year areas are especially important, since many consumer, business and home loans are pegged to these durations. Easy monetary policy here may be at least as, if not more, important than merely targeting the fed funds rate.
The Federal Reserve has come out several times over the years (and recently) with the consistent message that it’s opposed to the use of a negative rate policy. Many economists also appear to see such a policy as a low probability event, anomalies aside, but we’ve all learned to never say never.
U.S. stocks gained last week, with optimism on several fronts that gave investors hope following weeks of record-breaking negative economic news. Appearing on the popular CBS news program 60 Minutes the prior Sunday evening, Fed chair Jerome Powell’s announced that the Fed had not run out of ammunition ‘by a long shot,’ and there’s really no limit to what could be done through government lending programs. Additionally, Monday morning’s announcement by Moderna that a Covid vaccine produced antibodies (the primary objective) in phase I of a trial buoyed market confidence for a quicker exit out of the pandemic. This is was coupled with government pledges of billions of dollars to firms involved with vaccine development. However, the data not yet sufficient enough to declare a victory over the virus—which will require additional testing through subsequent FDA phases.
On the negative side, U.S.-China trade rhetoric has ramped up again, with blame being assigned for the Covid-19 origin story, and lack of medical transparency afterward. In a series of enhanced actions, the administration tightened restrictions on Chinese telecom Huawei, in terms of who the firm could do business with and level of technology sharing (particularly important in the growing 5G segment). Additionally, the Senate imposed legislation requiring firms controlled by foreign governments to be delisted from U.S. exchanges.
The gradual U.S. economic re-opening does seem to be making a difference in economic data. Although rates of change versus a year ago reached levels of -90% to nearly -100% in some segments, some green shoots are appearing, with activity seeming to improve each week. This was seen by the sharp rally in small cap stocks, which are assumed to be among the hardest-hit. By broader S&P sector, industrial and energy gained over 6%, followed by a recovery in real estate, while defensive health care and consumer staples trailed the pack.
Foreign stocks broadly earned similar returns to those in the U.S., helped by a weaker dollar in Europe and the U.K. Japanese and emerging market stocks lagged with minimal gains. A 500 bil. euro recovery fund for the next seven years, backed by sometimes-economic opponents Germany and France, boosted sentiment, although the stimulus nature solicited pushback from some EU members wanting loan-only provisions. Interestingly, despite downplaying the idea in recent weeks, policymakers in the U.K. are now actively reviewing the prospect of negative interest rates. Emerging markets, especially in Asia, were negatively affected by soured U.S.-China trade relations, as well as additional crackdowns on Hong Kong by China.
U.S. bonds rose slightly, mostly as spreads for corporate credit contracted, which offset small price declines in treasuries. High yield and senior bank loans gained strongly, followed by a less dramatic gain for investment-grade debt. Foreign bonds gained along with a weaker dollar, and for emerging markets, a continued return to risk-taking.
Commodities gained last week on the heels of a continued recovery in energy, while industrial metals also gained some ground. The price of crude oil rose by over 10% to just over $33/barrel. This came along with strong broader sentiment for risk assets as investors peeked around the corner for an end to the Covid-based downturn, and a recovery in energy commodity demand, also seen by a spike in natural gas prices last week.
(0/-) The Philadelphia Fed manufacturing index rose by 13.5 points in May to a still-severely contractionary -43.1, just below the -40.0 reading anticipated. Under the hood, shipments, new orders and employment all increased significantly, but remained in contraction. Prices paid rose by over 10 points to expansionary territory, in keeping with higher prices in certain areas. Expected business conditions for the next 6 months rose by 7 points to a strongly-expansionary level of 50, which again shows the general optimism in the economy for improvement in current lockdown conditions.
(-) Existing home sales in April fell by -17.8% to a seasonally-adjusted annualized rate of 4.33 mil. units, the worst pace in a decade, but not quite as bad as the -19.9% expected. By type, single-family home sales fell by -17%, while condos/co-ops declined by -27%. Every region experienced declines, led by the West, down -25%, following more severe Covid lockdown policies.
(-) Housing starts for April fell by -30.2% to a seasonally-adjusted level of 891k, below the 900k consensus level expected. This was despite an upward revision for the prior month by 60k, despite still a steep double-digit drop. The entire segment experienced a severe decline in activity, with the decline in multi-family starts by -41% was more severe than the -25% drop in single-family. All four regions suffered strong declines, with the harder-hit Northeast and West each down over -40%, while the Midwest fell ‘only’ -15%. Building permits fell by -20.8%, faring a bit better than the median forecast of -25.9%. Here, single-family activity fell by -24%, while multi-family permits were down -14%, with similar dynamics for the four national regions as seen in the starts numbers.
(+) The NAHB homebuilder survey for May showed improvement by 7 points to 37, beating expectations calling for a lesser gain to 35. All three segments improved sharply, with future sales expectations outperforming current sales and prospective buyer traffic. The Western U.S. surprisingly improved by over 10 points, while the Northeast fell by several points. This reversal in sentiment perhaps is based on a combination of some lockdown easing around the country, the inherent outdoor nature of the business (not as affected by social distancing), and a normal uptick in optimism prior to the key summer construction and sales season.
(0) The Conference Board Index of Leading Economic Indicators for April fell by -4.4%, which was slightly less severe than the over -7% historic drop the prior month, but a sour trend nonetheless. Most inputs declined with the financial components of stock prices and interest rate spread being the sole exceptions. Similarly, coincident indicators fell by -8.9%, while the lagging index rose by 4.1%. The charts below are about as ugly as it gets, other than the 2008-09 financial crisis period.
Source: The Conference Board. Shaded areas represent recessions as determined by the NBER Business Cycle Dating Committee.
(-) Initial jobless claims for the May 16 ending week fell by -249k to 2.438 mil., just above the 2.400 mil. estimate. Continuing claims for the May 9 week rose by 2.53 mil. to 25.073 mil., higher than the estimated 24.250 mil. Claims continued to increase in the largest states affected by Covid, including NY, WA, and CA, while falling claims were seen in a few locations where opening-up activity has occurring. Considering the pace and locations of lockdowns, claims are not expected to worsen, with a trough of 1/5 to 1/4 of the U.S. workforce (which most would agree is bad enough).
(0) The FOMC minutes from the April policy meeting showed a less eventful agenda than March, with no further fed funds action to take. Discussions seemed more focused on forward guidance (an increasingly important policy tool when rates are already at zero, in terms of how long they may stay at zero), and the QE program of purchasing treasury and agency mortgage-backed assets. The concept of ‘yield curve control’ was mentioned, which simply refers to the sufficient purchase of treasury assets to keep treasury yields pegged at a certain level. This has been done in the past, notably by name at the end of World War II, as a measure to keep monetary policy consistently stimulative as the post-war period saw a weakening of economic activity. So, there is precedent.
There is a good deal of uncertainty surrounding the forward-looking outlook, which is largely dependent on health conditions, including additional waves of virus outbreaks to be prepared for. In general, it appears an accommodative stance could be in place for some time as needed for the economy to repair itself. Inflation levels have fallen, partially due to lower oil prices and otherwise due to lower demand for consumer goods during the Covid epidemic. The committee appeared to discuss ways of measuring improvement in employment and inflation as the pandemic eventually subsides.
Have a good week.
Ryan M. Long, CFA
Director of Investments
FocusPoint Solutions, Inc.
Sources: FocusPoint Solutions, American Association for Individual Investors (AAII), Associated Press, Barclays Capital, Bloomberg, Citigroup, Deutsche Bank, FactSet, Financial Times, First Trust, Goldman Sachs, Invesco, JPMorgan Asset Management, Marketfield Asset Management, Morgan Stanley, MSCI, Morningstar, Northern Trust, PIMCO, Standard & Poor’s, StockCharts.com, The Conference Board, Thomson Reuters, T. Rowe Price, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wall Street Journal, The Washington Post. Index performance is shown as total return, which includes dividends, with the exception of MSCI-EM, which is quoted as price return/excluding dividends. Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor terms.
The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness. All information and opinions expressed are subject to change without notice. Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product. FocusPoint Solutions, Inc. is a registered investment advisor.
Notes key: (+) positive/encouraging development, (0) neutral/inconclusive/no net effect, (-) negative/discouraging development.