Gil’s Musings

Ignore the Fed

Over the years, the Federal Reserve has developed a reputation for being increasingly politicized. The inability of the Executive Branch to replace the Governors at will is supposed to provide insulation from political pressure. Yet, the practical reality is that the desire for friends in high places does in fact cause Fed leadership to pander. The president is eager to cement his legacy, asserting the recovery complete. The end of QE, or the normalization of interest rates is key. Yet, the Fed has been jawboning since 2011 about the need to raise rates, but has not yet done so. They won’t this time either.

There are several reasons that make me think this way. First, the hiking of rates would be a boon to foreign investors in our bond markets. The Germans would love an opportunity to buy two year US treasury bonds at 2% when theirs pay -.31. Yes, you read correctly. Negative rates. They put up $100,620 to be assured $100,000 at maturity. In Euros, of course. But that’s not all. The inflow of offshore currencies converting into dollars for the purchase would also drive the dollar even higher, making the German’s bond purchase even more profitable.

So what? U.S. exporters are already feeling the heat from a strong dollar. Most other countries have been on a binge to suppress their currencies in order to attract foreign purchases of their exports. This of course comes at a cost to US exporters. This would only get worse with rate hikes.

Slack in the economy is evident in lots of places, most notably in declining commodity prices. Oil is the latest victim, but iron ore, gold, and silver all peaked in 2012. The labor market is also not robust and loan demand is also weak since businesses are not aggressively adding capacity.

If I’m correct, this scenario would be good for the bond market. Prices on bonds would rise (and yields fall) as early sellers realize the mistake they’ve made. The recent bounce in utility stocks also foretells this shift since regulated utilities are viewed as a proxy for the bond market. This would also favor pipeline MLPs, yet their future is still a bit unknown as they try to navigate the trauma in the oil patch. This also provides an improving backdrop for European equities since they are talking about further rate reductions. Any surprise hike here would only accelerate that trend.

The greatest takeaway should be that if you’re buying bonds, longer maturities and longer call dates on munis is a plus.

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