Monday, July 15, 2013

Guest Post: 2nd Qtr Economic Review by Dorothy Jaworski

Shell Shocked

If you are a fixed income investor, you have seen the worst that the markets have to offer in the second quarter of 2013. Between May 1st and June 24th, when rates peaked, longer term Treasury yields rose by 86 to 100 basis points. The 5 year Treasury more than doubled from 0.65% to 1.51% and the 7 and 10 year Treasuries each rose 1% to 2.07% and 2.61%, respectively.

Mortgage rates fared poorly too, with the 15 year FNMA posted yield moving up 1% to 3.12% and the 30 year yield moving up 1.20% to 4.12%. Mutual funds and ETFs specializing in mortgage backed securities saw their worst quarter in terms of losses and outflows since 1992. However, all bond portfolios have suffered losses in this blood bath.

You are not alone in trying to understand how quickly the markets changed. If you are looking for a villain behind this madness, you can look no further than the Federal Reserve, the once proud institution who prided themselves on communication and transparency, but whose credibility sank as fast as bond, stock, and commodity prices. If you are a fixed income investor, you are clearly shell shocked.

In the past decade, we have seen several Treasury routs that resulted in huge selling in the markets, most notably in 2003-2004, 2005-2006, and 2009. The selloffs in 2003 to 2006 came during periods of higher GDP growth (4%+), healthier home prices, moderate core inflation, rising commodity prices, strong stock prices, a weak US dollar, and Fed tightening.

The selloff in 2009 was an adjustment following the extreme crisis in late 2008. In this 2013 selloff, we have sub-par GDP growth of less than 2%, rising home prices that are still 20%+ on average below their former highs, core inflation that is very low with inflationary expectations declining, falling commodity prices (except for oil), Fed easing, and a relatively stable dollar. We have the strong stock market, but of course that is where Ben Bernanke wanted you to put your money. By the way, rates have risen so violently that the advantage stocks enjoyed for the past one to two years with a higher dividend yield than the 10 year Treasury has been erased.

As we witness the last several months of the term of the once great Ben Bernanke as Fed Chairman, we long for the nostalgic “promises,” “forward guidance,” and scatterplot Fed Funds projections that defined Bernanke’s wish to be open about Fed activity. And in a few short weeks during May and June, the message from Ben and the Fed was mishandled very badly.

The only one who has not said much is our favorite dove, Janet Yellen, seen to be in the running to replace Bernanke. The Fed Governors’ conflicting messages, miscommunication about current and future policy moves, especially as they relate to the QE3 bond buying program and rate guidance left the markets unable to believe a word they said. Even though nothing had changed in the economic realm, the Fed implied that easing is about to end and then they said it will not end—short term rates will remain low until 2015.

When the Fed first made their “promise” to keep short term rates low for two years in the third quarter of 2011, Treasuries were as follows: 5 year at 0.96%, 7 year at 1.44%, and 10 year at 1.93%. If they do not tighten until 2015, two years from now, shouldn’t the math be similar—especially with lower inflationary expectations today?

When asked about bond buying, the Fed said that it will end soon and then they said it will end later, maybe when the unemployment rate gets to 7%. Then they said that the bond buying could increase! Exactly where did that come from? It then said that the QE buying doesn’t matter, but the size of the Fed’s balance sheet does. Confused yet?

When given a chance after the Fed meeting in June to reassure the markets and clear the confusion, Bernanke did nothing to convince the markets that tightening is years away, that a healthy employment market is years away, that sustainable GDP growth is years away, or that the Fed cannot predict the future with their crystal ball any better than we can. Instead, he let the markets think that the Fed will soon abruptly “taper” and then end the QE bond buying program, which was the reason rates were staying low.

He let the markets think that rising long term rates, including skyrocketing mortgage and municipal bond rates, are acceptable. Well, Mr. Bernanke, we are here to tell you that they are not. Why did you even bother with QE3 if you were going to work so hard now to negate its impact now?


The Fed Governors were quick to talk about the markets and the volatility that they themselves created. The war of words has begun. My personal favorite was when Dallas Fed President, Richard Fisher, stated that “Big money (on Wall Street) does organize itself somewhat like feral hogs.” I am surprised he did not talk about sheep, herds of cattle, or lemmings jumping off a cliff. Instead, he tried to reassure the markets with “I don’t want to go from Wild Turkey to cold turkey overnight.”

Indeed. During the last week of June, other Fed Governors have been feeding quotes to the Wall Street Journal in an effort to let the markets know that the Fed is not tightening anytime soon, that the market reactions have been “outsized” and likely wrong. But here we sit in the new, volatile reality. I personally am waiting for Jamie Dimon to save the day.

What About the Data?

Real GDP growth for the first quarter of 2013 was just revised down to 1.8%, following the anemic 0.4% growth in the fourth quarter of 2012. The nascent housing recovery will likely see home prices face some resistance as mortgage rates moved higher so quickly. Housing affordability is still good, but mortgage borrowers are shell shocked, too.

The index of leading economic indicators for May was only up 0.1% after the stronger momentum in April of +0.8%. Payroll employment growth has averaged 189,000 per month for the first five months of 2013, which is
lackluster for a recovery this old. The unemployment rate is at 7.6%; the labor force participation
rate is at a 30 year low at 63.4%; the pool of available workers stands at 18.5 million people—
representing tremendous unused capacity. This does not seem like an environment where growth
will break out anytime soon.

If we are hoping for growth to come from international trade, we will be sorely disappointed as China’s growth is slowing, almost all of Europe is in recession, and Japan is not likely to go on a buying spree. Oil prices have held in recently much to the delight of OPEC; gasoline prices are 3-4% higher than last year and continue to strangle consumer spending.

Ever increasing regulations, health care law enactments, and now the newly approved Basel III increased capital requirements for banks make it more difficult to achieve sustainable GDP growth. The future direction of Fed policy will be determined by data that is not yet even created. I don’t care what they say.


I have come to the conclusion that we are becoming too complacent. Why do we accept what is placed in front of us and not demand something better? One case in point is the still high price of gasoline, currently at $3.50 per gallon. Why don’t we work to increase the supply here by approving a new pipeline? Why don’t we provide incentives for researchers to find viable alternatives, ones that do not include plugging in my car for recharging like a phone! Come to think of it, why don’t we provide incentives for researchers to improve battery life for our phones?

Now is the time to incent people to improve and invest in the economy. Otherwise, we will just move along this mediocre economic growth path—QE3 or not.

Thanks for reading. DJ 07/03/13

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with First Federal of Bucks County since November, 2004.

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