Financial markets are typically quiet in August. But not this quiet. The past 30 days have been the least volatile in more than 20 years, with only five days during that stretch seeing the S&P 500 move more than 0.5%. The eerie calm has caused some to worry about a potential downturn. Prior periods of similarly low volatility include early 2011, which preceded the debt-ceiling debacle in Congress that triggered a steep correction in risk assets, and January 2007, which foreshadowed the earliest stages of the global financial crisis.
"Everything feels distorted and unnatural; you know the source of that is the central banks but equally there's nothing to stop them carrying on," said Matt King, head of credit strategy at Citigroup, in an interview with the Wall Street Journal.
Many investors feel markets (especially yield assets) are overpriced, but there is no obvious catalyst for current conditions to change. The U.S. economy is growing steadily. Brexit failed to cause a meltdown. Italy is addressing its debt-ridden banking system. China is so far weathering the storm of economic liberalization. And if any problems do arise, there is the expectation that global central banks stand existentially ready to act. The "Greenspan put" became the "Bernanke put" became the "Yellen put." The only danger would be political developments jeopardizing central bank authority and independence.
Over the past few weeks we've discussed issues surrounding duration risk being taken by investors buying long-dated safe-haven sovereign bonds - or picking up pennies in front of a steamroller. Even modest price corrections would wipe out years-worth of yield payments. Well, a similar dynamic is developing in the volatility derivatives market.
Pension funds and other investors desperate for yield are increasingly engaging in put-writing in an attempt to profit off other people's fear. When volatility is low, those investors can enjoy steady returns, but if extreme volatility strikes, they are in line for significant losses. According to data from the U.S. Commodity Futures Trading Commission, positioning on VIX futures was recently the most bearish ever.
Analysts, including the last two guests on Wall Street Week, are also growing wary of a potential bubble in dividend-yielding stocks. Low-beta telecoms, conglomerates and utilities have continued to dramatically outperform broad indexes this year. Forward price/earnings ratios for the one-fifth of stocks in the S&P 500 with the lowest betas are 1.12 times the average P/E on the overall index... close to as extreme as the valuation spread between the two has been in the past 30 years. Also: "The five-year rolling correlation between S&P 500 companies' dividend yield and the index's performance has been at 0.80 or above for the five quarters through June, according to S&P Global Market Intelligence. That is the highest since 1993 and up from an average of minus-0.1 dating back to 1941." Running out of options for yield, Chinese investors are also piling into dividend stocks.
In the words of Seth Klarman, "don't be a yield pig."
Yellen Speech Raises Expectations For 2016 Rate Hike
All eyes this week were on Jackson Hole, Wyoming for the Federal Reserve's annual economic symposium. The biggest attraction, aside from les trois tétons, was Chairman Janet Yellen's speech Friday morning addressing both short-term interest rate expectations and potentially developing a new monetary policy framework for the future.
Regarding short-term policy expectations, Yellen said "the case for an increase in the federal funds rate has strengthened in recent months" in light of solid labor market performance and an improved outlook for economic activity and inflation. She indicated the economy is nearing the Fed's dual goals of full employment and stable prices without discussing specific timing for the next monetary tightening. Markets perceived the speech as more hawkish than expected as bets increased on the prospect of a rate hike in 2016.
Following the Brexit vote in late June, markets fully discounted the prospect of a September hike. However, following a muted response to the referendum within the European economy and two straight months of huge domestic job gains and promising wage growth, by last week odds had recovered to almost 20% (where they remained heading into Friday's speech). However, hours after Yellen's remarks those implied odds grew to 36%. Entering the week implied probability of a rate hike by December were basically a coin flip, but by Friday afternoon they had grown to more than 60%.
Yellen's message was the latest in a parade of commentary from Fed officials over the past few weeks appearing to prime the market for a rate hike (much like they did in the spring prior to having plans derailed by Brexit). Stanley Fischer, Fed's number two policymaker, said early this week the job market was close to full strength and still improving. New York Fed President William Dudley said a rate hike would be possible in September. Kansas City Fed President Esther George, the only voting member to dissent in favor of a hike at the last meeting, reiterated "I think it's time to move."
After spending most of the morning in positive territory, stocks retreated on Yellen's hawkishness, with rate-sensitive telecoms and utilities leading the decline. Next week's non-farm payrolls number could go a long way toward determining the Fed's path at its next meeting, although skepticism remains about whether the Fed will risk destabilizing markets ahead of the election. Citigroup believes a Donald Trump victory could "exacerbate policy uncertainty and deliver a shock (though perhaps short-lived) to financial markets."
Aside from the potentially harmful foreign exchange implications of pursuing monetary policy so divergent from the rest of the world, sources of Fed hesitation center on concerns over low inflation and headline GDP growth. Those worries show no signs of abating as on Friday the Commerce Department revised down last quarter's already-anemic GDP print from 1.2% to 1.1% on lower government outlays and bigger depletion of inventories.
While traders were focused on gleaning clues about short-term rates from Yellen's speech, a perhaps more-important discussion was taking place regarding the Fed's long-term policy future.
Traditionally labor markets and inflation have been heavily correlated. As people get back to work and the labor market nears full employment, wage growth and inflation accelerate. In the Great Moderation of the 1990's things worked in such a straightforward way. As a result, the public bought into the Fed's omniscience and Alan Greenspan enjoyed a 70% approval rating. However, since then Greenspan has seen his legacy wane, and the central bank has seen its credibility slowly erode. Most significantly, central bankers failed to recognize the conditions leading to the global financial crisis. While accommodative policy contributed to the subsequent recovery, the Fed has been perplexed by declining worker productivity and the growing disconnect between inflation and employment. The Fed has also projected faster growth than the economy delivered in 14 of the past 16 years, bringing into question its basic understanding of the economy. Each year the market laughs at the Federal Open Market Committee's (FOMC) ambitious projected course for rate hikes. Today only 38% of Americans have a "great deal" or "fair" amount of confidence in Janet Yellen.
In a bid to better understand current economic fundamentals - and justify emergency-level interest rates - central bankers have recently engaged in a discussion around the concept of r* (or r-star). R-star is essentially the natural long-term rate of interest that would create stable growth with modest inflation (the final target on the Fed's infamous dot plots). The Fed's projection of r-star has fallen from 5.25% in 2007 to 4.25% in June 2012 to 3% this June.
The Fed's policy rates are always viewed behind a background of natural rates. The spread between the Fed Funds Rate and r-star expresses the level of accommodation. Peak policy rates will be lower in a low r-star environment and higher in a high natural interest rate environment. In a recent blog post, former Fed Chairman Ben Bernanke said the combination of a savings glut and aging population has caused international r-star to fall lower than previously estimated. San Francisco Fed Chairman John Williams has expressed a similar belief, with which former Treasury Secretary Larry Summers largely agreed. Given the low natural rates of interest around the world, negative interest rates are perhaps not as extreme and expansionary as previously thought. As such, there should be less urgency in hiking rates.
Natural long-term interest rates are driven primarily by demographics, productivity and consumption, and there are several ways for governments to stoke them. The most obvious would be fiscal policy, which is even more heavily incentivized in a low-rate environment. The second would be promoting heavy immigration, from which the U.S. has always benefited but at the moment is politically tenuous around the developed world.
From a global central bank perspective, the only meaningful policy left in the tool-belt would be helicopter money, which is essentially the monetary financing of a fiscal operation. Recent discussion has also included the idea of raising inflation expectations beyond the traditional 2% marker, although that would have little effect without actual policy provision.
The biggest takeaway from this crash course in economic theory is that the Fed looks increasingly likely to target a lower long-term destination for policy rates, partly in order to justify past and future cautiousness. That doesn't mean there won't be a rate hike in September or December - after all, the Fed projected four rate hikes at the beginning of the year. But don't expect the Fed to ramp up the pace of monetary tightening any time soon.
European Economy Continues to Weather Brexit Storm
Italian President Matteo Renzi this week hosted his counterparts from Germany and France at a symbolic mini-summit at the island of Ventonene, where anti-Fascist political theorist Altiero Spinelli penned the manifesto credited with inspiring post-WWII European Federalism. The gathering is meant as an outward sign of unity ahead of next month's EU summit in Brataslava, where the bloc will attempt to chart a path forward following Brexit. Renzi faces his own constitutional referendum this fall. If the measure fails, he has promised to resign, which would set the stage for the nationalist Five-Star Movement to gain further influence within Italian politics.
Despite an initial shock from the Brexit result, the European economy has held up well this summer. This week the flash Markit Eurozone Composite PMI survey edged higher to 53.3 for August, a seven-month high. Worries still persist regarding the European banking system, however. Deutsche Bank CEO John Cryan lashed out at the ECB for its counterproductive policies, while the magnitude of opaque Level 3 assets at European investment banks is fueling worries about capital levels.
Chinese Firms Eye IPO Market
China continues to move forward cautiously with economic reforms. In a bid to curtail leverage in its domestic bond market the People's Bank of China (PBoC) is cutting the amount of cheap seven-day repurchase agreements (repos) in favor of pricier 14-day repos. China is also moving closer to the launch of a credit default swap market.
To help firms weather the economic slowdown accompanying liberalization, Beijing is cutting corporate taxes and reducing red tape, according to a Monday release from the State Council.
Meanwhile, Chinese firms are increasingly eyeing the IPO market. Waldorf Astoria owner Anbang is reportedly planning a Hong Kong IPO of its life insurance unit while China's Postal Savings Bank has apparently secured 60-80% of commitments for its planned $8 billion offering.
U.S. Economic Data Continues to Impress
The wave of strong economic data continued in the U.S. this week. Durable goods orders grew by 4.4% in July. Weekly jobless claims data declined to their lowest level in five weeks. New-home sales surged in July to their highest level since October 2007.
In the labor market, workers at the bottom of the ladder are getting pay raises as competition for labor increases. Even laid-off workers are having better luck finding jobs, as two-thirds of long-tenured U.S. workers laid off in 2013-2015 had new jobs by early 2016.
Follow Anthony Scaramucci on Twitter: @Scaramucci