The market feels a little like that Simon and Garfunkel song, whipsawing away. And that’s what stocks and bonds are doing a little of at present. The Fed held rates steady and the markets were a little surprised. (I don’t get that).
And why? Because Powell not only held rates steady but he also toyed with the IOER (interest on excess reserves) and made some comments about cutting, asset prices and bonds. The net result was a modest repricing of assets. All this time we thought Powell was going to be a Patsie for the President. Powell said in a nutshell that inflation was transitory and expect a surge at some point and that the Fed had no bias to ease or tighten policy.
The results suggest that the markets had gotten a little ahead of themselves. The Fed toyed with IOER and reduced that by 5bp to 2.35%. The IOER is one of the levers the Fed now uses to control cash rates and is what it pays to the banks for excess reserves lodged with the Fed. The cut ensures that the key overnight rate remains in the target band. The upper end of the target range was challenged last week, and this is why the interest paid on excess reserves was changed.
What we saw happen in the bond market was a flattening of the curve as the front end was shunted higher in yield. The long end remained reasonably steady. Powell’s observation of the economy was bullish, and this was the demise of the front-end trader.
For traders though, the big pointer was inflation and the transitory nature of inflation. Powell sees no reason why inflation is persistently below the target level. And this means that the Fed can be patient with its monetary policy. This gives time for the Fed to tighten or ease depending upon the circumstance. The Fed raised rates four times in 2018 and had anticipated a further rise in 2019.
For the stock market, Powell’s results were a bit of a shock. Powell poured cold water onto an otherwise bubbling market and cooled it quite quickly. The comment – “we aren’t any closer to a cut than we were before” – was the catalyst to sell. Stocks fell from their record intraday high. The selling was broad-based with most sectors lower on the day. Volumes were good with 7.44 billion shares trading versus the 20-day average of 6.61 billion. For the hedge funds shorting the Vix, today was not a great day.
Economic data will be important in assimilating the investment strategies as they will need a few tweaks. S&P 500 earnings are now only expected to decline by 0.5% for the quarter. This is in stark contrast to the 2% decline analysts were expecting. U.S. factory activity was at a 2 ½ -year low amid a sharp drop in new orders and a slowing of construction spending.
ISM said its index of national factory activity fell to 52.8 in April, the lowest read since October 2016. This reflects a slowing of factory activity. Construction spending declined by 0.9% in March. The ADP National Employment Report showed an increase in jobs for April, up 275,000. Unemployment is forecast to remain around 3.8%.
The dollar was the beneficiary of Powell’s comments. Oil on the day declined initially after U.S. crude production output set a new record. The day ended mixed as the intensifying crisis in Venezuela continues and the stopping of Iranian oil waivers commences.
Share buybacks are becoming topical again. This time it is Moody’s who are signalling a concern that investors will be expecting more of the same in the future. But at some point, these buybacks will impede a company’s ability to pay down debt. That’s the part that concerns Moody’s.
The shift away from credit positive activities such as repaying debt and the use of share repurchases suggests that the benefits of Trump’s tax cuts are waning. The problem, and I said this on more than one occasion, is that companies are borrowing to fuel the investor demand for share buybacks. It’s not excess cash reserves but borrowings that are driving the buybacks. This, in turn, imperils the company, which at some point will presumably have to repay debt.
In the second half of 2018, companies spent $114 bio on stock buybacks, compared with $38 bio on capital expenditures and $28 bio to pay down debt. In the first half of 2018 prior to the cuts, companies spent $71 bio on buybacks, $47 bio on capital expenditure and $72 bio paying down debt.
Any incremental spending on share repurchases for 2019 would neutralise any cash flow benefits received. Corporate America returned $664.9 bio of offshore profits (Commerce Department) and that’s well short of the trumpeted $4tr that Trump said would return as a result of his tax cuts. The new tax law sets a one-time 15.5% tax rate on cash and 8% on non-cash assets regardless of where profits sit. The corporate tax rate was also lowered to 21%. The incentive is to actually still keep profits made earlier offshore.
Equities: The S&P 500 fell 0.75% and the Dow fell 0.61%. The Vix closed at 14.8 while the Stoxx Europe 600 Index fell 0.1%.
Currencies: The Bloomberg Dollar Index rose 0.2% and the euro fell 0.2% while the pound rose 0.1%.
Bonds: (as at 4.30pm). The ten-year is trading at 2.502%. The 2-year is trading at 2.308% and the 30-year is at 2.908%. The U.S. curve closed on the day with the following closes 2/10 at 19.4 bp, 2/30 at 59.8 bp and the 10/30 closed at 40.2 bp. The U.S. 5-year closed at 2.303%. The 2/5 spread is now -0.6 bp. The ten-year bund closed at 0.012% and the British gilt closed at 1.152%. The 10-year yen gilt is trading -0.031%.
Commodities: WTI fell 0.5% and gold fell 0.6%.
Bitcoin is trading around $5,290.
Aussie Market Today.
Equities could look to weaken on the day. Offshore factors mean that volumes in Asia will remain thin. With both the U.S. and Europe weaker and commodities slightly weaker, the ASX looks set for a red day of sorts.
Bonds are likely to be steady with maybe a possible uptick in the front end to flatten the curve. Bonds should remain relatively stable because we have the election looming and also the RBA meeting next week. Headlines such as the worst of the property market declines over will also figure in the RBA’s thinking as to go with a rate cut. Credit looks better bid on the day.