2014 Direction

Friday, Janaury 31, 2014

Market Update: Risk On, Risk Off and QE or not QE

This week marked the end of the Bernanke era at the Federal Reserve. This is one for the history books and economists may debate for decades about the unprecedented actions taken by the Federal Reserve under Ben’s leadership. Was QE necessary or ultimately created such large asset bubbles and wealth redistribution to the 1%, that it failed, making matters worse. Janet Yellen’s job may prove to be equally challenging as the Great Unwind of monetary stimulus begins. I mentioned last week that the market had anticipated higher rates by the tune of 50bps during 2014 versus the close of 2103. This past week reminded everyone that predictions are rarely correct, with rates dropping another 8bps. The 10yr stands today at 2.66% and at one point during Tokyo trading was below 2.65%. A lot of action this week as rates continued to grind lower. US Economic data supported the Fed’s decision to continue the pace of tapering asset purchases by another $10B to $35B a month of Treasuries and $30B of MBS. S&P Case Shiller Home Price Index came in close to expectations but did show home prices were leveling off rather quickly in November. GDP, the best measure of the economy came in at 3.2% annualized for the 4th quarter, in line with expectations. Personal Consumption and Personal Spending were good figures, however Personal Income was flat. The economy continues to chug along despite no real job or income growth. That is concerning.

The big news this week that is likely to get continuous focus are the emerging markets. Emerging markets for all practical purposes, are tier 2 countries. There is no real standard definition but generally defined as the BRIC (Brazil, Russian, India and China) as well as MIKT (Mexico, Indonesia, South Korea and Turkey) but there are a dozen or so others. The currencies in these countries are becoming devalued relative to the dollar rather abruptly and some have taken drastic steps to protect the value of said currency. Turkey raise their short term interest rate from 4.5% to 10% in a single day. Hard to say at this point if that will stabilize the outflow of cash but it could cause a panic (which hasn’t happened yet). Imagine for a minute you are buying Russian made televisions for $100 and you have concern over the quality of the TV’s and ultimately how much you could sell them for. Now picture if the manufacturer decided to lower the price of the TV’s to $40 in one day. Would that inspire confidence for you to buy more or cause you to question the quality of the TV? That’s basically the dilemma investors in Turkish (and emerging markets to some degree) currency are faced with. I apologize to the people of Turkey for comparing their economy to Russian television manufacturing.

When you have the super-power United States reduce stimulus and dictate to the world that it intends to raise interest rates eventually, that echoes around the entire globe. Thanks to the low interest rates that monetary stimulus has provided, investors looking for higher yield have moved their money into thousands of different places. Call that the ‘Risk On’ trade. Investors are willing to take risk for higher return than what the lowly Treasury rates can provide. Well at some point there will be higher rates (who knows what higher actually is – TBD) and the greed for higher returns turns to fear of potential losses. If lower rates causes money to flow out, shouldn’t higher rates cause money to flow back in? And so the ‘Risk Off’ trade begins. Emerging markets are feeling it the worst. The stock market is beginning to feel it. The fear of economies standing on their own with higher interest rates should and will cause every investor to rebalance their risk position. Meanwhile interest rates in the US are pushing lower, even with the removal of stimulus. If you needed another reason why it’s great to be a citizen of this country, it’s that the ‘Risk Off’ trade typically involves the purchase of US Treasuries. The safest bet is almost always US Treasuries, one of the best parking spots on the planet. And that’s where we stand today, grinding lower in rates while emerging markets around the globe race to protect their currency. Keep an eye on those markets and it will be very interesting to see how the Federal Reserve responds. As of now they are sticking with their game plan but there will certainly be pressures to slow the taper if the troubles around the world continue.

Shifting back to home prices in the US; with the simultaneous rise of both interest rates and home prices, housing affordability has dropped a fair amount. But how much and historically where does it stand? Today housing affordability is still very strong as the graph below would indicate. The red line is for the Western US and blue is all states. As you can see affordability came down rather quickly in 2013 and has leveled off recently. A score of 100 means the average income can afford the average home price, higher than 100 indicates the average income can afford more than the average home price. While affordability has come down, it is historically very low. And as you would expect, affordability is lower in the western states where there typically is greater demand for housing.


Economic Data Release Calendar:

Monday 02/03

ISM Manufacturing and Construction Spending

Tuesday 02/04

Factory Orders

Wednesday 02/05

MBA Mortgage Applications and ADP Employment Change

Thursday 02/06

Trade Balance, Initial Jobless Claims and Bloomberg Consumer Comfort

Friday 02/07

NonFarm Payrolls and Unemployment Rate



Jason Obradovich,
VP of Capital Markets, New American Funding