Morning Report: The push-pull of monetary policy

Vital Statistics:

			Last	Change
S&P futures			2732	3.75
Eurostoxx index			391.38	-1
Oil (WTI)			70.81	0.11
10 Year Government Bond Yield				2.98%
30 Year fixed rate mortgage				4.55%

Stocks are higher this morning as trade tensions with China eased somewhat over the weekend. Bonds and MBS are down small.

The Trump Administration is pushing Congress to get a long-term funding deal done by the August recess. 

There won't be much in the way of market-moving data this week - housing starts and retail sales will be the only possibilities. We will have Fed-speak every day however. 

As the yield curve flattens, it is attracting more and more attention. Chris Whalen argues that Fed manipulation of the curve is the driving force behind the flattening. By paying interest on excess reserves, the Fed has pushed up short term rates far further than demand for credit would imply - in fact he argues that if the Fed stopped paying interest on excess reserves, the Fed Funds rate would get cut in half. On the other side of the coin, fears of taking losses on its QE portfolio has caused the Fed to hold down long-term rates. Finally, he argues that the reason for the growth in nonbank lending has been due to unwritten guidance from the government to the big banks: don't go lower than 680 on FICO scores. There is a conflict between macroprudential regulation and monetary policy, which is inhibiting credit growth despite the FOMC's attempts to stimulate it. Whalen argues that credit growth is not high enough to really stimulate a recovery and that is due to hard caps the regulators have imposed on commercial and industrial lending, construction finance, and multifamily lending. I wonder if credit is behind the lack of housing construction despite such high demand. 

As rates rise, we are seeing more and more money flow into passively-managed bond funds. One of the interesting dynamics of passively managed indices is the self-reinforcing mechanism of the investing itself. For example, look at the FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google). Their weight in the S&P 500 is based on their market caps. So, as these companies outperform the S&P 500, their weighting in the index increases, which causes passive investors to buy more in order to maintain their weighting. It becomes a self-fulfilling prophecy. Here is where it gets strange in bond-land. Companies with the most debt end up dominating the index. So in theory, as a company gets more risky (by issuing more debt), passive investors demand more of their debt. So unlike passive equity investment, which builds on strength, passive bond investing builds on weakness. This means that there should be much more room for index outperformance with actively managed bond funds than with passively managed bond funds. 

Interesting chart from David Stockman:

If the ratio of net worth to income is going to revert to the mean, that means either asset prices are going to crash, or incomes are going to rise. I think the latter is what will occur.