Key Issues The FOMC Might Face In 2015

Key Issues The FOMC Might Face In 2015 by Bill O’Grady and Mark Keller, Confluence Investment Management

Summary

• The Federal Reserve will raise rates next year but in a very cautious fashion. We expect the first rate hike to occur next autumn and a target rate of 0.50% by year-end.
• The economy will grow around 2.5%; consumption will remain sluggish as household deleveraging continues and net exports deteriorate. On the other hand, the government sector will become less of a drag on growth.
• Our baseline forecasts for the S&P 500 for 2015 are earnings per share of $123.19 and a P/E of 17.7x, yielding a year-end price target of 2180.46. We assume that a recession will be avoided and so the most likely risk to our forecast is that we are too conservative.
• We forecast the 10-year T-note yield to hold in a range of 2.15% to 2.40%. Current low inflation and low foreign yields, along with steady inflation expectations and a modest policy tightening, will keep yields mostly stable.
• The dollar’s bull market should continue, driven by widening policy stances between the Federal Reserve and the European Central Bank and the Bank of Japan. Our forecasts are calling for a 1.170 $/€ and a 130 ¥/$ by year-end 2015.
• Commodity prices will remain under pressure due to weaker Chinese growth and a stronger dollar.

Key Issues

Every year has its own particular concerns and this year is no different. We have identified three key issues: the anticipated change in monetary policy, the continued ambiguity of America’s superpower role and the 2016 presidential election. This report will only focus on the first issue. We recently addressed the superpower role in our 2015 Geopolitical Outlook,1 and the 2016 elections have already been addressed in earlier reports.2 We will note how the latter two issues may affect next year’s markets in this report, but the details of our thoughts have been discussed in the aforementioned reports. After completing our discussion on monetary policy, we will offer our expectations for the economy, equities, interest rates, foreign exchange rates and commodities.

The Change in Monetary Policy

Since becoming independent in 1954, the Federal Reserve has never targeted interest rates this low or held rates steady for this long.

As this chart shows, the Federal Open Market Committee (FOMC), the body that sets interest rate policy, has never engaged in the sort of policies that we have seen since 2009. This situation creates significant uncertainty. For instance, keeping rates at this level for this long may have inadvertently caused parts of the economy to become increasingly sensitive to small changes in interest rates. Thus, will homebuyers be willing to accept higher mortgage payments if interest rates rise, or have they become so accustomed to low rates that a small increase dampens housing activity or forces sellers to reduce their asking prices? Will modest increases in deposit rates send savers flocking back to low-risk money markets and certificates of deposit, draining cash from other markets?

In addition to conducting the Zero Interest Rate Policy (ZIRP), the FOMC has also engaged in expanding its balance sheet, a process known as “quantitative easing” (QE).

The Federal Reserve’s balance sheet, which was $870 billion in August 2008, is now $4.4 trillion. The FOMC added to its balance sheet in three
stages (QE1, QE2 and QE3), marked as the gray bars in Chart 2. The latest phase has just ended.

The FOMC is considering changing policy due to improvements in the labor markets. The Federal Reserve has two mandates-controlling inflation and achieving full employment. For much of its history, the central bank has avoided placing numeric goals on either number to maintain policy flexibility. However, in light of the general trend toward transparency, the Federal Reserve has established unofficial targets for both numbers—2% for the core personal consumption expenditure deflator (core PCE) and 6% for the unemployment rate.

Although the long-term relationship between unemployment and inflation is rather inconsistent, since the mid-1990s, unemployment below 6% has tended to coincide with the core PCE deflator rising to the target inflation rate or above. Now that unemployment has broken 6%, the majority of FOMC members are leaning toward raising rates next year.

This chart, from the December FOMC meeting, shows that the vast majority of committee members believe that the policy rate should rise next year. Since inflation remains well below target, we can only conclude that the improvement in the labor markets is prompting  the expectation of tightening monetary policy.

Implicit in this conclusion is our presumption that a majority of the FOMC believes that there is presently a “taut rope” between improving labor markets and inflation. We doubt that the “rope is taut.”

However, this outlook is not universal because it isn’t clear whether the unemployment rate is correctly measuring the degree of slack in the economy.

This chart shows the unemployment rate along with the employment/population ratio on an inverted scale. From 1980 to 2010, the two series closely tracked each other; when the unemployment rate fell, the employment/population ratio improved. That correlation has not been the case in this recovery. The difference between the unemployment rate and the employment/population ratio represents nearly 7.5 million jobs. If those workers remain available to the economy, we could see higher growth without the sort of constraints that lead to inflation.

Unfortunately, a number of studies suggest this gap may be a permanent part of the economy. Some of the gap is due to the retirement of baby boom workers, while skill and location mismatches also keep potential workers out of the workforce. We tend to think that strong growth may narrow the gap somewhat, but the labor markets are probably tighter than the employment/population ratio would suggest. At the same time, the employment/population ratio does suggest that there are problems in the labor markets which may act to keep inflation under control. And so, an aggressive rate tightening cycle may not be necessary.

With this much uncertainty, why should the FOMC raise rates? It all comes down to available “slack” in the economy. There are numerous models one can use to determine the neutral rate for fed funds; one of our favorites is from Greg Mankiw. The Mankiw Rule is a simplified version of the Taylor Rule; both attempt to estimate a neutral policy rate based upon inflation and the level of underutilized capacity in the economy. The latter uses the difference between actual GDP and an estimate of GDP with fully utilized factors of production (potential GDP). Potential GDP is not directly observable and thus there is a good deal of uncertainty as to the actual degree of slack. Mankiw’s original model used the unemployment rate as his proxy for economic slack. We have created our own versions of his model; one uses the unemployment rate while the other uses the employment/population ratio as measures of slack.

The two variations generate significantly different results. Using the unemployment rate, the model’s projected policy rate should be 2.39%, suggesting the FOMC is “behind the curve” in raising interest rates. On the other hand, the version with the employment/population ratio, another measure of labor market slack, suggests the current policy rate (expressed officially as a rate between zero and 0.25%) is about right.

In general, the two models stayed roughly in line until late 2011 but have diverged since. The difference stems from the aforementioned divergence between the employment/population ratio and the unemployment rate.

The Mankiw Rule chart highlights the risks that the FOMC is facing. If the unemployment rate is the correct measure of slack, then the hawks on the FOMC are right—the central bank needs to be raising rates to achieve a neutral policy. If the employment/population ratio is correct, then the doves are right—the Federal Reserve has already achieved a neutral policy rate and should do nothing. Given the voting chart above, it appears that most members of the FOMC are leaning toward a hawkish stance, but with some degree of caution. If they really believe that the unemployment rate represents slack, then they would start tightening now; the uncertainty surrounding slack is probably leading to the slow pace of withdrawing stimulus. After all, QE3 just ended in October 2014.

Three Potential Outcomes from the Change in Policy

Recession: Perhaps the most unattractive outcome would be a recession. Although we believe recession is the least likely outcome, that doesn’t mean the likelihood is trivial. Whenever the Federal Reserve tightens policy the risk of recession rises. Below is a case showing the FOMC tightening too much and triggering a downturn.

Despite being in recovery since June 2009 and expansion since Q3 2011, this economic cycle has been much weaker than normal.

This chart shows the economic recoveries since 1960. The current recovery is the slowest over the past 54 years. In addition, economic growth remains well below its
long-term trend.

This chart shows a trend regression of GDP going back to 1901. The lower line shows the deviation from trend; current GDP remains below trend and is expected to remain so through next year. The only previous period that exhibited weaker growth was the Great Depression. Why is the economy so weak? Mainly because households are deleveraging.

Note that when GDP was well under trend during the Great Depression, households were deleveraging as well. The pace of deleveraging has slowed recently, prompting some analysts to argue that the economy could lift because deleveraging is complete. We disagree. Although there is no reliable way to determine how much debt is “too much,” the historical record suggests that a reading between 40% and 60% is probably a likely area of sustainability.

High levels of household debt have depressed consumption.

This chart shows the three-year moving average of the quarterly contribution of consumption to GDP growth. The gray bars represent periods of recession. Note that, at current levels, consumption is only adding about 1.5% to GDP each quarter; usually by this stage of the recovery, it is adding 2.25% to 3.00% each quarter. Reducing debt and weak income growth are keeping growth slow.

This chart shows trends in real median household income growth. In the mid-1970s, the trajectory of household income growth had flattened. Initially, households were unable to keep up with inflation. Later, globalization and deregulation led to widening income differences that have led to slower median family income growth.3 From the early 1980s into 2008, households tried to maintain their spending through borrowing; now that deleveraging is taking place, the impact of slow income growth is magnified.

The last time we saw conditions of deleveraging and slow growth was in 1936. Franklin Roosevelt had won his second term and the economy was recovering. The consensus among policymakers was that it was time to normalize policy and raise rates.

The U.S. experienced two recessions during the 1930s.

This chart shows industrial production from 1929 to 1940. During the Great Depression, the industrial production index fell by half. However, our interest is in the “echo” recession of 1937 -38. The recovery from the Great Depression began in 1933 and by late 1936 industrial production had exceeded the 1929 peak. As the economy recovered, policymakers pressed to normalize policy and raise rates. They were afraid of inflation and uncomfortable with the unconventional fiscal policies of the Roosevelt administration
and the devaluation of the dollar. The result was recession.

What is interesting about this downturn is that the rate hike was actually quite modest.

Three-month T-bill rates rose from 10 bps to 75 bps; a rise in rates of 65 bps was enough to trigger a downturn. Of course, a rapid fiscal tightening contributed to the recession as well.

The fiscal deficit narrowed from 5.4% of GDP in 1936 to a nearly balanced budget in 1938. Spending was cut; in 1936, federal spending was 10.3% of GDP, whereas by 1938, spending had fallen to 7.6% of GDP. Over the same time frame, receipts rose from 4.9% of GDP to 7.5% of GDP.

We would not expect the same degree of fiscal restraint in 2015. It is highly unlikely that tax rates will rise and the rise in employment, along with the sequester, has reduced spending and lifted tax receipts.

We doubt there will be further structural tightening to the fiscal budget. Thus, the primary risk to an echo recession is the FOMC. If the Fed lifts rates too high, the risk of recession rises. As the above T-bill chart warns, small changes in rates may have an outsized impact on the economy. There are other risks the FOMC will have difficulty calculating. Slowing global growth and a rising dollar will probably amplify the effects of tightening. Another risk might be that inflation expectations decline, which would tend to lower longer duration yields and could flatten the yield curve.

In fact, the best evidence that a recession may be in the offing would be the yield curve. Although there are a myriad of ways to calculate the yield curve, Chart 15 to the left shows what the Conference Board uses in its leading indicators. In every recession since 1970, this relationship inverts prior to recession. One could argue that it has generated two false positives, one in 1966 and in 1998, but in both cases, after steepening the curve subsequently inverted and a recession occurred. Since the 1970 recession, this indicator has had no false negatives; in other words, every recession was preceded by an inversion of this yield curve.

Once the FOMC begins to raise the fed funds target rate, investors should pay close attention to the 10-year T-note yield. If the yield fails to rise as quickly as the policy rate increases, the odds of recession will rise. However, to invert the curve, the FOMC would probably have to raise rates to at least 2.00%, if not higher, and the 10-year yield would have to decline or at least stay near current levels. That scenario is possible if the economy grows slower than our forecast. However, there are two caveats worth considering.

First, some fed funds target forecasts suggest rates higher than this level, which would increase recession concerns. The “dots” chart below shows the target level estimated by each member of the FOMC. If the hawks dominate the discussion, we could see fed funds in excess of 2.00% in 2016.

Second, although the stated aim of QE was to lower long-term interest rates, in reality, QE seemed to actually lift these rates. With QE ending, we could see further declines in long-term rates.

This chart shows the two-year and 10-year T-note rates with the gray bars denoting periods of QE. Note that the 10-year yield rose in all three episodes of QE; it subsequently declined after QE ended.

Overall, we believe the recession scenario is the lowest likelihood; however, this doesn’t imply that the probability is trivial. The most common cause of a recession is a policy mistake in which the FOMC raises rates more than economic conditions merit. Given the Federal Reserve’s domestic mandate from Congress, the FOMC is particularly vulnerable to being late to international developments.

Perhaps the key issue is Yellen’s evolution as Fed chairman. In general, chairmen tend to be either dominant or collegial. In the era of Fed independence, since 1954, most chairmen (in terms of tenure) have been dominant. William Martin, Paul Volcker and Alan Greenspan were all dominant chairmen. Generally, they were able to impose their views on policy and the rest of the board went along with their positions. Arthur Burns, William Miller and Ben Bernanke were more collegial and less dominant.

Bernanke did manage to implement unconventional policies that he clearly favored, but also tried to sway opinions on the FOMC to his position. Dominant chairmen have rarely concerned themselves with dissent…they simply overcame it by force of personality. So far, Yellen appears to be a collegial chairman. Remarks from various members of the FOMC praise her for her openness to their viewpoints. At the same time, Yellen may be the most dovish chairman since William Miller. It is unusual for a member of the FOMC and a Federal Reserve chairman to be as sensitive to the plight of the unemployed as she appears to be. A key unknown is whether she will continue to be as collegial when policy is moving in a direction she opposes. The “dots” chart suggests a FOMC that is leaning hawkish. Will Yellen acquiesce to the position of the board or will she move to impose her will on the board? Simply put, is Yellen “the Bishop of Rome or the Pope” in terms of monetary policy? If Yellen remains collegial, we will likely see a more hawkish policy than the financial markets currently expect. If a more hawkish policy is the outcome, the odds of recession will be elevated.

It should be noted that we expect two more governors to be appointed next year and they usually vote with the chairman. In addition, the FOMC composition next year will be more dovish than in 2014.

Four of the regional bank presidents rotate on the FOMC; this year’s slate included perhaps the most hawkish members of the FOMC, Presidents Fisher and Plosser of Dallas and Philadelphia, respectively.

It is not likely that anyone as hawkish will be on the voting board next year. Thus, the path of policy restraint will probably be less aggressive going forward. However, if Yellen were to find her “inner Volcker,” then policy would likely remain very accommodative.

Melt-up: There is an obvious, and clearly positive, relationship between unconventional monetary policy and equities.

The gray areas represent periods of QE. The correlation between the size of the Fed’s balance sheet and the S&P 500 is a positive 97%, suggesting that QE has been very positive for equities. A simple S&P/balance sheet model shows the relationship.

Of course, the relationship between the fed funds rate, the Fed’s balance sheet and equities could be purely spurious. Some other variable may be responsible for rising equities and the observed correlations may not be meaningful. Resolving this issue is the role of theory; simply observing the correlation isn’t sufficient to determine why variables are related. To determine causality is to establish why the variables are related. We have concluded that the impact of QE on equities is because the unconventional policy boosts sentiment.

This chart shows a form of cyclical P/E; we take the average four-quarter trailing earnings for the past 10 years against the current average quarterly S&P 500 index. Note that this P/E rose during periods of QE, suggesting that the primary conduit of unconventional monetary policy was investor sentiment. When the FOMC engaged in unconventional policy, it appears to have signaled to investors that the Federal Reserve was committed to supporting the economy and the markets.

So, now that unconventional policy is coming to an end, does that mean that equity markets are at risk? Perhaps, but there is a distinct possibility that if the FOMC signals that policy will rise slowly and with caution, it could embolden investors who have probably been concerned that the end of unconventional policy will be a major negative for equities. If it becomes apparent that the FOMC will not trigger a recession by raising rates, it might encourage investors to be more aggressive in equities.

Chart 21 examines the problem the Federal Reserve has created for itself. The blue line on the chart shows the Chicago Federal Reserve Bank’s Financial Conditions Index. The index is a measure of financial stress; it includes indicators like credit spreads, volatility indices and the overall level of interest rates.

From 1973 until 1998, the Financial Conditions Index closely followed the level of fed funds. The two series were correlated at +85.1%. However, since 1998, the two series have become almost completely independent.

Prior to 1998, when the FOMC raised rates, stress rose and acted as a “force multiplier” on policy. The increase in financial stress would curb investor enthusiasm and help slow economic growth and reduce inflation. And, of course, cutting rates would have the opposite impact. After 1998, tighter policy would not necessarily slow investor activity nor would cutting rates reduce stress and commensurate risk taking.

For example, during the 2004-06 tightening cycle, long-term rates rose modestly and risk-taking behavior expanded, especially in real estate. When the financial crisis ensued, the FOMC rapidly cut rates, implementing ZIRP. However, it still took nearly five years for stress levels to decline to pre-crisis levels, even with extremely accommodative policy.

If financial stress levels remain low after tightening commences, it could trigger risk-taking behavior similar to what we observed in the last decade. However, given the damage that remains in residential real estate, we doubt this market will be the target for investor funds. Instead, we would expect the equity market to receive most of the attention, especially since lower income households have borne the brunt of the real estate deleveraging.

Finally, why did the correlation between stress and fed funds break down? We believe it was caused by the Federal Reserve’s decision to become more transparent. Over the past 15 years, the Federal Reserve has steadily changed its policy toward revealing its policy goals. Until the late 1980s, the Fed did not indicate its target rate for fed funds, its inflation or employment goals or its policy decisions. Essentially, the FOMC met, decided and executed. The market had to figure it out on its own. The only announcement the Fed made was when there was a change in the discount rate and, given that this rate was for emergency use only, those changes weren’t significant. However, over time, the Fed became increasingly transparent, establishing a fed funds target, releasing statements, “dots” charts, consensus forecasts, etc. Although we live in a society that seems to place a high value on transparency, we have our doubts that this trend has served policymakers well.

By being so transparent, market participants can figure out the direction of policy and rapidly discount the endpoint. Without some degree of uncertainty, if market participants generally believe the FOMC won’t trigger a recession in a tightening cycle, the usual fear of recession which constrains investing, borrowing and lending will generally be absent. This condition will tend to undermine the effectiveness of policy tightening (as seen in the 2004-06 tightening cycle). Similarly, any hint of restraint in an easing cycle will tend to undermine the effectiveness of rate cuts.

Thus, the risk of a melt-up occurs when the FOMC begins tightening but makes it clear that rates won’t rise very high or very fast. This situation might embolden investors and press market values to potentially unsustainable levels.

Serendipity: The best outcome for monetary policy would be one that supports continued economic expansion but prevents overvalued financial markets. This outcome is often called a “soft landing,” in that the FOMC does reduce the pressures caused by an overheating economy by raising rates but avoids a recession.

This chart shows the fed funds rate dating back to 1954, when the Fed became independent; the gray bars represent recessions. There have been three tightening cycles that
didn’t result in recession, the 1960-67 cycle, the 1984 cycle and the 1994-95 cycle. Virtually every other cycle eventually triggered an economic contraction. Clearly, tightening
monetary policy increases the risk of recession.

For the FOMC to get policy “just right,” it will need to raise rates enough to prevent financial markets from becoming excessively valued but not so high as to cause an economic downturn. Referencing Chart 6, most likely, we would see a rate well below the 2.39% projected by the Mankiw Rule, calculated with the unemployment rate. Policy Conclusion: Given Chairman Yellen’s dovish tendencies and the clear historical example of 1937, we would expect the FOMC to err on the side of caution when tightening policy. We do not expect an overly strong economy next year or high inflation, which should also support a cautious approach. With little evidence of a recession in the next year, we lean toward  either scenario two, the melt-up, or scenario three, serendipity. Although the odds of a policy mistake that leads to recession are lower than the other two, they are not trivial. We do expect policymakers to avoid the recession outcome, but the FOMC could be vulnerable to underestimating the impact of overseas developments on the U.S. economy. Thus, a recession probably only occurs either by policy malpractice or an exogenous event (geopolitical, political, etc.). And so, the major risk next year is probably a melt -up (which is not in our baseline equity market forecast), although we place the most likely outcome as serendipity.

Expectations

The Economy: There is little to suggest that the economy will fall into recession this year.

This chart shows the Philadelphia FRB business outlook index, one of the indicators we closely monitor to determine if a recession is near. A reading of -10 confirms a recession; the current reading is well above that level and suggests a recession isn’t likely in the coming months.

That being said, overall growth should remain modest, at 2.5% to 3.0% for real GDP. Consumption will tend to remain weak due to the debt overhang (see charts 8-11 above); although it does appear that deleveraging is slowing, we do not believe that current debt levels are sustainable in the long run. Thus, consumption should continue to add about 1.5% to 2.0% each quarter. Government should be less of a drag on growth next year, but the stronger dollar will tend to weaken net exports and act as a growth depressant.

This chart shows the three-year average contribution to GDP coming from net exports, along with the dollar’s broad real effective exchange rate. In general, when the dollar index rises above 97.5, the contribution from net exports tends to become negative. And so, we would expect growth to remain positive but rather modest. Essentially, the economy will continue with below-trend growth but will avoid a recession.

Equities: Perhaps the most remarkable characteristic of the equity markets is the historic margins the corporate sector is enjoying.

This chart shows corporate profits (on a national accounts basis) compared to GDP. At 14.1%, it is near historic highs (excluding the spike seen during the Korean War). Similar conditions exist for the S&P 500.

Total earnings for the S&P 500 are just above 6% of GDP, a record high. These remarkable margins are due to slack labor markets and the low cost of capital. Low labor costs combined with rising productivity means that labor’s share of national income is declining.

Prices for finished products are rising relative to productivity-adjusted labor costs, which have consequently reduced labor’s share of the economy to near-historic lows. Deregulation, which allows for the rapid introduction of new technology, and globalization, which allows firms to optimize supply chains, are the primary factors for margin expansion.

Assuming that margins remain at current levels and nominal GDP grows by 4.8%,4 the S&P 500 companies would generate $1.113 trillion of earnings on an annualized basis in 2015. Taking this number and generating S&P earnings per share requires dividing this number by the index divisor.

The index divisor is a scaling factor used to derive the index. The divisor changes based upon (a) corporations entering and leaving the S&P 500, (b) share issuance and repurchase, and (c) firms conducting special stock-related transactions. For example, if firms repurchase stock, the divisor falls and, by definition, earnings per share will rise, all else held equal. Note that in the 1990s, the divisor rose steadily as companies issued stock to take advantage of equity financing. Since 2005, the opposite has occurred as firms have repurchased stock. We are assuming a steady divisor as there is no clear model to forecast the behavior of the divisor. However, the actual level of earnings per share is affected by the divisor.

Using a steady divisor yields an operating earnings per share forecast of $123.19. Our P/E model, which uses demographics, the long-term trend in CPI, consumer sentiment, fed funds and AAA corporate bond yields, suggests a P/E of 17.7x for 2015.5

The current four-quarter trailing P/E is running at 17.0x; historically, a reading of 18.9x would put the S&P 500 in overvalued territory.6

Assuming a P/E of 17.7x and S&P 500 earnings of $123.19, our 2015 year-end target for the S&P 500 is 2180. Given that margins are already extended, if our forecast is too conservative it will be because (a) multiples expand more than forecast, or (b) earnings per share rise because the divisor declines due to share buybacks. If investors become overly optimistic (the aforementioned melt-up scenario), then it will likely come from P/E expansion.

In terms of foreign equities, in general, we remain skeptical of foreign developed or emerging equity markets. We are expecting a stronger dollar this year which will act as a headwind for foreign investing.

This chart shows the relative performance of emerging markets compared to developed markets. When the blue line rises, developed markets are outperforming emerging. The red line shows the tradeweighted real dollar index. As the chart indicates, when the dollar rises, investors are better off in developed markets.

As the chart below indicates, the performance of the S&P 500 has been much stronger than the comparable Eurostoxx. Unfortunately, Europe is teetering on recession and the ECB is struggling to implement unconventional policies. At some point in the coming year, Europe may become attractive enough to consider allocations although, at present, we believe such moves are probably premature.

Fixed Income: Since the entire first section of this report discusses monetary policy, we won’t repeat that analysis here. We do expect the FOMC to raise rates in 2015, but gingerly, and this slow increase in rates should not have a dramatic impact on this sector next year.

Last year, we remained bullish on longer duration assets despite the consensus that longterm rates will be rising in 2014. Although economic growth improved as the year wore on, long-term interest rates have remained quite tame. The primary reasons for continued low rates have been slowing global growth and fears of global deflation.

This chart shows our 10-year T-note yield model. Currently, it is indicating a fair value for longer duration Treasuries of 2.26%, suggesting a modestly undervalued Treasury market. In general, with the low fed funds rate, steady inflation expectations and falling German sovereign yields, there is little upside for yields at present.

The model suggests that every 1% rise in fed funds causes the 10-year T-note yield to rise 0.38%. Thus, if fed funds reach 0.50% next year, the fair value yield on the 10-year T-note will rise to 2.45%, which won’t trigger a significant bear market in bonds. And, if the FOMC remains on the sidelines and Europe continues to struggle, we will likely see yields stay near current levels or even decline. Thus, our official forecast for the 10-year T-note is to hold in a range between 2.10% and 2.40%.

In terms of credit spreads, we have seen some widening recently, particularly in the below investment grade sector. However, due to our expectations of a relatively benign economic environment and stable financial stress, spreads should remain well behaved.

The spread between Baa corporates and the 10- year T-note are within normal ranges and would suggest corporate bonds still offer reasonable return opportunities. High-yield spreads have increased recently, mostly due to falling oil prices raising credit concerns among energy firms, which have been major issuers of “junk”-rated debt in recent years.

The spread between high-yield bonds and the five-year T-note has widened recently, although it does remain below average. However, as long as the economy avoids a recession, we should not see this spread widen much above average.

One area of particular concern is emerging market debt. The Bank of International Settlements (BIS) recently warned that emerging market corporate borrowing, in dollars, has been rising at a rapid pace.

This chart, from the BIS, shows dollar dominated credit to borrowers outside the U.S. Emerging market borrowers, shown in purple, are the largest segment of this market.

Borrowing in dollars has been an attractive option for foreign entities due to the greenback’s persistent weakness and low interest rates. However, as the dollar appreciates and interest rates rise, debt service costs naturally increase. Chart 37 below shows the dollar’s recent appreciation. We expect the dollar index to rise over 100 in the not-too-distant future. The two previous times the dollar was this strong, it precipitated foreign debt crises. The dollar rise in the early 1980s coincided with the Mexican Debt Crisis that evolved into a “lost decade” for Latin America. The rally in the mid-1990s led to the Asian Debt Crisis. U.S. investors often prefer to own dollar-denominated emerging market debt on the assumption that such instruments allow them to avoid currency risk. What they often fail to realize is that avoiding currency risk increases the odds of default risk. Emerging market debt has the potential to be a key exogenous event that could be difficult for the Federal Reserve to navigate in 2015.

Foreign Exchange: Due to the divergence in monetary policy between the Federal Reserve and the European Central Bank and the Bank of Japan, the dollar will likely strengthen next year.

This chart shows the JPMorgan trade weighted and inflation-adjusted dollar index. Since the mid-1970s, this index has moved above 100 on only two occasions, in the early 1980s and from the late 1990s into the early 2000s. We expect that we will have another rise above 100 in 2015.

The stronger dollar will tend to dampen inflation by suppressing import prices, weaken growth by encouraging imports and depressing exports, support fixed income markets and depress commodities. It will also act as a headwind to foreign investing. We are forecasting a €/$ of 1.170 and a ¥/$ of 130 in 2015.

Commodities: Commodity prices have been under pressure this year and we expect more of the same in 2015.

This chart shows the inflation-adjusted CRB index of commodity prices, starting in 1915. We have regressed a time trend through the data and the long-term downtrend shows that, over the long run, commodity prices decline compared to consumer prices. This fact is one of the reasons capitalism “won” over communismra. Generally speaking, under capitalism, incentives are in place to reduce commodity input costs to improve margins and also to produce commodities more costeffectively.

This allows households and businesses to spend their revenues on other finished goods and services. However, as the deviation line on the lower half of the chart shows, there are periods during which commodity prices move well above trend.

These events tend to be associated with wars, although the extended strong performance in the 1970s was also due to excessively easy monetary policy and the Nixon administration’s decision to abandon the gold standard.

The most recent secular bull market in commodities, which began in 2002, was historically the least impressive. At its peak in 2008, the deviation failed to rise to the upper standard error line on the lower part of the chart. Still, for investors, commodities did very well during this period. It should be noted that there were several military conflicts during this period but none were as resource-intensive as the earlier wars.

This chart shows the deviation line from Chart 37 along with the JPMorgan dollar index from Chart 36. Note that the strong dollar from 1980 to 1985 depressed commodity prices, although the subsequent dollar decline did little to support a rally in commodities. The second dollar rally, from 1995 to 2002, was mildly depressive. But, the subsequent decline in the dollar did help trigger the bull market in commodity prices. In general, the expected dollar rally will tend to pressure commodity prices.

The recent decline in crude oil prices, driven by OPEC’s decision to hold its market share rather than defend higher prices, has led to a sharp decline in the last sector of the commodity space that had avoided weaknesses seen in other sectors.

This chart shows the relative performance of the six commodity sectors of the Goldman Sachs Commodity Index (GSCI), rebased to 1992. The wider green line on the chart shows the overall GSCI. As the chart indicates, the strongest sectors have been energy and precious metals. The latter sector began to weaken in 2012, and the recent drop in oil prices is clearly indicated on the chart. The other sectors have performed fairly well, but it is clear that much of the commodity bull market was energydriven.

Although OPEC will probably defend a lower price at some point, oil prices will likely remain under pressure for the first half of next year. We discuss the geopolitical ramifications in our 2015 Geopolitical Outlook report, published on December 15, 2014.

Conclusion

The key issue for 2015 is expected to be monetary policy. Although we expect the FOMC to maintain a cautious stance toward withdrawing stimulus, the potential for a policy mistake is heightened. This will be a year in which flexibility will likely be rewarded.

Bill O’Grady, Chief Market Strategist

Mark Keller, CEO and Chief Investment Officer