Interest Rates And Yield Curve Control – Part 1


The Trimmed Mean PCE inflation rate is an alternative measure of core inflation in the price index for personal consumption expenditures (PCE). It is calculated by staff at the Dallas Fed, using data from the Bureau of Economic Analysis (BEA).”

Through June 2020:

The Trimmed Mean PCE inflation rate over the 12 months ending in June was 1.8 percent. According to the BEA, the overall [June] PCE inflation rate was 0.8 percent on a 12-month basis and the inflation rate for PCE excluding food and energy was 0.9 percent on a 12-month basis.”

(Trimmed Mean PCE Inflation Rate)

The annualized one-month trimmed mean PCE inflation rate was 2.8% in January and plummeted to 1.1% in March; April was 1.3%; May was 1.5%; June was 1.7%. Note the steady increase of PCE inflation over the last four months. Using the trimmed mean PCE as the inflation measure of choice, we can conclude that the entire Treasury yield curve is now trading at negative REAL interest rates. We will have more on this later in this series (today is part 1).

In our view, this is an important series to follow. Reason: Fed Chair Powell has publicly mentioned that he follows it. In simple terms, the idea of trimmed mean inflation is to discard the very volatile items in the inflation statistics and thus narrow the estimate of inflation to the price changes of the majority of items in the center of the distribution. In Powell’s words:

It cuts off the big movements on the upside and the downside, looks at the mean movements of inflation on the various product categories and service categories.” (“Just when you got used to core inflation, Powell talks up another measure – ‘trimmed mean'”, MarketWatch)

In my experience, the concept of trimmed mean has been controversial, with advocates (including me) facing off against detractors. Readers may want to look at all historical series that estimate rates of inflation. That’s what I do. Together, they help me assess the rate of changes in prices.

The trimmed mean inflation estimation method originated, along with the trimmed mean CPI, in pioneering work done at the Cleveland Fed by Steve Cecchetti (now professor of global finance at Brandeis International Business School) and carried forward by Mike Bryan (now vice president and senior economist at the Atlanta Fed). Here is a link to the Cleveland Fed’s trimmed mean CPI monthly report.

(Bryan and Cecchetti and their colleagues produced a wealth of research on inflation measurement when they were in Cleveland and since. Here is another of their seminal papers: “Measuring Core Inflation“.)

I’ve had occasion to participate on panels with Steve and Mike and respectfully, hope I can articulate this concept in simple layman’s terms for our readers. The statistical method to optimize the “trimming” is, however, complex.

We believe that the trimmed mean estimation process has become extremely important during this very volatile pandemic period. We can see that volatility by examining the reports from the Dallas Fed and Cleveland Fed. I personally review them in detail every month as they are released.

Normally, the various measures of inflation track closely with one another. We would expect that in normal times. But these are not normal times. That is why the trimmed mean process is important.

The trimmed mean estimation tells us that inflation bottomed coincidentally with the March-April plummet in the US and global economies. For the US, the sensitive (monthly and annualized) numbers suggest that inflation is gradually reappearing. We believe these early signs must be respected.

The implication is that US interest rates are nearing or have reached a bottom. We will have more to say about that as this series on rates and yield curve controls is published.

At Cumberland, we are using a barbell approach now in our managed bond accounts. The degree of barbell shifting and the structure of the barbells is a topic for a technical conversation that can be held with a number of folks in Cumberland’s fixed-income division. The trimmed mean methodology suggests that the fierce deflation pressures from the pandemic ended in March, coinciding with the bottoming of the economy and the March 23rd bottom in the US stock market. Readers, please note that is an early and not yet confirmed assertion. It will be a year before we have sufficient data to verify this assertion.

Also, note that at Cumberland, we are portfolio managers, and our job is to assess and respond to changes in trends and in risk. Inflation shifting is an extremely important item for the performance of both bonds and stocks. That is why we are so focused on it. We’re working on part 2 of this series now.

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.





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Asian markets mixed as Fed keeps interest rates unchanged


Asian markets were mixed early Thursday, after the U.S. Federal Reserve left interest rates unchanged, as expected, and the CEOs of big tech companies emerged from a House antitrust hearing relatively unscathed.

Japan’s Nikkei 225
JP:NIK
slipped 0.1%, while Hong Kong’s Hang Seng index
HK:HSI
rose 1.2%. The Shanghai Composite
CN:SHCOMP
advanced 0.1% while the smaller-cap Shenzhen Composite
CN:399106
gained about the same. South Korea’s Kospi
KR:180721
rose 0.3% while benchmark indexes in Taiwan
TW:Y9999
, Singapore
SG:STI
and Indonesia
ID:JAKIDX
were mixed. Australia’s S&P/ASX 200
AU:XJO
picked up 1%.

In South Korea, shares of Samsung Electronics
KR:005930
inched up after the tech giant reported a strong boost in second-quarter profit, due to strong demand for chips. However, Samsung lost its title as No. 1 smartphone maker in the world, as China’s Huawei Technologies surpassed it for the first time in the second quarter. Analysts cited a sharp drop in Samsung’s sales due to the coronavirus pandemic coupled with Huawei’s strong sales within China.

Also Thursday, Japan reported retail sales rose by a better-than-forecast 13.1% in June over the previous month. That means retail sales in one of the world’s biggest markets were only 0.9% lower than in February before the crisis hit, Tom Learmouth of Capital Economics said in a report.

The Fed on Wednesday stayed pat on monetary policy, as Fed Chairman Jerome Powell said he sees the U.S. economy flattening as coronavirus cases continue to rise. Powell said additional aid from the Fed and Congress will be needed to weather the crisis, calling it “the biggest shock to the U.S. economy in living memory.”

Experts said if the economy worsens, the Fed will likely take incremental action at its next meeting, in September.

“Investors liked what they heard from Chair Powell,” Stephen Innes, chief global markets strategist at AxiCorp, wrote in a note. “Indeed, this is a Fed that appears to feel the pulse of the economy even despite the meeting coming in line with expectations and offering no new policy announcements. However, it did provide a suitable curtain warmer for a more resultant meeting in September.”

Also Wednesday, the CEOs of Apple
US:AAPL
, Amazon.com
US:AMZN
, Facebook
US:FB
and Google parent Alphabet
US:GOOGL
US:GOOG
testified before a House antitrust subcommittee. After more than five house of questioning, the hearing ended with few actual developments, though the panel’s final report may influence the direction of a number of investigations into the tech giants by the Justice Department and the Federal Trade Commission.

Stocks finished high Wednesday, with the Dow Jones Industrial Average
US:DJIA
gaining 160.29 points, or 0.6%, to 26,539.57, the S&P 500
US:SPX
adding 40 points, or 1.2%, to 3,258.44, and the Nasdaq Composite
US:COMP
climbing 140.85 points, or 1.4%, to 10,542.94.

In energy markets, benchmark U.S. crude
US:CLU20
rose 2 cents to $41.29 per barrel in electronic trading on the New York Mercantile Exchange. The contract gained 23 cents on Wednesday to $41.27. Brent crude
UK:BRNU20
, used to price international oils, added 7 cents to $44.16 per barrel in London.

In currency dealings, the U.S. dollar
US:USDJPY
was at 105.03 Japanese yen, up from 104.90 yen on Wednesday.

The Associated Press contributed to this report.



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The Fed isn’t likely to take U.S. interest rates below zero and that’s going to shock today’s bond holders


Bond investors may be setting themselves up for disappointment if they’re counting on pocketing gains from U.S. interest rates going negative. There is a growing body of research that negative rates are counterproductive. Moreover, the Federal Reserve is aware of this research and appears to be taking it seriously. As a result, it has become more likely that the Fed in the future will turn to other tools in its monetary stimulus tool chest besides reducing rates into negative territory.

One study pointing in this direction appears in the August 2020 Journal of Behavioral and Experimental Economics. The study, “To decrease or not to decrease: The impact of zero and negative interest rates on investment decisions,” was conducted by Lior David-Pur, Koresh Galil, and Mosi Rosenboim of the Ben-Gurion University of the Negev in Israel. David-Pur is also the head of the Government Debt Management Unit in the Israeli Ministry of Finance.

The researchers created a number of fascinating simulations and tests to see how investors might behave in various rate-decreasing scenarios. In one simulation, for example, interest rates were decreased to 0% from 1.0%, and in another to minus 1.0% from 0%. In theory, bonds should behave similarly in either scenario: for example, the iShares Core US Aggregate Bond ETF
AGG,
+0.10%

with an average duration of 5.5, should in theory produce a capital gain of 5.5% in each of the scenarios.

It’s the prospect of such gains that has enticed many investors to continue to bet on bonds despite record-low yields, as bond prices rise when yields fall. But if zero becomes the rate below which central banks are unlikely to go, then investors need to temper their enthusiasm.


If risk-taking doesn’t increase, what’s the point of making rates go negative?

This new research found that these two scenarios have much different impacts on the broad economy. In the former scenario in which rates are reduced to 0% from 1%, risk-taking across the economy increased, as you might expect. But in the latter scenario, in which rates went below zero into negative territory, leverage decreased rather than increased. That’s just the opposite of what central banks intend when decreasing rates below zero. If risk-taking doesn’t increase, what’s the point of making rates go negative?

Central banks are negative on negative rates

It would be one thing if this new study were a lone voice in the wilderness. But it builds on, and confirms, what many central bankers suspect. In December of last year, for example, the Swedish central bank moved the repo rate back to zero after keeping it negative for five years. Its governor was quoted as saying: “If the choice were to be at zero or slightly negative, to be at zero is a good place to be.” (See article in the Financial Times entitled: “Why Sweden ditched its negative rate experiment.”)

Upon studying the impact of negative interest rates in Japan, furthermore, researchers at the San Francisco Federal Reserve Bank found this reduced expected inflation rather than increased it. That’s just the opposite of what the Japanese central bank was hoping.

And at a Federal Reserve policy meetings late last year, Fed Chairman Jerome Powell said that “the evidence on the beneficial effects of negative interest rates abroad was mixed, and that it was unclear what effects negative rates might have on the willingness of financial intermediaries to lend and on the spending plans of households and businesses.”

To be sure, these statements don’t provide any certainty that the Fed wouldn’t cause rates to go negative. It is under some political pressure to do just that from President Donald Trump, who tweeted that the Fed should accept the “gift of negative rates.” But, in an email, David-Pur said that, based on statements from Fed Chairman Powell, he thinks “it is less likely that the U.S. will go below zero.”

Implications for bond investors

If so, then bond investors’ potential capital gain from current levels will be limited. With the 10-year Treasury
TNX,
+2.61%

TMUBMUSD10Y,
0.634%

currently yielding just 0.63%, a decline to zero would produce an estimated gain of 3.5% for the iShares Core U.S. Aggregate Bond ETF. That’s nothing to sneeze at, but perhaps not enough to counterbalance the losses if U.S. rates were instead to move markedly higher.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com

More:When low yields can be a good deal for investors

Also read: The No. 1 market-timer of the 1980s and 1990s has this message for today’s buy-and-hold investors



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Increased wait times for COVID-19 test results coincide with higher rates of infection among younger people


The average New Yorker is now getting their COVID-19 test results back in three days, Mayor Bill de Blasio said on Wednesday, as the city works against a national “logjam” in diagnostic testing. 

This week, test result time has started to “rapidly” decrease in New York City, de Blasio said, though with the caveat that the data was preliminary. “Based on the latest information, the average — this is not everyone — but the average for test results is down to three days.”

That’s roughly twice as fast as the nation’s leading laboratories, which this month revised their expected turnaround times up to a week or more as cases surge across the country. Earlier this week, de Blasio said the national “logjam” had slowed down test results in New York, where some 40,000 people are tested everyday. 

Potentially elongated wait times came at a moment when the virus is spreading fastest among young adults, a demographic that is more likely to be asymptomatic or only mildly ill, and who have shown to be more cavalier about social distancing and other precautions. Some of the most egregious examples of people flouting the mask mandates and distancing guidelines in New York City have been crowds of young adults around bars, restaurants and parks, particularly in Manhattan. 

See: COVID-19 is far from contained and could rival 1918 flu pandemic that killed 50 million, experts warn

Total infections among 18-to-44-year-olds in New York City grew three times as fast as the infections among people 65 and older in the first two weeks of this month, according to data from the city’s health department. Hospitalizations among people 18 to 44 years old rose roughly twice as fast as those 65 and older during that timespan.  

As in other parts of the country, much of the growth in cases has come specifically from people in their 20s, de Blasio said this week, as he announced a campaign to target that demographic with messaging about taking precautions and getting tested. Cases among 20-somethings have reportedly risen sharply in the Financial District, Greenwich Village and Lincoln Square—all in Manhattan. 

“We knew it was going to be more challenging for younger people,” said Dr. Jay Varma, a senior adviser to the mayor, on Wednesday, calling the phenomenon “epidemic fatigue.” 

“They need to sacrifice a lot even though their individual risk of getting severe disease is low,” Varma said. 

The challenge of quarantining at home while awaiting a test result only grows the longer the results take to come back. The challenge of contract tracing also grows if people who eventually test positive spend more than a week leaving their homes before receiving their result.

The city’s public Health + Hospitals system, which has dozens of locations with free walk-in testing, offers the fastest turnaround time, de Blasio said. An email sent to the hospital system seeking comment on why it can provide faster testing was not immediately returned, though the mayor said the city had been pushing “labs to step up.”

Inevitably, some New Yorkers will wait longer than others, and in some cases twice as long as they would have waited a month ago — before the surge in U.S. cases inundated national laboratories, where many of the city’s private clinics send tests.

Also see: Though New York City rat sightings are down overall, there could soon be an increase

In late April, when New York City was still the nation’s leading hot spot, walk-in clinic CityMD sent out an email to patients saying its branches finally had enough tests for anybody who needed one. Results could be expected in three to five days, the email said. Now, the chain, based in New York and Northern New Jersey, has had to update the turnaround time on its website and on the signage across its 120-plus branches, said Joy Lee-Calio, a spokeswoman for CityMD’s parent company, Summit Medical Group. 

“We have been telling all COVID-19 test patients to expect a minimum seven-day turnaround time for test results, based on guidance from our national lab partners,” she said in an email. “If we could speed up the process, we certainly would.” 

Indeed, two of the nation’s biggest commercial labs, Laboratory Corporation of America
LH,
+0.48%

and Quest Diagnostics,
DGX,
-0.38%

which combined can process north of 1.7 million tests a week, have seen turnaround times roughly double since mid-June.

A month ago, the average wait time for Quest to process a diagnostic test was 2-3 days. On Monday, the company updated that guidance to seven days or more and said it was working to ramp up capacity by 20% by the end of July to handle the surge in U.S. cases. 

Also see: Moderna’s stock extends rally as experts await details of the coming Phase 3 study of the coronavirus vaccine candidate

“We will not be in a position to reduce our turnaround times as long as cases of COVID-19 continue to increase dramatically,” the company said in a news release on Monday.

Northwell Health Labs, which processes thousands of tests a day at its in-house laboratories, typically turns around an asymptomatic or mild-case screening within three days, though a patient in immediate care in one of Northwell’s many hospitals in New York state will get a result in a few hours, said Executive Director Dr. Dwayne Breining.

“We have multiple tiers of turnaround time, depending on the clinical acuity,” Breining said. 

Breining acknowledged, however, that the wait time could be longer than three days in some cases because of certain dependencies, such as supply chains, that could be impacted on a nationwide level. 



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A Rise In Capitalization Rates Could Jeopardize Bluerock (NYSEMKT:BRG)


Bluerock Residential Growth (BRG) is a REIT that focuses on higher-end multifamily residential properties with the goal of achieving price appreciation. In general, its holdings have higher capitalization rates (for their respective location) while its tenants have higher incomes and lower rent-to-income ratios. It generally operates in lower-cost areas of the U.S. such as the South and Southwest which have seen strong growth in recent years.

This strategy has many distinct benefits. Most importantly, it is unlikely to be hit too hard by COVID-19’s economic ramifications as most of its tenants have a lower rent-to-income ratio. As such, the company was able to collect around 97% of its rent due during Q2 (as of June) with solid occupancy of 94%. The company has also maintained a strong new lease volume with 88% of last year’s during the month of April despite using virtual leasing. The pandemic has also resulted in an increase in renewals which offsets the decline in new leases.

Despite seeing minimal material impacts from the virus, BRG is down 33% this year and has a solid 8.3% dividend yield. It has also steadily grown cash flow and has sold numerous properties at a gain over the past few years, yet its stock price has not moved since 2014. Given this, BRG may be a hidden, higher-quality, value opportunity for investors. However, the company also has a very high preferred equity leverage that may take away this opportunity. Let’s take a closer look at its fundamental situation.

Strong Growth, But Leverage is a Concern

As you can see below, BRG has substantially grown its revenue per share and cash flow per share over the past few years. Despite that, its stock price has generally been in decline:

Data by YCharts

Unfortunately, this does not give us the full story as the company has relied on preferred equity sales in order to achieve growth over the past few years. As you can see below, it has essentially no cash-flow growth after preferred stock dividends:

ChartData by YCharts

In general, the company’s cash flow after preferred dividends is $5-10M per quarter or around $30M per year, which gives it a more normal cash-flow valuation to common stock of 8-9X. This is still low, but its margins are so thin that physical depreciation costs likely bring its adjusted cash flow per share to zero.

Given this, equity investors in BRG are betting almost entirely on asset appreciation which is the goal of its managers. Yes, the company has an 8% dividend yield, but investors should expect this to come out of BRG’s book value as has been the case over the past few years. As you can see below, the increase in preferred equity has brought BRG’s tangible book value to nearly zero:

ChartData by YCharts

Overall, I believe it is clear that BRG’s leverage is extremely high as common equity represents only 3.6% of its total assets. Of course, a decline in small revenues due to COVID (or related economic issues) is unlikely to jeopardize its equity as preferred dividend payments are not mandatory, giving the company a significant buffer. However, it does give BRG substantial risk of a lasting dividend cut as arrears payments are made.

BRG’s balance sheet is undoubtedly atypical of REITs which can cause difficulty for investors. To put it simply, buying BRG is a highly levered bet on asset appreciation and should not be viewed as a stable income investment as are most REITs.

Can BRG Manage to Appreciate its Portfolio?

While BRG’s book value per share has declined substantially, that does not mean its NAV has as well since depreciation rarely represents true physical depreciation. Bluerock has a TTM NOI of about $120M and has recently sold assets at low cap-rates around 4-5%. Estimating under a 5% metric, the company’s portfolio is likely worth around $2.4B with other tangible assets totaling around $320M, giving it an estimated asset value of $2.72B.

Subtracting its $1.61B in total liabilities and $785M in preferred equity, we come to an estimated common NAV of $325M ($10.4 per share). This is 34% above BRG’s current market capitalization of $242M, indicating that the company may be undervalued if it can continue to sell its assets at a cap rate of 5% or lower. Of course, if this figure rose to 6% then BRG’s NAV per common share is likely negative which goes to show how highly levered it is.

Given this, as well as the fact BRG is unlikely to sell at cap rates below 4.5% (due to mortgage rates), the company will need to improve its NOI per property in order for common shareholders to gain. According to its last investor presentation, the company currently estimates that its current renovations will have an incremental NOI increase of around $7-8M. Using the same process as above (5% cap-rate, etc.), I estimate this would increase its NAV to around $485M or about $15.6 per share.

Again, this goes to show just how highly levered common shareholders are. A 6% increase in NOI results in a nearly 50% increase in estimated NAV.

The Bottom Line

Obviously, there are other factors one could use to come to a higher or lower NAV figure, but the bottom line is that common-stock investors in BRG have a lot to gain if the company can improve income and a lot to lose if it fails to do so.

Given its metrics last quarter in light of COVID, I would say the company is likely fairly valued or potentially slightly undervalued at its current price. While the virus has not resulted in a substantial revenue decline, it is still possible that it eventually results in an increase to U.S. multifamily capitalization rates which are at extremely low levels by historical standards. This is an extreme risk to BRG’s value as a 1% increase in selling cap-rates would likely result in its NAV per common share falling to zero.

However, if BRG can grow same-store NOI at its expected pace and multifamily property maintains its high valuation, investors are likely to be rewarded with 50-100% gains. While this is feasible, caution is warranted in today’s environment as evidence suggests that commercial property valuations are more likely to decline than continue to rise.

Put simply, BRG may be undervalued from a NAV standpoint but its high leverage makes it a high-risk opportunity that is probably best avoided.

Interested In More Alternative Insights?

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.





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