Weekly Relative Value

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1 Why Are Economists Always Wrong? A mathematician, an accountant and an economist apply for the same job. The interviewer calls in the mathematician and asks: What does two plus two equal? The mathematician replies, Four. The interviewer asks, Four, exactly? The mathematician looks at the interviewer incredulously and says, Yes, four, exactly. Then the interviewer calls in the accountant and asks the same question: What does two plus two equal? The accountant says, On average, four give or take ten percent, but on average, four. Then the interviewer calls in the economist and poses the same question: What does two plus two equal? The economist gets up, locks the door, closes the shade, sits down next to the interviewer and says, What do you want it to equal? Funny, but it s not far from the truth! An economist is an expert who will know tomorrow why the things he predicted yesterday didn t happen today. - Laurence J. Peter Inquiring minds may be asking, why is the Federal Reserve and economists everywhere almost always wrong? Let s take a walk back through time. Since 2007, the Federal Reserve has been publishing forward guidance via a Summary of Economic Projections on a quarterly basis. These projections include their forecasts for GDP, unemployment and inflation. These reports generate extensive media coverage every time they are published. Investors parse every word and data point with great interest. The investing public assigns high credibility and importance to these forecasts as if there was reason to believe. It s as if the Fed is all knowing about the future.

2 The following graph (updated through November 2014) shows the evolution of the Fed's forecasts for GDP growth for the years starting from 2011 through to Notice any repetitive pattern? Virtually every quarter and every year the Fed has made the same mistake of being overly optimistic and forecasting higher growth and then being forced to lower their estimates over time. Overall, the Fed forecasts have been pitiful. The only thing one can say is they have been consistent! Given that crystal balls are not widely available missing a forecast from time to time would be more than understandable. But after four (heading into five) consecutive years of being dead wrong it begins to look less like bad luck. Are central bankers just naturally more overconfident than regular human beings, or are they smoking some powerful stuff at their meetings? Pay particular attention to that 2015 green line. And if history holds true, look for the green line to be revised lower and lower as we advance through the year. The Fed Constantly Revises Growth Lower. Enough Fed Bashing What about the so called Pros? So clearly, we as investors cannot rely upon the Fed for future clarity. How about the big money professionals: the economists employed at the biggest investment houses on Wall Street. You know the guys at JPMorgan, Goldman Barclays, etc. Surely, to justify the big bucks they must be more accurate. Right? Like the Federal Reserve forecasts, the Survey of Professional Forecasters is a quarterly macroeconomic survey of a number of professional economists. Below, is the same graph showing the forecasts as published in the Survey of Professional Forecasters.

3 So, there is virtually no difference whatsoever between the Fed forecasts and the Street forecasts. In a nutshell, the pattern repeats itself time and time again. Step 1: Start with a very optimistic forecast. Step 2: Revise your forecast lower to reality. Step 3: Repeat the same pattern the following year. Wall Street Constantly Revises Growth Lower So, in looking back over the past six years, the reality is the Federal Reserve and Wall Street have persistently failed to accurately predict future economic growth with an overly optimistic outlook proving to be consistently wrong. Forecasting Recessions Just as they had to in Q1, Wall Street's perennial optimists have taken the machete out to Q2 GDP growth expectations. The downward revisions in Q2 expectations brings Wall Street (once again) closer to where The Atlanta Fed's GDPNow model forecast is which is ONLY 0.7%. The U.S. economy flat-lined in Q1 and may have actually declined once revisions are factored in. And now Q2 is off to a less than robust start and is less than 1% away from a technical recession often measured by two back-to-back quarters of negative GDP growth. While it would be premature to call a recession in 2015 it s not far off. It is not a low probability at all. Yet, as shown below, economists believe there is ONLY a 1.2% chance the U.S. is in recession. We Should Feel Relieved, Right? Whether or not you think a recession is likely, assigning ONLY a 1.2% is totally absurd. But this is nothing new!

4 Like virtually every other forecast, economists track record for forecasting recessions is absolutely dismal. This is not only true for official organizations like the Federal Reserve, International Monetary Fund, the World Bank and government agencies, but for private forecasters as well. They're all terrible. The inability to predict recessions is a ubiquitous feature of better than expected growth forecasts. 1.2% Probability of Recession? There's one chart that sums up this thesis nicely. It comes from Societe Generale, and it shows economists' consensus forecasts for GDP growth. As you can see, it never goes negative during this 35 year span. The same held true for the Great Recession in Not one economist called for a recession. Collectively, they ve missed every single recession around the world over the past 30 years. Now that is impressive. Economists have a Perfect Record of Not Forecasting Recessions Only 1.2% Probability of Recession Adding insult to injury, the Federal Reserve not only failed to predict the recessions of 1990, 2001 and 2007, it also didn't even recognize a recession after they had already begun.

5 Most recently, as the financial markets were in meltdown, former Chairman Ben Bernanke believed that the U.S. would skirt a recession. Keep in mind, the recession had started in December 2007, yet in January '08 Bernanke told the press, "The Federal Reserve is not currently forecasting a recession." Bernanke continued seeing rainbows and unicorns ahead for the U.S. economy. He declared on June 9, 2008, "The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so." At that stage, the economy had already been in a recession for the past six months! "If you look at the history of the last three recessions in the United States, you will see that the inability of economists and central bankers to understand the state of the economy was so bad that you might be tempted to say they couldn't find their derrieres with both hands," wrote John Mauldin. "Economists have yet to correctly call a recession." Forecasting Interest Rates In 2012, the majority of the Federal Reserve predicted interest rates would have begun to increase in 2014 the highest forecast being that interest rates would be 2.75% by the end of the year, which seems like fantasy world now. (Interest rates haven't budged since 2008 and are currently targeted at between 0 and 25 basis points light years away from 2.75%.) In 2013, one seer at the Fed was forecasting interest rates at the end of 2015 would be a staggering 4.5%. Ouch! When looking at the historical forecasts, pros have been calling for higher rates since The latest Fed Survey of Professional Forecasters predicts that ten-year rates in 2015 will go up to 3%, see the last dotted line in the chart. Overestimating Interest Rates, Again and Again

6 In the early 1980s, forecasters did a good job of predicting the path of bond rates; though their job was a bit easier than usual because rates were so highly elevated that it was a pretty sure bet they d be headed back down. ( Regression to the mean, for all you statistics fans.) But the inability to forecast interest rates is NOT a new phenomenon. Since the mid-1990s, economists have consistently overestimated future yields. Below, we show the 10-year Treasury yield versus annual forecasts. Please note that since 1990 economists have overestimated the yield on the 10-year Treasury every year. That s 15 years of being Dead Wrong! The only really astonishing thing is not the record, but that anyone believes economists at all. Forecasts are about as useful as a screen door on a submarine. So Why Are Economists Always Wrong? Off the Mark since 1990 It is one thing to be wrong; it is quite another to be consistently, confidently and egregiously wrong. If the Fed and Wall Street economists are the best and brightest, have large supporting research staffs, state of the art econometric models and they have access to the most timely and accurate information, then why have their forecasts been so horrible? Clearly, there is a systemic bias in the forecasting world. So what s really going on? First: A major reason for the Federal Open Market Committee s (FOMC) flawed forecast for economic growth since the Financial Crisis has been its view of the effectiveness of quantitative easing and the reliance on the so-called wealth effect. In 2010, then FOMC chairman Ben Bernanke wrote, higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

7 Likewise, current Chair Janet Yellen said, And part of the economic stimulus comes through higher house and stock prices, which causes people with homes and stocks to spend more, which cause jobs to be created throughout the economy and income to go up throughout the economy. So, if the wealth effect is/was as powerful as the FOMC believes, consumer spending would be booming and so would the economy. The S&P 500 index has risen 213% since March Yet, consumption remains anemic and the current recovery is the weakest on record. Overall, the preponderance of research suggests that the FOMC has been incorrect in its presumption of the effectiveness of quantitative easing (QE) on boosting economic growth. The Weakest Recovery on Record! Second: The Fed as no vested interest in spooking anyone. The Federal Reserve Bank does not come out a say things simply in real-time, like "deflation is coming" or "the economy is going into a recession," even if that is what they believe. Third: The Fed is a cheerleader. Forward guidance is an attempt to guide (or influence) the markets, consumers and businesses. Strong forecasts imply good times ahead. Weak forecasts imply the opposite. By talking the economy up the Fed hopes that consumers will spend more and businesses will invest more aggressively. The intent is to create a self-fulfilling prophecy. Fourth: Wall Street firms typically get paid on investments, not counting cash. A Wall Street economist will never get fired for being too bullish. However, (just ask David Rosenberg) being bearish can put you out of a job. Thus, as a self-preservation mechanism, economists are trained to be bullish. Similar to home builders and realtors who always say "now is a good time to buy a home" to get people invested in something is to be 100% bullish, 100% of the time.

8 Below are some strong words from Pater Tenebrarum.... I totally hate how they have managed to buy off economists. There was time when economists were a thorn in the side of the ruling classes. Previously, the profession required one to tell impolitic truths. Today's economists are spokesmen for the most viciously statist ideology and have essentially become servants of the beast, paid far above their market value for the propaganda services they render. Unquestionably, economists are either a very optimistic bunch or they are paid to be optimistic. You decide! Summary Having an economics degree appears to be a handicap. Academic economics is predominantly ideological and belief based; like theology. Because economists present their ideology with mathematical equations and impressive graphs, people mistake it for science. Yet economists are treated with the reverence akin to the Oracle of Delphi. But unlike the Oracle, economists' predictions can be checked against the future, and anyone who does that will quickly conclude that economists make lousy soothsayers. The obvious conclusion is that forecasts should not be taken seriously. Yet, no matter how much evidence exists that seers do not exist, suckers will pay for the existence of seers. Even if experts fail repeatedly in their predictions, most people prefer to have seers, prophets, and gurus tell them something anything at all about the future. John Maynard Keynes famously looked forward to a day when economists could manage to get themselves thought of as humble, competent people, on a level with dentists. What Keynes meant is that we don t expect a dentist to be able to forecast tooth decay. We expect that the dentist will offer good advice on dental health and intervene to fix problems when they occur. We should expect the same from economists: proven advice about how to keep the economy working well and solutions when the economy malfunctions. And economists should

9 bear in mind that no self-respecting dentist would be caught dead forecasting when your teeth will fall out. Market Outlook and Portfolio Strategy Last Friday, Janet Yellen gave a speech in Providence, Rhode Island and said that it will probably be appropriate for the Federal Reserve to raise interest rates this year. Minutes of the most recent FOMC meeting, released last week, strongly suggest that June is too soon for the first increase, which puts the likely timing back to September or December. Fed Chair Janet Yellen basically reiterated the key points of the FOMC minutes monetary policy remains data-dependent and the Fed has to be confident that the labor market has recovered to its satisfaction, while inflation is on the way to its 2% target. As for the economy, the Fed dismissed the first quarter s weak data as transitory, as has almost every economist. Then again, and much to her credit, Yellen said in the passage below and something you almost never hear an economist, let alone a Fed economist say: I have no idea. Of course, the outlook for the economy, as always, is highly uncertain. I am describing the outlook that I see as most likely, but based on many years of making economic projections, I can assure you that any specific projection I write down will turn out to be wrong, perhaps markedly so. For many reasons, output and job growth over the next few years could prove to be stronger, and inflation higher, than I expect; correspondingly, employment could grow more slowly, and inflation could remain undesirably low. Also of note, the persistently weak first quarters in recent years had a number of pinheads dancing around the data, and the San Francisco Fed came up with the bright idea of doubling the seasonal adjustment for the year s first three months to make them look better. What that accomplishes is debatable, because seasonal adjustments wash out over the course of the year.

10 As Peter Boockvar incisively discerns, The FOMC continues to day-trade the economic data with the micro management of every data point. So, best guess is there will be no rate hike as long as the data disappoints, and maybe one hike later this year if the numbers are respectable. The Fed has been so wrong, so many times and in so many ways. Why anyone bothers to listen to such speeches other than to poke fun at them remains a mystery. Market Outlook and Portfolio Strategy Today, the world is waiting for the Fed to hike the federal funds rate. As/if the Fed again demonstrates its conviction to control inflation, we should not be surprised to see long term bond yields remain steady or even decline. Consider what happened when the Fed last hiked the Fed Funds rates in Long before the federal funds rate actually increased, Treasury rates began to rise (just like what is now occurring). Interestingly, once the federal funds rate did begin to rise in 2004, long term Treasury yields declined over the next two years. From May 2004 until February 2006 the federal funds rate increased by 350 basis points and the five-year note increased by 80 basis points, yet the 10-year bond yield remained virtually unchanged. The yield on the long bond fell by 84 basis points. Why did long term rates decline when the Fed hiked rates so much? The reason is simple; as the Fed demonstrated their conviction to slow the economy inflation expectations fell. Reports may begin soon about Conundrum II the redux of the period in 2005 when long-term interest yields remained low as the Fed raised short-term rates. If the Fed follows through with its forecast and short rates rise, the dampening effect on inflation expectations should again cause long rates to fall. On the other hand, should economic activity continue to moderate or should we fall into a recession then the downward pressure on inflation will continue. If so, long term Treasury rates will remain low. continued

11 What Happened to 10-Year Rates? ( Rate Hike Cycle) That said, and as we have been highlighting of late, there will be a lot of volatility and choppiness in the bond market as we move throughout the year. Don t be shocked by temporary tantrums. However, and despite higher volatility, we do not believe the 10-year Treasury yield will rise significantly and remain there for any extended period of time. I would not be surprised if the 10-year Treasury yield ends the year roughly where it started (closer to 2.20%) Given this backdrop, we continue to advocate buying on weakness. In terms of relative value, please click here for the Analysis. 10-Year Treasury Yield (YTD)

12 For more information about credit union investment strategy, portfolio allocation and security selection, please contact the author at or (800) , ext Tom Slefinger, Senior Vice President, Director of Institutional Fixed Income Sales, and Registered Representative of ISI, has more than 30 years of fixed income portfolio management experience. He has developed and successfully managed various high profile domestic and global fixed income mutual funds. Tom has extensive expertise in trading and managing virtually all types of domestic and foreign fixed income securities, foreign exchange and derivatives in institutional environments. At Balance Sheet Solutions, Tom is responsible for developing and managing operations associated with institutional fixed income sales. In addition to providing strategic direction, Tom is heavily involved in analyzing portfolios, developing investment portfolio strategies and identifying appropriate sectors and securities with the ultimate goal of optimizing investment portfolio performance at the credit union level. Information contained herein is prepared by ISI Registered Representatives for general circulation and is distributed for general information only. This information does not consider the specific investment objectives, financial situations or particular needs of any specific individual or organization that may receive this report. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities. All opinions, prices, and yields contained herein are subject to change without notice. Investors should understand that statements regarding future prospects might not be realized. Please contact Balance Sheet Solutions to discuss your specific situation and objectives.

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