Written by Aaron Hartfield
My last essay was a summary of a Letter from the Federal Reserve Bank of Chicago. (You can find that here.) I encourage you to read it, as this essay is a follow-up.
This essay is about another Chicago Fed Letter titled “Economic Outlook Symposium: Summary of 2016 results and 2017 forecasts.” There is a plethora of good information in this Letter. I am going to focus on 2016 business fixed investment and gross domestic product. This essay will compare the observed numbers from 2016 with the theory presented in my last essay. It appears that 2016 played out as expected, based on the theory.
In late 2015 there was a monetary shock; in early 2016 there was a financial shock. The theory tells us that both business fixed investment and gross domestic product should be affected. Indeed, these measures were negatively affected during the first 3 quarters of 2016.
Bond Supply and Demand
As my last essay pointed out, a change in the excess bond premium (EBP) affects business fixed investment (BFI). When the EBP increases, BFI decreases, because the cost of business investment has increased. Along with being the cost of business investment, the EBP is an indicator of investor risk appetite in corporate bonds. Let’s take a look at how this works through supply and demand.
In order to see how this works, 2 charts are needed. When investor risk appetite decreases, demand for bonds decrease. The first chart demonstrates how this leads to decreased bond prices, price 1 to price 2. The second chart demonstrates the inverse relationship between bond prices and interest rates. When the demand for bonds decrease, bond issuers must entice potential investors by increasing the coupon rate (interest rate) the bond pays, rate 1 to rate 2. When prices fall due to decreased demand, interest rates (EBP) must increase, increasing the cost for the business that issues the bonds. This increased cost leads to fewer businesses issuing bonds and decreases business fixed investment, because businesses sell bonds to raise capital for investment.
2016 Excess Bond Premium
Let’s take a look at what happened to the EBP in 2016.
This chart shows the “Bank of America Merrill Lynch US Corporate 3-5 Year Option-Adjusted Spread©” from 10/01/2015 through 12/31/2016.[1] In simple terms, this number represents the difference between a group of corporate bonds and a group of similar duration Treasury notes, adjusted for prepayment options in the corporate bonds. (A Treasury bond with a duration of 1 to 10 years is called a note.) For more information, here is a good explanation of option-adjusted spreads. For our purposes, we will think of this option-adjusted spread as the EBP.
Recall that when the EBP increases, financial conditions tighten. If the theory holds, the spike in early 2016 should have caused a decrease in BFI. That is exactly what was observed.
The first page of the Economic Outlook Letter reads “real business fixed investment decreased at an annualized rate of 0.4% in the first three quarters of 2016.” The increase in EBP in the beginning of 2016 resulted in a decrease in BFI during the first 3 quarters of 2016.
It appears that, at least in this one instance, the real-world matched the theory; however, we must be careful with this one factor analysis. The Federal Reserve also raised the FED Funds rate in December 2015, the first time in 9 years. The theory states that gross domestic product (GDP) should have been affected by this monetary shock, which is what was observed.
The Letter states that “the annualized rate of real GDP growth over the first three quarters of 2016 was 0.2 percentage points below the average of the current expansion.” GDP did not decrease, but the rate of increase slowed.
Which shock affected which variable? According to the theory, the increase in the EBP most likely had a greater effect on BFI, while the monetary shock most likely had a greater effect on GDP.
Does this phenomena exhibit itself in the stock market?
Stock Market
I was curious if any stocks exhibit a pattern with the EBP. The stocks of companies who benefit when other companies invest should have an inverse relationship with the EBP. When the EBP is low, BFI is high, and stocks of companies who benefit from BFI should increase. I decided to test this thesis on US Steel, trading symbol X.
US Steel sells many different types of steel. I decided to use this stock because many companies will require steel when they are making investments, think new plants and equipment. If companies are investing, the outlook for US Steel should improve, increasing its stock price.
I plotted the year-over-year percentage price change from 1996 through 2016. US Steel stock prices are from Yahoo finance. The EBP is, again, the “Bank of America Merrill Lynch US Corporate 3-5 Year Option-Adjusted Spread©”.
The pattern does appear to be what is expected. When the EBP is decreasing, US Steel stock prices are increasing. The 20 year correlation between these measures is -36.5%, meaning there is an inverse relationship.
Disclaimer: this is not an endorsement for US Steel stock. I do not own this stock, and if you are thinking about owning it, you should do more research. This is simply pointing out how investors and professional money managers may use this theory when making investment decisions.
Conclusion
In conclusion, the observed 2016 numbers matched the theory about the relationships among monetary shocks, excess bond premium, business fixed investment, and gross domestic product.
What is in store for 2017? The FED raised the FED funds rate in December 2016 and again in March 2017. The economy will most likely experience more monetary shocks in 2017, as there is an expectation of more rate hikes this year. FED chair Janet Yellen, however, has “confidence in the robustness of the economy and its resilience to shocks.” Only time will tell if the theory holds true in 2017.
[1] BofA Merrill Lynch, BofA Merrill Lynch US Corporate 3-5 Year Option-Adjusted Spread© [BAMLC2A0C35Y], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLC2A0C35Y, March 17, 2017