Market Update 10 26 10 _ Remember the Good ol' Days?

The good ol’ days?

Remember the good ol’ days?  I’m not talking about the 1950’s (I wasn’t around back then but given how long the show Happy Days was on the air I assume they were some good years)…I’m talking about mid-2008 when a gallon of gas and the 10-year Treasury were both at 3.92.

That was a time when the biggest complaint I heard was “OMG I’m paying soooo much for gas.”  Times were simpler then.  Fed Funds was at 2.00% and the FOMC was worried about inflation.  Bernanke and Co. hadn’t started manipulating the Treasury, Agency, and MBS markets yet.  Bonds were being called but we could reinvest in MBS at spreads anywhere from +180 to +250 over Treasuries (at a time when Treasury yields still reflected investor sentiment).

Fast forward 2 years.  It’s late 2010 and we are nowhere near the end of the troubled road we travel.  The Fed has cut the overnight rate to zero.  Treasury yields along with Agency and MBS spreads have all been forced artificially low by the Feds actions, and many at the Fed are pushing for an even larger balance sheet expansion to support the recovery and depress yield levels even further.

The yardstick we’ve been given by New York Fed President Dudley is that the Fed can achieve an “equivalent” Fed Funds Rate reduction of 50 to 75 basis points by purchasing $500 Billion worth of Treasury bonds.  Remember when $100 Billion was a big number?  That’s a Rodney Dangerfield number now-a-days…it gets no respect.  The first big number we saw was when Bernanke and Paulson got together in late 2008 and came up with a plan to spend $200 Billion to support the GSE’s…it was a staggering sum at the time…now that seems to be the minimum increment for “fixing” things.

Where are we now?

We are eight days away from the next FOMC meeting.  We are also seven days away from mid-term elections.  Both of these events are casting a long shadow over the markets right now.  

It is widely expected that the Fed will announce a new round of Quantitative Easing at its next meeting.  I personally think it’s a terrible idea that will prove to be long on costs and short on benefits but to date nobody from the Fed has called for my opinion…so you have to hear it instead.  We’ll know in a few days which direction they’ll decide to go.

It is also widely expected that there will be a big shift in the political balance of power.  Almost everyone I speak with is praying for gridlock on Capitol Hill.  Everyone knows that neither party has the magical answer to the problems we face.  It looks like the business community is just hoping for an environment where neither party has enough power to do anything stupid or more expensive than what has been done to date.

What is everyone doing?

I get this question a lot.  With rates at their current levels everyone is looking for ideas.  The trading activity lately can be broken down into a few groups.

The first group is taking gains.  As we head into the 4^th quarter a lot of banks have some holes to plug and they are using gains in the portfolio to bridge the gap.  Whether you are trying to offset loan losses or just bump earnings for the year there are a number of swaps that will work.  The most common swap is selling higher coupon MBS with large gains and reinvesting in longer final muni’s or Agencies. 

The next group of is looking for yield.  This group has been buying 10 and 15 year step ups with 2.50% to 3.00% front-end coupons and have big enough steps that if the bond does go to maturity then they can live with the yield.

The floating rate group is concerned about rising rates and has been buying 5 to 7 year corporate fixed-to-float type structures and Agency Hybrid ARMs.

The Full Faith and Credit Group.  This is the group that wants zero risk-weighted securities and the vehicles of choice in this arena are SBA fixed and floating rate securities, GNMA MBS (both fixed and hybrid ARM structures), and USDA guaranteed loans.  There are other full faith and credit options such as Treasury bonds and FDIC insured corporate paper but the yields on those products are low enough that they don’t have a big following among bank investors.

 Why would anyone extend in this environment?

You might be asking “why would anyone extend in this environment?”  It’s a valid question.  In a world where we only buy one or two bonds I can see how one might question the wisdom of purchasing a long final maturity in this environment.  The reality though is that we buy and own portfolios of bonds…not just one or two.  It’s how this portfolio of bonds acts in concert with each other that dictates how well it performs over time. 

A very short portfolio will do very well if rates rise quickly and it will do poorly if rates remain steady or drop.

A very long portfolio will do very well if rates drop or if they remain constant, and it will do poorly if rates rise.

A balanced portfolio will perform relatively well in all rate scenarios.  If rates remain steady or drop, the longer bonds in the portfolio will deliver the yield (and gains) you need for earnings.  If rates rise, your longer bonds will be at lower rates and have losses but the short end of your portfolio will all be able to re-price upward and take advantage of current rates.  The balanced portfolio tends to outperform other portfolios over time.

What we’ve seen over the last two years is a large migration to very short portfolios.  As rates dropped and bonds were called many portfolios shifted toward shorter durations.  It was an easy thing to do for a while.  Everything the government was doing seemed inflationary, and reinvestment options on the short end were still acceptable.  Now however, we’re not seeing any inflation and rates are exceptionally low…this is a much more complicated environment.

Portfolios with durations of 1.5 years or less are essentially laying on a very defensive bet that rates will rise in the very near future.  While it’s possible that they could rise, there are many indications that rates will remain low for quite a bit longer. 

The first and perhaps strongest indication is that the Fed itself is still maintaining its pledge to keep rates “exceptionally low for an extended period of time”.  Furthermore they are aggressively talking up the idea of forcing rates even lower than their current levels via another round of Quantitative Easing (Treasury purchases). 

Extremely short or long durations are basically big bets on the direction of rates.  Big bets on interest rates are generally not something that community banks do.  Historically the high performing institutions maintain a balanced portfolio across interest rate environments.

A more balanced approach is what we tend to gravitate toward.  Given the extraordinary duration compression in most portfolios over the last two years you can view the purchase of longer final bonds not as extension…but as more of a rebalancing of portfolio duration.   If you historically run a portfolio duration of 3 to 5 years, but you are currently at 1.5 then you may have some room to pick up yield by returning your portfolio duration to your target range without taking undue risk.

That’s all great Steve…but you’re not the one in the hot seat

Having said all of that I also understand that I don’t have to answer to, or explain anything to shareholders, a board of directors, or regulators.  These people may not understand (or care) about portfolio management.  When rates rise many of these people will look at only one thing…the “unrealized loss” column on a bond-by-bond basis…and they will ask “what were you thinking buying this bond right here?”  They won’t care how much better off they were during those low rate years because of your efforts to maintain a properly balanced fixed income portfolio that generated a higher risk adjusted return than your peers.  All they will care about is the one number they can understand…the unrealized loss column.

I know that there are times when no amount of reason, logic, or well articulated explanation will be satisfactory for some of these folks.  I understand that there are times when you can win the battle but lose the war.  So ultimately I understand than many people would like to maintain a balanced portfolio, but the pain of having to explain things at a later date outweighs the benefits associated with taking such actions today. 

In closing

If you have any questions on strategies that work in this environment, whether it’s a swap to take gains or a rebalancing of portfolio duration, just let me know.  If you shoot me a copy of your current portfolio I can run analytics and bring ideas that might work for you.

Steve Scaramastro, SVP

800-311-0707

 

Market Update 10 5 10 _ The Fed, Quantitative Easing, and your future

The big issue looming over the market currently is Quantitative Easing.  We have a number of very influential Fed members speaking publicly in support of more QE.  The more Fed speeches I read the less I doubt that they will do it.  The Fed maintains that they are data dependent...and the data continue to point toward weakness.  This morning we got more data and these numbers would support those Fed members in favor of another round of QE. 

The ADP Employment Change figure was expected to post a positive 20k reading…the release was actually -39k.  The market is rallying strongly on this data.  The 10-year Treasury is trading up ¾’s of a point to trade at 2.38%.  This is what it looks like when the market begins to price in more QE.  If everyone knows that the Fed will be in the market buying Treasuries over the next year then market participants will want to take positions before the Fed starts putting money to work.  The market buys now while rates are high rather than waiting until after the Fed throws $500 billion to $1 trillion into the market and squashes yield levels.  Yep…you read that right…I said “while rates are high”.    The next FOMC meeting is on 11/3/10.  It is widely anticipated that they will announce the next round of QE at that meeting. 

If the Fed starts another round of QE they aren’t going to push rates down just for a month or two and just by 10 bps or so…this will be a longer term deal.  Will it be a year?  Two years?  It’s impossible to tell how long they will keep rates low…but we know it’s not going to be a short period of time.  We’re three years into this business cycle, Fed Funds is at zero percent, the Fed says it’s going to stay there for a long time, and they are about to embark on another massive round of quantitative easing.  Again I think of the economist in Japan and when it was that they realized that they were in a “lost decade”?

Where will yields be after QE?

Bank of America recently changed their forecast for the 10-year Treasury based specifically on a scenario of another round of QE.  Based on this expectation they’ve lowered their forecast on the 10-year Treasury…for 1Q 2011…to 2.00%. 

That is a remarkable forecast.  Keep in mind that at the height of the crisis…during the economy’s darkest hours…the 10-year Treasury only hit a low of 2.08%.  Now B-of-A says the next round of QE will push the 10-year yield even lower than that.  It’s difficult to get your head around that number…but it provides a glimpse into what the near to mid-term future could look like under a new Quantitative Easing program.

What to do?

It looks like the stars are aligning for another round of QE.  If you expect this to happen, and if you anticipate having to put any money to work over the next quarter or two (or four for that matter)…you may want to consider buying bonds right now rather than waiting and doing it after the steamroller has come through.  As low as investment yields look right now…they will be a whole lot lower after the next round of Treasury purchases by the Fed. 

It’s really a question of “do they” or “don’t they”.  If they do embark on another round of QE then rates are going lower…no doubt about it...the entire goal of QE is to drive rates into the dirt.  If they don’t do the QE then we’ll likely see rates stay in the range we’ve been in over the last 6 months or so. 

Given the current landscape there appears to be very little downside to accelerating your bond purchases.  It sounds crazy doesn’t it?  I can hear many of you shouting at the computer right now “why in the world would I load up at these levels?”  The answer is because the levels we have today are going to look great after the Fed starts buying more Treasury bonds, and in six months time you’ll probably be staring at this screen asking yourself “why didn’t I buy back then?”  Rather than wait until the 10-year is trading near or under 2.00% why not put that money to work now and lock in the extra yield?

At best you get in at much higher rates than will be available after the Fed starts the next round of QE.  Your worst case is limited because the economy still stinks and nobody is talking about raising rates any time soon.

You have some upside to purchasing before the next round of QE, and little downside if you buy and they don’t do it.  It’s essentially buying out of self-defense. 

If you have any questions or if there is anything I can be doing for you just let me know.

Steve Scaramastro, SVP

800-311-0707

 

Market Update 10 4 10 _ Quantitative Easing and the Karate Kid

Quantitative Easing and the Karate Kid

I got home Friday evening shortly before the wife picked up the kids from Karate.  After a few minutes I heard the garage door open, and I knew the kids would be excited to tell me all about their first day so I went to meet them.  My seven year old daughter got out of momma’s car wearing a karate uniform, flip-flops, and a pony tail.  It was quite a sight.  With all the interest of an adoring parent I walked over and asked her how her first karate lesson went.  She responded immediately by launching her tiny seven year old fist directly into my mid-section with Bruce-Lee-like-ferocity.  After a brief discussion about not using your new karate powers on people that aren’t attacking you I congratulated her on the well executed strike.

As I pondered the incident later it began to remind me of the Feds Quantitative Easing program.  What good is acquiring a new tool (karate or quantitative easing for that matter) if you don’t intend to use it?  The Fed hasn’t brought up the topic of Quantitative Easing because they don’t intend to execute it.  In an era that history will record as one with unusual clarity in Fed communications, they have brought the QE topic center stage. 

A few weeks ago we had St. Louis Fed President Bullard come out and discuss how a new round of QE should look.  Specifically he stated that in his mind any new Quantitative Easing would be done through the purchase of Treasury securities rather than via more Agency purchases.  He also said that he would expect a degree of flexibility in the program that would allow the Fed to buy at any point on the Treasury curve that they deemed appropriate.  A few days later the FOMC announced that they would be using their MBS cash flows to purchase longer dated Treasury securities. 

The announcement to purchase Treasuries with MBS cash flows was as much an indicator of a sentiment shift inside the Fed as it was about the direction of Treasury yields.  A rough calculation showed that they may have $200 billion per year in MBS cash flows to play with.  In and of itself this isn’t expected to cause a huge shift in yields.  However…the fact that they felt this was even necessary was the biggest news as it opened the door for further action.

Now that they’ve cracked the ice by using MBS cash flows to fund Treasury purchases, let’s look at the prospect for additional purchases.  Its speech time at the Fed.  Now is the time when the voting members go on the road, talk to various groups around the country and use these platforms to tell us what’s on their mind.  This is essentially a window into the next FOMC meeting.  With that in mind let’s look at the latest speech from the New York Fed President…William Dudley.

Dudley speaks

On October 1^st, 2010 Dudley spoke to the Society of American Business Editors and Writers at their Fall Conference.  Sounds like a real hum-dinger doesn’t it? 

Dudley begins his remarks by acknowledging that this recovery has been very tepid.  He also reminds us that the dual mandate of the Fed is to maintain full employment and price stability.  Everything the Fed says and does needs to be measured against this set of goals.  Given the current set of conditions Dudley views the current levels of inflation and employment, along with their expected timelines for improvement to be “wholly unsatisfactory”.  He goes on to state that it looks to be “several years before employment and inflation return to levels consistent with the Federal Reserve’s dual mandate.”

A portion of the speech is the kind of canned recap of the financial crisis that we are all used to reading.  In this speech it is used to lay the groundwork to get to this conclusion: The recovery has lost steam and hit a soft patch…soft patches in the recovery process tend to occur…but this soft patch is more worrisome than others.  The first difference between this soft patch and others is that it is longer in duration.   The second difference (and one that concerns them greatly) is that it is occurring at a time when the overnight rate is already at zero percent.  From both a monetary and fiscal policy perspective they have done everything they can to get a fire going under this economy…but so far all they’ve gotten is a little smoke…and even that is fading.

Next he touches on some familiar topics like the lack of household savings and how the housing market and cheap credit provided the ammo for consumers to fuel their spending binge.  Basically he says that it took a while for this problem to build up, and now that it has crashed it will take a considerable time to recover.  He sees some favorable trends in the household sector and to ensure that they continue “the economic environment needs to become more supportive”.  Notice that he didn’t say “stay” supportive…he said “needs to become more” supportive.  This is not a sit and wait attitude…the only way you can read that is that more action must be taken. 

What can they do?

The way Dudley sees it there are two things that the Fed can do to help this process move along.  First is that they can communicate better about what they are trying to do and how they will do it.  Second is that they can increase the level of monetary stimulus through their balance sheet. 

On the first point (communication) he states that by clearly expressing their intent to return inflation levels toward the Feds preferred range they can help anchor inflation expectations.  This in turn should reduce the probability of further disinflation or (and he mentions the really scary scenario here)…the debt deflation spiral.  If you would like to review the Debt Deflation Spiral you can pull out the Market Update piece I wrote on 12/18/08.  If you don’t have it just let me know and I can shoot you a copy.

The Fed has been placing a heavy emphasis on their need for clear communication of their intent…this is a huge sign to those of us in the market that we need to be listening to what they are saying in these types of speeches.  They will be broadcasting their intent frequently and in more concise terms than many of us are used to hearing from Fed officials.  Gone is the era of “Greenspan speak” where Fed officials spoke in vague circular references with the apparent intent of befuddling anyone who heard them.  This Bernanke led Federal Reserve understands the importance of communication and will be uncharacteristically transparent in their statements.  Our most recent example might be this speech by Dudley as he lays his thoughts on more quantitative easing.

How much will they buy?

The plot thickens with this speech as Dudley provides us a yardstick for measuring the effect of more QE but doesn’t give us a hint as to how much he’d like to see.  By his estimates a $500 billion purchase of Treasury debt would provide the equivalent of a reduction in the Fed Funds rate of one-half to three-quarters of a point.  He cautions that this relationship depends on the market’s perception of how long the Fed will hold these securities.

From here you can use this yardstick to scale the potential magnitude of their purchases.  If they are in the news saying they think an additional 50 bps of easing would be warranted then you know they are looking at around $500 billion in purchases.  If 100 to 125 bps seems to be  preferred, then it’s on the order of $1 Trillion in purchases.  Now that we have this yardstick we can put it together with other speeches to get a gauge of what might be coming. 

Why lower rates?

You might be asking yourself “why lower rates”?  Money is already cheap enough…people that don’t qualify for a 5% loan won’t magically qualify for a 4% loan.  Much of the reasoning goes back to the goal that has proved most elusive for both the Fed and the politicians…a refi wave.

They have talked about generating refi activity from day one of this crisis.  Consumer spending drives 2/3’s of GDP…it is a high priority item.  The consumer has been reeling; he has been rocked in all quarters of his life.  His job is in jeopardy, his home is in jeopardy, his 401k has been crushed, and his very lifestyle is in danger.  He has been deleveraging out of self defense and he just doesn’t have the discretionary income to spend right now. 

What does all of this have to do with lowering rates?  If they can ignite a refi wave then they can get an extra few-hundred dollars per month into the pockets of millions of consumers.  Whether they spend it immediately or use it to accelerate the liquidation of existing debt it will help speed our time to recovery.

Below is a list of positives that Dudley lists for lowering interest rates via another round of QE:

-          Support the value of assets

-          Make housing more affordable

-          Support consumption by enabling households to refi

-          Facilitate debt restructurings that allow negative equity borrowers to refi

-          Reduce the cost of capital for businesses

It comes down to this

The bottom line:  absolute levels of unemployment and inflation, along with the time frame over which they are expected to improve are unacceptable.  The longer this situation exists the more exposed we are to another shock.  Right now the economy is in the ditch...if we stay here long enough then the next “shock” could bury us. 

It’s a bit like the kid on the playground that walks in front of the swing-set and gets wrecked.  You cringe watching it but then you realize that things are in danger of getting much worse because as he’s trying to square himself away and get back up…here comes the swing again.  Dudley would really like us to not be hit twice by the swing and he views Quantitative Easing as the tool to shield us from that blow.

Dudley concludes with this statement: “Thus, I conclude that further action is likely to be warranted unless the economic outlook evolves in a way that makes me more confident that we will see better outcomes for both employment and inflation before too long.”

So there you have it…if there isn’t an immediate and robust reversal in the data then Dudley is going to vote for another round of QE.  How much will it be?  Who knows…but the yardstick he laid out is measured in $500 billion increments.

If you have any questions on this material or if there is anything I can be doing for you just let me know.

Steve Scaramastro, SVP

800-311-0707