A question
What do the years 2009, 2010, and 2011 have in common?
They all started with Fed Funds at zero and the FOMC statement telling us that rates will remain low for a long time. If there is one thing we’ve learned about this Fed over the last few years it’s that when they say they are going to do something…they mean it.
So we begin 2011 with the Fed broadcasting that rates are expected to remain “exceptionally low” for an “extended period”.
Monetary Policy
Economic conditions will determine when they raise the rate…and to date the Fed continues to see only modest economic progress set against a backdrop of an atrocious unemployment rate and declining levels of inflation. This is not a scenario under which they will be raising rates.
We recently got the minutes from the last FOMC meeting of 2010. The statement points out that progress toward the Feds dual mandate of maximum employment and price stability has been “disappointingly slow”. This has solidified their support for the originally planned QE2 purchases. Like it or not…QE2 will continue.
The unemployment rate is running just under 10% currently. Several Fed members have stated recently that they expect this rate to remain elevated for the next few years. They also state that inflation continues to trend lower and if left alone…could continue for years and endanger the economy. While most at the Fed discount the potential for outright deflation they will not tolerate the current trend.
The summary on the Monetary Policy side is that unemployment is unacceptably high, inflation is running too low, and the rest of the numbers are modestly positive but pretty weak…the Fed will not raise rates while this situation exists. These will be important points to consider as you make your plans for 2011.
What phrase could sum up the year?
“Government Spending” might be the best summation for 2010. We saw the extension of unemployment benefits to 99 weeks, we got $900 billion worth of QE2 on the schedule, the first time homebuyers credit was extended, you name it they spent money on it. Our government spent so much money (that it didn’t actually have) that it prompted statements from ratings agencies and foreign countries that these actions could ultimately affect our credit rating…and therefore our borrowing costs. We spent so much that even the Fed warned Congress that the current trajectory on the fiscal side was unsustainable and that the Fed couldn’t fix everything by itself.
Among the multitude of problems that come with rampant government spending is the fact that it is not as efficient as private sector spending at producing results. I was reminded of this recently on…of all things…a duck hunt. There aren’t many parallels between the two because duck hunting provides a venue for entertainment and family time that government spending obviously can’t…but the one similarity made me laugh.
Our duck lodge sits in the Mississippi delta. The delta is a wide expanse of agricultural land that sits between the Mississippi river on the west and the rolling hills of central Mississippi on the east. It plays a vital role in the migratory patterns of all manner of waterfowl and it is a great place to go when you want to “get away” from life for a bit. I went to the lodge on a Tuesday night and I had the whole place to myself. I spent a few minutes in the freezing darkness, gazing up at the ink-black winter sky and taking in the billions of stars that are visible in such a remote area. Once I was satisfied that I was truly away from civilization I went inside and hit the rack early. The following morning I got to watch the sun rise on some of the best wetlands habitat that this country has to offer. There are few getaways that are better than this…its great “down time”.
After a few hours of peaceful solitude in the duck blind (interrupted occasionally by the blast of a 12 gauge pump action shotgun) I gathered all of my gear, loaded it onto my 4-wheeler, and headed back to the lodge. At one point I stopped and looked back over my shoulder to watch some birds that were working a hole on the north end of the property. As I looked back I caught a glimpse of the gear bag on the back of my machine and the irony of the whole situation hit me. I’m riding a $4,000 ATV that is loaded with expensive decoys, ammo, a gun, waders, heavy hunting jacket, duck calls etc. I’m rolling across the wetlands with about $7,000 worth of gear…and I’ve got a grand total of 4 ducks strapped to the top of the decoy bag. I had to laugh looking at the situation. This is without a doubt the most cost inefficient thing I’ve ever done.
If this weren’t a recreational activity there is no way I could justify my participation in the event. The cost that morning was roughly $1,750 per bird. Chicken is WAY cheaper. The scene reminded me of the stories of $400 government hammers, and $2,000 government toilets, and of the inefficient nature of government spending in general.
Now obviously there are a whole host of benefits to duck hunting beyond the ducks themselves…but me paying $1,750 per duck instead of $5.00 per chicken at a grocery store reminded me a lot of the government paying someone $7,000 to buy a house today that they would have bought on their own in the next 18 months anyway…it’s a pretty inefficient way to get the job done.
At least I get some fun stories out of the duck hunting…I don’t hear any bureaucrats sitting around telling stories about how much fun they had last weekend with their family and friends luring homebuyers into real estate offices with tax credits.
The Review
The Short story
For those in a hurry just skim the bullet points below for quick refresher of last year’s events.
What happened last year? How will 2010 be remembered? Here is the short story:
- 2010 starts with Fed Funds at zero
- Who Dat? Saints win the Super Bowl
- New Home Buyers credit extended
- GSE’s clear “logjam” of late paying loans from pools…prepays have one month spike
- Goldman execs appear before congress
- Global economic problems spread
- Austerity measures spur riots in Europe
- Fed announces $600 billion QE2 program (up to $900 billion with MBS portfolio cash flows)
- Inflation trending lower causes concern at fed
- Outright deflation fears wane
- Unemployment continues to climb
- Double dip recession fears fade
- 10-year Treasury trades down to a 2.41% yield
- Curve steepens dramatically in 4th Quarter and 10-year rises to 3.50%
- Recovery is underway but is modest and vulnerable to shocks
- Fed leaves rates at zero, and maintains that they will stay exceptionally low for extended time
- Year of the Step Up…every day the new issue screens are filled with step ups
- Unemployment benefits extended to 99 weeks
- Housing still in the dumps
- The Fed still owns the $1.5 Trillion in Agency debt they bought in 2009
- Tiger Woods wins zero tournaments
The longer story
When you look at the activity in 2010 it is dramatically different than prior years. 2008 saw a massive meltdown that threatened the existence of Wall Street, the banking system, and our economy. 2009 saw drastic steps taken to stabilize the situation. By the time 2010 rolled around there was some discussion of a double-dip scenario and of deflation but things seemed more stable. 2010 was when everyone was looking for solutions that would get people back to work.
On the investment side
When you think of investments in 2010 you have to think of Step-Ups, huge premiums on MBS, and gains in everyone’s portfolio. For most of the year the New Issue monitor on Bloomberg showed that the majority of the new issues from the GSE’s were step-ups. This was largely a reflection of investor sentiment. Many buyers wanted the yield associated with the longer paper, but wanted some protection in case rates rose…thus step-ups became a huge part of the investment landscape. At some point in time it became difficult to find a straight Agency Callable.
On the MBS front it became difficult to find a bond that didn’t trade north of $105. When the 10-year Treasury yield drops to the 2.40% range and MBS spreads are tight it leads to huge premiums. This is great for the bonds you already own at lower prices, but it created significant challenges for new purchases. Structure was the name of the game at that point. It became very important to pick structures that would provide some natural disincentive to prepay activity. Things like lower coupons and shorter amortization schedules were in high demand.
For much of the year the comments were along the lines of “I really don’t like the yield levels…but at least our bond accounting looks good.” Then the 4th quarter hit. In November the Fed announced its QE2 program. The goal of the program was to keep rates low to support asset prices and enable low cost borrowing by consumers. This did not work out as the Fed planned. QE2 actually coincided with the beginning of a sustained pullback in prices that caused yields to rush higher. Now borrowing costs are higher for everyone and refi activity has slowed.
The run-up in yields has caused a significant drop in the “gains” column on the bond accounting reports.
Why did we see the run-up in rates? Many explanations have been tossed about. They include but are not limited to:
- Concern over our debt load is causing risk premiums to rise.
- It’s a reversal of the deflation/double-dip trade.
- Speculation that the new tax initiatives will spur economic growth.
- Bond vigilantes are punishing the Fed and Congress for poor decisions.
- Portfolio duration rebalancing.
- Year end liquidity concerns.
- Investors taking gains for year end.
Inflation?
Many investors harbor a large reservoir of fear over the potential for inflation that QE2 brings with it. The thought process is that pushing $900 billion into the market will provide the kindling for a massive bout of inflation.
Minneapolis Fed President (and soon to be voting member) Kocherlakota addressed this thought directly in a speech recently. His position is that there are already over a trillion dollars in excess reserves sitting on bank balance sheets currently…and those haven’t sparked any inflation at all. In fact even with that massive amount of excess reserves in the market inflation is actually trending lower. With this in mind, he says that another $600 to $900 billion won’t do anything that the first trillion didn’t do.
Another thing to keep in mind on the inflation front is that everyone at the Fed is confident that if inflation becomes an issue that they have the ability to efficiently and effectively pull back the liquidity that they’ve provided the markets, thus choking off any potential for runaway inflation.
It’s also worthy of note that it’s difficult to find anyone outside of the Fed that has the same degree of confidence in that plan.
Now vs. then
While many economic indicators have been posting modestly positive results recently it’s interesting to note where some of the other indicators are as we begin the New Year.
Fed Funds today 0 to 0.25%, 1-year ago 0 to 0.25%
10 year Treasury today 3.39%, 1-year ago 3.81%
Unemployment Rate today 9.80%, 1-year ago 9.70%
CPI Year over Year today 1.1%, 1-year ago 2.6%
Consumer Confidence today 52.5, 1-year ago 56.5 (in Feb of ’07 this was running at 111.2)
On the horizon in 2011
Monetary policy
There are at least four things we know about monetary policy in 2011.
1 -The Fed isn’t happy with the Unemployment Rate.
2 - They aren’t happy with the inflation rate.
3 - They’ve told us that rates will remain exceptionally low for an extended period of time.
4 - They started saying that in 2009 and we are still at zero.
Some Fed members (like Pianalto) have come out and stated that they expect the unemployment rate to remain elevated for years. It is difficult to find anyone that thinks it will drop below 8.50% before the year 2013. It is hard to envision the Fed raising rates before there is significant downward momentum in the unemployment rate.
Municipalities
Municipalities will be big in the headlines in 2011. This is widely considered to be “the next big bailout”. The recession has compounded an already complex set of problems that face many municipalities around the country.
Regulators have ramped up their attention on muni’s and they would love to see a thick file of backup that shows you are keeping on top of the financials of the muni issuers you own. We can provide a portfolio review of your municipal holdings that will help greatly when it comes showing the regulators you are staying current. If you would like us to run this for you just shoot me a copy of your portfolio.
If you have the ability to do so, now would be a good time to consider dumping credits that might keep you up at night if we start to see an uptick in worrisome municipal headlines.
Higher rates?
While it’s never possible to call rates we can certainly use the pieces of data we have in front of us to help guide our outlook.
We know that the Fed doesn’t want to raise the short end. They continue to tell us at every opportunity that the overnight rate will remain exceptionally low for an extended period. We also know that they are continuing (with almost unanimous support) the QE2 purchases which should serve to offset further increases in yields to some degree.
That doesn’t mean that the rest of the curve can’t go up though right? Right. When long term yields rise faster than short term yields it is called a steepening. We commonly measure the steepness of the yield curve as the yield difference between the 2-year Treasury and the 10-year Treasury. Using this method we can make some comparisons.
Over the last 34 years the average spread between these two points on the curve over has been 83 basis points ( I use 34 years because that is as far back as Bloomberg will allow me to go using a weekly figure). The record spread was 287 basis points (4/16/10) and the current spread is 270 basis points. We are operating very close to record spread levels in the current market.
While it is certainly possible for the curve to steepen even more than it is today…and to break all existing records for steepness…it would seem that there are some limits to how high rates can go with the Fed anchoring the short end at zero and the market already pushing record spread levels.
Fannie and Freddie?
What of Fannie and Freddie? It seems like they barely make the news now-a-days. Once every few months they’ll show up looking for a few hundred billion to plug some losses but nobody really pays attention anymore. The idea is to ultimately remove them from “conservatorship” status and into something more permanent. None of the powers-that-be have offered any solutions to this problem and nobody seems gung-ho to tackle the problem right away.
Regardless of how they proceed with the GSE’s the most logical outcome is that any existing debt will be “grandfathered” so to speak and will be backed by the Government. What will replace the GSE’s is anybody’s guess…but the one thing we know is that the Government can’t afford an attempt to force a haircut on anyone’s GSE debt. The carnage from that tactic would make the melt-down of 2008 look like a picnic.
They are still out there
The Fed wants you to make loans, the regulators are still criticizing you for making loans, and people like this next guy are still coming in and asking for loans. I was talking with a friend of mine shortly before Christmas and he relayed this story to me. A guy comes into his bank. This guy hasn’t had a driver’s license in 20 years because he’s had so many DUI’s. He owes a neighboring state $44,000 in fines and fees, he owes his current state $1,500 fines, he owes the casino’s money, he is unemployed, and he went home the other day and his girlfriend told him she’s pregnant. So what does he do? He goes down to the bank and asks for a $7,000 loan.
I know this isn’t indicative of the “average” loan customer that comes in the door…but it points out the fact that not all borrowers have really come to grips with reality yet. Who knows…some may have never had a grip to begin with.
If you have any questions or if there is anything I can be doing for you just let me know. If you have any bond-buying friends that you think would like to receive these updates please let me know and I’ll get them on the distribution list as well.
Thanks,
Steve Scaramastro, SVP
800-311-0707
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