Interpolated Yield Curve report for July

Each month Bloomberg surveys 60 to 70 economists to get their estimates of where Fed Funds, the 2-year Treasury, and the 10-year Treasury will be over the next several quarters. I take this data and interpolate for the points in between the survey data to create the attached report. This allows us to get a broad view of where various economists see interest rates going over the coming quarters.

All of the talk from the Fed is of rates staying low for a long time to come. Just recently Janet Yellen said that the Fed could conceivably leave the overnight rate at zero for “years”. Recent statements from the Fed also say that if we weren’t already at zero on Fed Funds then they’d be lowering rates right now…the economic picture is just that bad.

With a recovery nowhere in sight it looks like the only thing that could change the Feds mind on leaving rates at current levels is inflation. While the Fed would love to keep rates low long enough to let the economy work through its problems, the government continues to spend money like a drunken sailor on a 72 hour liberty. How long that can continue without igniting inflation concerns is another matter.

The Fed for its part insists that if inflation reignites they will have the political independence necessary to raise interest rates…even in the face of an economy that is still stalled. It will be a very interesting story to watch if we have 10% unemployment and the Fed has to begin tightening. The terms “stagflation” and “double-dip recession” have been getting more air time recently…“recovery” not as much. The economy is in such poor shape that even the politicians are pushing back talk of recovery. Now we hear statements like “it may take years” for a recovery to take place.

The survey data below are the latest estimates from economists surveyed by Bloomberg. This can serve as a useful sounding board as we move into the second half of 2009.

If you have any questions on this material just let me know.

Market Update 7 09 09 _ How many unemployed?

It’s another beautiful summer morning here in Memphis, Tennessee. On my way in to work this morning it was 72 degrees, no humidity, clear skies, and the windows were down. The big decision was “do I turn right and go to work, or do I turn left and go bass fishing?” Work always gets the nod but asking the question at least makes me feel better. So on the way in I was thinking about today’s pending economic releases and the plans I’ve heard from the government on how to “fix” the economy. More specifically I had been pondering the government’s plan to reduce unemployment by putting people to work on infrastructure projects funded by the stimulus plan. We frequently joke about the wisdom of using unemployed people from non-construction industries to build roads and bridges as it doesn’t seem efficient or safe. For instance, how many unemployed waitresses have ever tied rebar for pouring a reinforced concrete slab? I’m certain it’s not many. However, on the drive in this morning I was waiting for my turn to go through a construction zone that had funneled a two-lane road down to one-lane. As I sat there it hit me…every job site like this one has at least two people that don’t need any skill at all…these are the guys holding the “stop/slow” signs. In theory you could put all 7 million unemployed to work if you had 3.5 million construction sites that needed “stop/slow” sign holders (one guy at each end). In reality this is likely a union job anyway so we’d need 5 people per sign to get a full 8 hours of sign holding done…so 10 people per site. All we need is 700,000 construction sites like this and the government can get the unemployment rate to zero percent. I’m writing my congressman this morning…then I’m going fishing.

Initial Claims

Initial jobless claims were released at a lower level than expected this morning. This is a series that tracks the number of first time applications for jobless benefits. This number has been running north of 600,000 per week for 22 consecutive weeks. The pace has been quite dramatic. Today the number broke below 600,000 and posted a 565,000 reading. The estimate from the Bloomberg Survey was for 603,000 people to file. The series has definitely seen a slow decrease in filings over the last several weeks, today’s number was a larger drop than the trend would have indicated. It’s interesting to note that last week was a short week…how many people can you fire in a short week? And of those fired they have 1 less day to file for benefits if the government office that takes the applications is closed on Friday. It will be interesting to see if this number bounces back up next week.

Continuing Claims

Even though the pace of Initial Jobless Claims has dropped a bit, we still have a huge stockpile of unemployed people. The Continuing Claims number was expected to show 6.7 million receiving unemployment benefits, the actual release was 6.88 million. Where will these almost 7 million Americans find jobs? We still have close to 600,000 a week losing their jobs. It must be a surreal scene at the unemployment office. 6.8 million people picking up unemployment checks with the TV in the background telling them that things are getting better…the line will only be 580,000 people longer next week.

How long does it take to put 7 million Americans back to work? Where will the economic growth come from to create jobs? When you step back from the day to day process of being involved in the market and you look out over a longer horizon you don’t see a lot of factors that scream “growth”. I see massive deficit spending, higher taxes, and more government regulation; none of these things causes growth…they work against it.

Below is a graph of Continuing Jobless Claims going back to 1967. If you have any questions on this material or if there is anything I can be doing for you just let me know.

An ominous jobs number

Jobs lost

The most interesting event of the day was a Bloomberg story that showed the relationship between jobs created and lost over the business cycle. The article pointed out that at this point in the recession the economy has lost more jobs than were created during the previous expansion.

Over the last expansion (say 2000 to 2006, I don't have the article in front of me so my dates may be off a bit) the economy created 5.2 million jobs. Since the downturn, the economy has shed 6.3 million jobs. That is the first time this has happened since...you can guess this one....come on...the great...the greaaaat....depression, that's right. One more thing to add to the "worst since the great depression" list.

I think the worst part about the metric is that the job loss figures are still in freefall. There doesn't seem to be any POSITIVE news that would indicate a bottom...a stabilization of some sort. We just blew past a record with no sign of slowing down.

Right now everyone is grasping and reaching for a leg of hope. There doesn't seem to be any truly "good" news out there. There is an abundance "less bad" news...but that hardly qualifies as "good" does it?

It's a bit like the doctor telling you he has "good news", then he says that you'll likely live 3 more years instead of just the 2 years he initially thought. It's tough to spin that as good news but plenty in the media seem ready to do so.

Muni problems

Moving on from that...how is California NOT rated as junk? THEY CAN'T PAY THEIR BILLS!!!

If California were a company (a different company than Fannie or Freddie who don't operate under the rules of the real world...or even AIG...but I digress) their debt would be trading with junk ratings and junk prices. If a company is handing out IOU's to their suppliers in lieu of cash it's a pretty big warning sign.

So far Fitch is the only rating agency that has even come close. They downgraded California GO paper to BBB...just two notches above junk. It makes you wonder how much political pressure is being put on Moody and S&P to keep their ratings levels articifially high. Just what we need on the heels of ratings agencies misleading people on CDO deals (remember the AAA rated CDO deal that dropped 17 ratings notches in ONE DAY?)...doing it again on Muni's.

The political pressure on the ratings agencies is likely to come due to the fact that so many regulated depositories hold California paper. If that debt gets downgraded to junk there will necessarily be a massive wave of OTTI writedowns associated with the debt in bank investment portfolios. If a bank holds $1 million of a California GO that they bought at par ($100) and the paper subsequently gets cut to junk and trades at $45, the bank has to write the value of the bond down to it's market value. They will see a $55 write-down go through the income statement (ruining earnings) and then hit the capital account on the balance sheet.

The last thing a bank needs in this environment is anything that erodes earnings and capital. This could be enough to push some marginal banks over the edge. It will certainly prolong the time it takes to get the financials back on solid footing and therefore stall any hope of economic recovery. This is why I expect there is a lot of political pressure on the ratings agencies. If you think there isn't take a look back at how the Treasury twisted Ken Lewis' arm at Bank of America when he thought about backing out of the Merril Lynch purchase. I'm sure there is dirty pool being played all over right now.

This will be an interesting train wreck to watch.

Market update: 6 26 09 _ Americans are saving more

The Personal Savings Index

Fear is a powerful motivator. It took the fear of a global meltdown, a terrible recession, a potential DEPRESSION, 7 million Americans on unemployment, everything short of a plague of locusts, it took all of this to get the national savings rate above zero percent. The graph below shows the personal savings rate as a percentage of disposable income from 1969 to the present. I inserted a red line on the chart just to point out a bit of the insanity that has taken place in recent years. The savings rate actually went negative a few times since the year 2000. That’s right…NEGATIVE…as in spending more disposable income than you have. For a while it looked like Bloomberg might have to change the name of this from the Personal Savings Index to the “I spend way more than I make Index.”

With a flood of easy credit, home prices rising, equity indices climbing, jobs plentiful, and 10 credit cards in every wallet many people in this country saved nothing. Why should you? Times are good so they’ll always be good right? Right? For the financially illiterate and the dreamers among us it would be a pretty easy story to buy into.

The chart below shows a line that represents the behavior of a large group of people…alternatively it could be viewed as their outlook on risk. You can watch the herd move toward the zero percent savings rate and you can hear them calling out “all is well, allllll is well”. Actually they were probably calling out “this big-screen TV looks awesome…and I didn’t even have to give them any money for it”. A savings rate at zero percent tells us that people think there is no reason to save, that they see no risk (it could also be a good indicator of IQ but that’s a study for someone in another field). The normal reasons to save, like having a cushion against losing one’s job, or an unexpected expense of any sort…those were no longer considered important. People either decided these were low probability events, or that they could just use the credit card as their primary source of liquidity if needed. It was assumed that the credit would always be available, and it would be at the same cheap rate.

In retrospect it seems odd that people would rely on a credit card company to “be there for them” if any big shock ever happened…but that was considered the backup plan for many people. I saw a show on the Discovery Channel one time about the guys that climb these huge communications towers. The scene that comes to mind is where the seasoned tower-climbing veteran is going over the safety gear with the rookie before he climbs a 500 foot tower. He tells him how to stay safe and he reminds him that he alone is responsible for his well being. He tells the kid “nobody loves you more than you do.” It’s a great reminder that ultimately each person is responsible for their own safety...whether it’s climbing a tower or funding your own liquidity needs don’t expect anyone else to help you.

It looks like Discovery must still be showing that episode in re-run because the graph below shows that the average saver in America just realized that nobody loves them more than they do. The savings rate has increased from 0% of disposable income in 2008 to almost 7% as of May 31 2009.

The market

After a big rally in Treasury prices yesterday the market is up a bit again this morning. The yield on the 10-year is in the low 3.50’s and there really isn’t much to report today.

If you have any questions on this material just let me know. Have a great weekend.

FW: Market update 6 25 09 _ Jobless Claims up...GDP down

You can tell it’s summer by the number of “out of office” replies you get in the returned e-mail box. It seems like everyone is on vacation…if this keeps up I might go myself. If anyone has a suggestion on where I could go, preferably a place with no cell phone reception, please let me know.

We had several important economic releases this morning. GDP (Quarter over Quarter, Annualized) was expected to shrink at a -5.7% pace. The actual number was very close to that, coming in at -5.5%.

Personal Consumption and Core PCE came in very close to their estimates as well. The numbers that surprised this morning were the employment data. Initial Jobless Claims was expected to be 600,000 for the week…the actual number was 627,000. Continuing Claims was expected to be 6.714 million the actual release was 6.738 million.

The jobless numbers have got to be high on the head-ache list for the Fed, the Treasury, and the politicians. I told you a while ago that I’d try to avoid writing about politics, but it’s a difficult thing to do now that politics is smack-dab in the middle of my capitalist system. You can’t avoid considering politics in any discussion about the markets now that the government has weaseled its way into so many corners of the free market system.

You can try to spin the news all you want to say that you’ve “save or created” one hundred sixty thousand jobs or so (as the administration did last week), but it’s difficult for me to hear that argument over the steady drum-beat of more than 600,000 people per week hitting the unemployment line. We joke around here that the government has now spent and/or made guarantees of around $11 Trillion and they’ve only “saved or created” 160,000 jobs…so far that equates to $68 million per job. Where do I sign up for one of those saved or created jobs? Heck I can remember back when it was big news that contractors were charging the government $400 for a hammer or $1,000 for a toilet…my how things have changed.

The number of Americans currently drawing unemployment benefits is still running near record highs. Keep in mind that this report doesn’t count ALL people that are out of a job, it just counts those that are receiving unemployment benefits. Some people run out of benefits before they find a job so they don’t get counted on this list.

GDP on a quarter-over-quarter basis was -5.5%. You have to go back to 1981 to find the last time period where GDP shrank at a comparable rate. I thought this graph provided a bit of perspective so I wanted to include it. There’s really not much to say about it…the chart speaks for itself. It’s tough to envision an economy rebounding while it’s still firing more than 600,000 people per week. Keep in mind that the US Workforce is roughly 150 million strong. 600,000 is almost half-a-percent of the overall work force. We’ve seen initial jobless claims running higher than 600,000 per week for the last 21 consecutive weeks. The numbers are getting pretty large.

That’s all the news this morning. The Treasury market is up in price a bit on the news, but it’s not a terribly strong move. The 10-year treasury is trading around a 3.67% currently. The Fed’s doing nothing, the markets doing nothing, I may go fishing.

If you have any questions on this material just let me know.

Interpolated Yield Curve from June survey data

Each month Bloomberg surveys 60 to 70 economists to get their estimates of where Fed Funds, the 2-year Treasury, and the 10-year Treasury will be over the next several quarters. I take this data and interpolate for the points in between the survey data to create the attached report. This allows us to get a broad view of where various economists see interest rates going over the coming quarters.

It appears that we’ve not been alone in calling for a steepening of the yield curve. The Bloomberg survey data has also been trending toward a steeper curve over time. As of yesterday the yield curve was trading with 356 basis points separating Fed Funds and the 10-year Treasury. The analysis that follows points out that this is quite steep by historical standards. How long will this last? Will it get steeper? What does it mean to me? Read on. In the following analysis I highlight some trends to consider as we move through this cycle.

What did they say six months ago?

Below I’ve attached the Interpolated Yield Curve from January of 2009. In the “furthest period forecast” for that survey (looking out to 3Q 2010) the average forecast showed a curve with 236 basis points separating Fed Funds and the 10-year Treasury.

The current survey “furthest period forecast” shows 315 bps of spread between the overnight rate and the 10 year.

How steep does the curve get?

A quick look at the history books is in order here. In the chart below I’ve run the historical spread between the Fed Funds index and the 10 year Treasury. This measures the steepness of the curve. The higher the number of basis points between these two instruments, the steeper the curve.

You can see from the chart below that the current yield curve (far right) is in an area that history shows to be among the steepest. With a current spread of 356 bps between Fed Funds and the 10 year Treasury we’re clearly at levels that are among the highest we’ve seen over the last 20 years.

Keep in mind that the bottom panel of the chart below represents the SPREAD between Fed Funds and the 10-year Treasury. A high number means a steep curve and a low number indicates a flat curve, a NEGATIVE number indicates an inverted curve. As you see the line dip from a high toward a low you are looking at a FLATTENING of the yield curve. The bottom panel just shows the spread.

Putting both halves of this screen together gives you a very good feel for how the shape of the yield curve changes in association with changes in the Fed Funds rate.

The white line in the top half of the graph below represents Fed Funds. I’ve pointed out a period that shows Fed Funds rising (white line on top half of page) along with the reaction of the Treasury Curve (yellow line on bottom half of page). As the white line rises the yellow line eventually drops. This is just a picture that illustrates the relationship between Monetary Policy and the yield curve. When the Fed lowers rates to spur economic activity it will eventually lead to inflationary concerns and the curve will again become steep (buyers of long term bonds require more yield to compensate them for the higher expected inflation). The economy will eventually heat up causing the Fed tighten again to fight inflation and the curve again becomes flat. This is just the cycle of monetary policy…the Fed using rates to combat inflation.

In December of 1993 Fed Funds were at 3.00% and the 10 year Treasury was trading at 5.78%, so we had a spread of 278 basis points between them. Beginning in December of 1993 the Fed began tightening aggressively, raising the overnight rate to 6.00% over the next 14 months. After that tightening we had Fed Funds at 6.00% and the 10 year Treasury at 7.44%. The spread between them was then 144 basis points.

The Fed tightens like this to control expected inflation. A 300 basis point hike in the overnight rate is powerful medicine on inflation, the market understands this and reacts by pricing in less expected inflation on the long end of the curve (because they see the Fed acting to prevent this expected inflation from getting out of control)…so yields on longer term bonds drop.

The yield on the 10 year Treasury dropped from a 7.44% in Feb of 1995 to 6.22% just five months later. At that point the spread between Fed Funds and the 10-year was only 22 basis points. As indicated by the 22 basis point spread, the Feds actions forced a massive flattening of the yield curve.

You can see this in the BOTTOM panel of the graph below. As the Fed raises rates they squeeze the spread between Fed Funds and the 10-year, and the line trends downward indicating a flatter yield curve. Alternatively you can just look at the green shaded area in the top panel...this represents the amount of spread between Fed Funds (white line) and the 10 year Treasury (orange line).

You’ll notice several time periods where the white and orange lines are on top of each other…this indicates periods where Fed Funds and the 10-year are trading at the same yield level…a flat yield curve.

Any time the orange line is above the white line you have positive spread…the wider the spread the steeper the curve. This is all said to point out that there are a number of ways one can look at the graph below.

Below we look at a different period on the same timeline. As Fed Funds drops from 6.50% in late 2000 all the way down to 1.00% in 2003, you’ll see that the curve moves from an inverted configuration (orange line below the white line with a red shaded area indicating negative spread between Fed Funds and the 10-year) to one that is quite steep.

So what?

The first chart we showed illustrates that we’ve got a pretty steep curve right now, and we’re looking at several factors that could cause this curve to steepen even more. Adding to the uncertainty is that a steep yield curve can persist for long periods…years in fact. Big deal right? Of what practical use is this information?

At this point it is helpful to consider the way we tend to look at bonds. Everyone wants the most yield for the least risk (unless you work for the government…they tend to view this differently). At this point I’ll ignore credit risk because community banks generally don’t take a significant amount of credit risk in the investment portfolio. The two primary risks that bank investment portfolios are exposed to are optionality and interest rate risk (price risk). Since we’re at the lows of rates and most everything than could have been called HAS been called, and everyone is concerned about rising rates, this leaves us to focus on price risk. Nobody wants to go long because they don’t want to take a big hit on the price of a 7 to 12 year bond in an up 300 shock. They like the yield but they sure don’t want to be exposed to that type of price volatility.

Most everyone uses Bloomberg models that run price volatility shocks on bonds under an immediate parallel 300 basis point rate shock. This simply means that the entire yield curve shifts up or down by 300 basis points the day after you buy the bond. It’s an extreme test, it is also one that doesn’t do a great job of modeling reality. The yield curve doesn’t generally move up and down in easily modeled immediate and parallel shifts. The curve changes shape as it rises and falls. It can flatten and steepen as we move through the various stages of the business cycle, and all points on the curve don’t experience the same magnitude of movement.

Food for thought

Rates up from 1993 to 1995

Let’s take a look at how rates have moved up over some recent interest rate cycles. In December of 1993 Fed Funds was at 3.00%. Over the following two years the Fed tightened until the overnight rate sat at 6.00%. Were all bonds affected equally? Was this a parallel rate shock where every point on the curve was up 300 bps? No. This was a classic flattening of the yield curve. The Fed pushed the short end up, but the long end actually fell a few basis points.

The chart below shows that the 10-year was the LEAST affected of any bond on the curve. The green line shows the December 1993 yield curve and the white line shows the yield curve in December 1995 (after the rate move). You’ll notice that the short end of the curve bore the brunt of the move. The 3 month spot was up 227 bps, the 2 year spot was up 117 bps, and the 10 year spot was actually DOWN in yield by 3 basis points.

On December 15^th 1993 (just before the tightening):

- The 2-year Treasury yielded 4.20%, and received a 117 bps rate shock over the cycle which translates to a 2.3% price loss.

- The 10-year Treasury yielded 5.83%, and experienced a down 3 bps move over the cycle which translates to a 0.2% price increase.

If you bought a 10-year Treasury rather than a 2 year then you earned 163 basis points more yield AND you had less price volatility. How is this possible? It’s possible because the yield curve doesn’t do parallel shifts. There is generally a pivot point on the curve…much like a see-saw. Not all points on the curve experience the same movement.

When the Fed pushes up on the short end of the curve, the curvature of the yield curve changes. Yields on the short end will rise quickly, yields on longer bonds will tend to fall a bit, and yields on the intermediate part of the curve may not move much at all. The following example shows that after the Fed raised rates 300 basis points over a two-year period…the 10-year Treasury yield was virtually unchanged.

Are we saying to run out and load up on 10-year paper? Of course not. But this information should be considered as we make changes to the investment portfolio. Most bank portfolios have become very short over the last two years. I think the story the yield curve tells us is that diversification is still our friend…even when we expect rates to rise. If you can get some money to work at the yield levels that a steep curve offers at the 7 to 10 year spot, and history shows that intermediate term bonds can receive less of a rate shock than short bonds in a rates up move…then we have the potential to increase portfolio yield and decrease its price volatility at the same time…a textbook definition of diversification.

Rates up 2004 to 2006

Let’s look at another example from the graph at the top of the page. From 2004 to 2006 the Fed raised the overnight rate by 425 basis points. Again we have an example of a “pivot point” on the curve that is unaffected by rate moves…and again the shorter bonds take the brunt of the move.

The 1-Year Treasury got a 300 basis point rate shock…the 10-year got only a 39 basis point shock over the same time period. Over much of this time frame the 7-year spot on the curve served as the “pivot point” and was unchanged in yield for a long time while shorter bonds began seeing losses from outset of the cycle.

What does all of this mean to me?

This review is really a reminder to consider the big picture when making investment decisions. View each purchase within the context of the overall portfolio. Think about the risk profile of not only the individual bonds but of their contribution to the overall portfolio. How will I be affected if the yield curve remains steep for two years? How will I be affected if rates rise quickly in a year? Which bonds get hit the hardest in an up 300 flattening move? Could I pick up more yield AND reduce the overall price volatility of the investment portfolio by putting SOME money to work on the 7 to 10 year spot on the curve?

The information above is really just to provide some additional context to your decision making process. A solid understanding of how the Feds execution of monetary policy impacts the shape and level of the yield curve can lead to higher quality decisions regarding the investment portfolio.

This is not an exhaustive list of considerations, it’s merely food for thought so to speak. If I typed any longer I’d undoubtedly begin putting people to sleep. If you have any questions on this material please let me know.

FW: Slippin' away

 

The Fed isn’t having a good afternoon.  Their plan to hold interest rates low is being undone by forces yet unknown.  The 5 year Treasury auction went well this afternoon.  The Treasury sold $35 billion worth of 5-year bonds, there was good participation, and all was calm.  About an hour after that auction Treasury prices began falling…and MBS prices were falling too…at an even faster rate than Treasuries…this is an unusual thing.  The 10 year pulled back at a very rapid pace until it was down over a full point. 

 

I picture Bernanke and Geithner in an office staring blankly at a Bloomberg as they realize that they’ve spent hundreds of billions of dollars on MBS and Treasury securities over the last few months and they currently losing their shorts on those positions.  I would guess that it is difficult even for the Ivy League economics professor to maintain his cool in the face of it.  If it were me I can imagine the Bloomberg terminal being verbally and physically abused over the remainder of the day.

 

There is no specific news yet on what is driving today’s pullback.  It’s not a gigantic move in Treasuries but it is material and it was unexpected.  You can always gauge the magnitude of the surprise factor by the pace of the chatter going “over the box” as we call it (we have a worldwide intercom system that allows us to maintain real-time communication with the rest of the firm).  The chatter picked up after the 10-year  dropped by over the half a point, and as it approached a one-point loss the there were people scrambling  and talking over each other in a rapid-fire staccato trying to get things done before the situation deteriorated any further.  A one-point move on the 10-year Treasury generally doesn’t raise too much of an alarm in a market where we’ve seen record volatility (think back to the nine-point intra-day move we had late last year).  So while the magnitude of this afternoons movement isn’t even close to being a record it is having a chilling effect on the market due to the surprise factor.

 

The general trend in rising Treasury yields appears to be coming from an uneasiness in the market regarding the Treasuries ability to place as much debt as they need to bring.  Supply may simply overwhelm demand. 

 

If you were looking to sell bonds you’ll be looking at much lower prices today as Treasury prices fell AND spreads widened (mainly on MBS).  If you were looking to buy bonds then today is probably a very nice day to do so.  I can’t imagine the Fed and Treasury just throwing their hands up and saying “there’s nothing more we can do”.  It wouldn’t surprise me to see them up the size of their buyback plan from their current $300 billion amount to something much more material.  If you can buy on a pullback before the Fed counter-attacks you may have an opportunity to pick up some spread.

 

Below are two screens showing today’s Treasury market activity and the movement in the yield curve over the last month.

 

If there is anything I can be doing for you just let me know.