As our clients are aware, the basis of our investment thesis is that interest rates have been artificially depressed by the Federal Reserve’s bond buying program and that as the operation concludes, interest rates will normalize at higher levels. That thesis has been challenged this year, and especially so in last month. Ironically, May was the first month that economic data hadn’t been skewed by the cold snowy weather much of the country endured during the first quarter. The results were decidedly strong in virtually every category and forward looking indicators are forecasting a continued acceleration in activity. Despite the better than expected data, interest rates fell for the month, with the yield to maturity of the 10-year Treasury note dropping from 2.64% to 2.47%.
Happily, the yield-to-maturity of the 10-year note has reversed last month’s fall and retraced nearly 100% of the May movement, at the time of this writing.
Reviewing the data for the period it’s clear that economic activity continues to accelerate, with the jobs picture improving materially. During the month, initial claims for unemployment insurance fell below 300,000 for the first time since 2008, indicating that job losses have slowed to a normalized level. At the other end of the spectrum, new hires have continued to grow at robust rate, growing in excess of 200,000 jobs a month for the last four consecutive months and in six of the last eight months. With those gains, the economy has now gained back all of the jobs lost since the recession began.
Away from easy money policy of the Fed and the noticeable improvement in the job market, there were other signs that the market has fully returned to the pre-crisis rate of expansion. Of particular note was Mel Watt’s first speech as head of the Federal Housing Finance Agency (FHFA). Mr. Watt, the former Congressman from North Carolina, was appointed by President Obama to head the agency that oversees Fannie Mae and Freddie Mac, the beleaguered housing agencies subject to Government receivership. Since the crisis, there has been a bipartisan call for a winding down of the agencies and investors were prepared for Mr. Watt to outline such a course of action. Given that expectation, investors were stunned to hear Watt outline a plan to lower the credit standards of the agencies in an effort to channel an increase in mortgage lending to lesser quality borrowers. Further into the speech, Watt emphasized that there was no immediate plan to wind down the mortgage guarantors and that it was not his role to oversee such a wind down. The speech was a complete “about-face” and can only be interpreted as an additional degree of monetary stimulus.
Additional evidence of economic strength was evident in the bank debt market. Bank debt, also known as leveraged loans due to the highly leveraged balance sheet of the borrowers, are an instrumental tool in financing small to mid-size corporations. The loans are typically made by a syndicate of banks, and ultimately sold to investors either individually or packaged as an asset-backed note. The issuance of levered loans has skyrocketed this year, while the loan covenants demanded by lenders have steadily deteriorated as banks vie for the business by offering ever more attractive terms. The most glaring evidence of easing is the reemergence of payment in kind (PIK) loans, which, in lieu of cash, pay coupon payments in the form of additional IOU’s. The Federal Reserve has expressed concern over the proliferation of the loans and has begun to scrutinize such lending but that has done little to slow the market.
With such increasingly widespread signs of frothiness in the economy, we expect that the Fed is on the verge of another incremental reduction of their easy money policy. Bill Dudley, arguably the most dovish member of the Open Market Committee, has publicly ruminated on what he envisions the backdrop for monetary tightening to be. Less sanguine in his view, Dallas Fed President Richard Fisher publicly stated that he’s worried that the Fed has “…painted ourselves into a corner which is going to be very hard to get out of.” We will be paying close attention to the text of next week’s FOMC meeting, as well as the press conference and subsequent question and answer period hosted by Chair Yellen. We’ll be listening for any hint that the Fed is considering ending quantitative easing sooner than expected, an acceleration of the first rate hike, or any other sign that the committee is getting nervous that they are falling behind in their ability to manage monetary policy. At the time of this writing, such a view is decidedly out of consensus.