September 2015 – Monthly Commentary

September 2015

While forecasters had handicapped the probability of a rate hike at the September 17th FOMC meeting at less than 50%, it seems that the expectation was much higher. On the back of the unchanged rate and the conciliatory tone of the Chair at the post-meeting press conference, stocks plunged around the globe as did emerging market foreign exchange rates and commodity prices. Driving commodity prices was the falloff in demand from a slowing China. That coupled with the supply driven drop in oil prices weighed heavily on the economies of energy producers like Mexico, Brazil and Canada. Brazil, especially, has fallen mightily. The one-time darling of many diversified investment models, touted as being a better credit than the United States, the Brazilian Real has plunged 81% in the last year. Meanwhile, back in the U.S., the economy is doing quite well. Unemployment has fallen to 5.1% and is likely to dip below 5% in the coming months. Auto dealers are selling cars at a record pace and with the average age of the car on the road touching a record 11.5 years, the replacement cycle should support cars sales for years to come. Moreover, average hourly earnings are growing at 2.2% year-on-year and new home sales have touched a post-crisis high. Yet Chair Yellen articulated that she is worried about heightened market volatility and the slowdown in economic growth in China. I can understand her concern surrounding those issues, but am perplexed at her ignorance of the problem the Fed has created in the money markets. Simply put, there is too much money chasing too few securities. At the time of this writing, every Treasury-Bill maturing now through the end of the year is trading at a negative yield to maturity. At the September auction of one month Treasury bills, the auction result was a yield to maturity of 0.00%, and it was nine times oversubscribed. Earlier this year we wrote about impending changes in SEC rules governing money market mutual funds. To summarize, Prime money market funds were required to hold 80% of portfolio assets in U.S. government paper prior to the rule change. The balance could be held in various credit securities including commercial paper, corporate bonds, or general collateral repurchase agreements. Deeming 20% of “other” paper as posing a liquidity risk, the SEC mandated that those funds must have a floating daily NAV and under certain times of panic, must implement a 2% redemption fee. To avoid those harsh terms, funds must increase the holding of U.S. Government paper to 99%, and the changes must be implemented by October 2016. However, earlier this year, several of the largest funds announced plans to implement the change by the fourth quarter of this year. As those funds boost their government exposure to 100% they will likely drive T-Bill yields further into negative territory.

The Fed has flooded the money markets with so much liquidity that we don’t know if they’ll be able to raise interest rates when they finally decide to. It’s not widely understood that when they ultimately decide to raise rates, they don’t simply do so by mandate. Instead, the committee needs to balance the supply and demand of capital such that the marginal demand and marginal supply changes hands at the targeted rate. Prior to the crisis, the amount of intervention to raise interest rates was as little as $2 Billion in asset sales, technically referred to as “reverse repo’s.” But with excess bank reserves amounting to approximately $2 trillion, those reverse repo’s will need to be much larger. Exactly how much? There is no way to model that, nor has the Central Bank suggested an amount. It is widely expected that the Fed will implement an overnight rate corridor with Reverse Repos setting the floor and Interest on Excess Reserves representing the cap. Considering a 25 basis point hike, we expect the range would be a 0.25% floor and a 0.50% cap. Our suspicion is that there is so much liquidity that Fed Funds will rise only to the floor rate. Under that scenario the rate tightening in Fed Funds will only be 11 basis point higher from the 14 basis points at which they are currently trading. Equally unknown is what will happen to the T-Bill market. Our guess is that Bills will continue to trade at a significant premium to the Fed Funds rate. Given the complexities in raising interest rates, it’s no wonder that the markets don’t like a confused message from the Fed.