March 2018 – Monthly Commentary

March 2018

March has followed the pattern of the previous two months, with heightened equity market volatility creating worry for anxious investors. Despite that worry, the bond market has been a bastion of calmness with the 30-year bond trading in a relatively benign range of 3.22% to 3.00%. Given the continued strength of the U.S. economy, we had expected the bond to come under price pressure pushing the yield closer to 3.5%. That price action has been befuddling, especially given the steadily deteriorating budget deficit. On April ninth, the Congressional Budget Office announced that the deficit would likely hit $1 trillion dollars in 2020, two years sooner than earlier forecast. Investors didn’t blink an eye, which really is no surprise given the complacency that has swept over the public with regard to the U.S.’s profligate spending. The reaction was much the same last month when Republicans pushed through the $1.3 trillion spending bill.

American’s seem to have come to the conclusion that the Fed has and will continue to ensure prosperity for all and the idea of fiscal responsibility has become nothing more than an old fashioned notion. However, we got a glimpse of the future last month when the Treasury Department flooded the market with Treasury Bills. With the risk of a government shutdown earlier this year, Treasury reduced bill issuance in an attempt to stay under the borrowing cap. Because of the prospect of a shortage of T-bills, the yield to maturity in the secondary market plunged below the low end of the Fed Funds range. As a result, the Federal Reserve’s reverse repo program, which is available to select institutional clients and a de facto loan to the U.S. Government, skyrocketed to nearly $500 billion dollars. When a shutdown was averted and the debt cap lifted, Treasury issued nearly $300 billion in additional T-Bills, a 38% increase over the amount issued in February. As a result, T-Bill yields rose sharply and traded above the upper bonds of the Fed Fund range as investors sought to digest the additional supply.

With the increase behind us, T-Bills maturing in early June have fallen in yield by 15 basis points despite the rate hike in March and the expectation of another rate hike in June. The open interest in the reverse repo program also plunged from $500 billion at the peak to $4 Billion at the time of this writing, a nearly 100% plunge in open interest! The message here is that large moves in supply and demand will move the market, despite the Fed’s manipulation. It just so happened that with the freeze in the Bill market there was an alternative investment. We wonder who’s going to be the alternative source of buying when the Treasury is issuing a trillion dollars of additional debt year after year.

There are those who believe that should interest rates rise meaningfully in the face of supply, the Federal Reserve would restart their bond buying program to absorb the additional supply. While that may be sustainable in the near term, it’s a deeply flawed solution longer term for a number of reasons. First one trillion dollars is approximately 5% of GDP and as interest rates rise the compounding effect is going to cause the debt load to rise at an unsustainable pace. Secondly, as rates rise, the value of their existing portfolio is going to fall in value and that is likely to come under congressional scrutiny. Under the current spending regime both of those outcomes have a material probability of coming to pass. The fiscal irresponsibility of the U.S. Government resembles an individual getting caught up in the vicious circle of credit card debt. The debt is sustainable in the beginning but as spending exceeds income, it ultimately overwhelms the borrower.

In the history of money there have been numerous instances of countries pursing such a policy and in the vast majority of cases, the country was forced to either default on their debt, devalue their currency, or both. One has to wonder what will be the outcome for the U.S. dollar. It currently enjoys the status of being the world’s reserve currency and it’s bonds the store of wealth for many nations. That is unlikely to change overnight, but there’s a very good chance that it will erode. The big question is to what extent?

February 2018 – Monthly Commentary

February 2018

Six weeks ago, as we closed out January, the S&P 500 Index settled just below its all time high. Financial pundits
at the time were saying that a healthy correction would be good for the market. The term healthy correction
has always seemed an oxymoron. How can a decrease in the value of one’s investment portfolio be
described as healthy? Yet, the term has been in the lexicon of Wall Street for as long as traders have been
able to short stocks. The state of the market since the first of February is a telling example of the lunacy of a
healthy pullback. Stocks plunged more than 10% in the first two weeks of February and despite having
bounced off of the low, nervousness still abounds as witnessed by the sharp intraday spikes higher and lower.
Anecdotal evidence suggests that ETF’s were at least partly to blame for the panic. We’ve written on
numerous occasions of retail investors bemoaning that stock valuations were too high and rather than buying
expensive stocks, have invested in an ETF instead. To be clear, the SPDR S&P 500 ETF invests in every stock in the
S&P 500, even the overvalued ones. To maintain the correct proportions, the ETF manager must buy in the
open market. When demand rises for an ETF, the buying pressure lifts the entire market. Conversely, when
investors dump the ETF, the manager must dump all of the stocks and in the instances we saw in February, the
result is a precipitous drop in the overall market value. Compounding the selloff was an excessively large short
position in stock index volatility (VIX and VIX-like) products. These products have become a fad with active
traders and we believe that many of those trading them did not fully understand the ramification of the risk.
The VIX is a proxy for the expected annualized volatility of the S&P 500 and has traded mostly below 10% since
last summer. Investors had been collecting income by buying an inverse structured note that went higher in
price as implied volatility fell. Viewed as a “no brainer” money maker, retail investors piled in. The problem was
that when stock prices fell, implied volatility rose, inflicting losses on the VIX sellers. The market makers of the
products were forced to buy offsetting positions in the open market which pushed the value of implied volatility
higher and had the collateral effect of further spooking ETF holders. In short order a vicious circle developed
which drove the price of the broad market 10% lower in the course of a week. Happily, corporations stepped
in to buy back stock at a ravenous rate, staunching the selling and emboldening investors with the confidence
to do what they’ve been conditioned to do since 2009. Namely, buy the dip!

While not directly responsible for equity weakness, newly sworn-in Fed Chairman Powell made his first public
comments in testimony before Congress and his remarks were interpreted as being decidedly hawkish. Before
the testimony, consensus opinion was for three rate hikes this year, with some members of the FOMC arguing
that even that was too hawkish. Since the testimony, the market now reflects 100 basis points of tightening this
year including one later this month at the March 21st meeting. That has translated directly into higher interest
rates, with 3-month LIBOR crossing the magical two percent level. Also adding upward pressure to short
maturity interest rates is the sharply higher amount of new T-bill issuance coming to the market. As we’ve
discussed last month, the U.S. government is going to need to finance their continued excessive deficit
spending and that means more debt issuance.

Also catching the eye of investors was the rise in the yield of the 10-year note as it approaches 3%. This is the
third time since 2012 that the yield has approached 3% only to reverse direction. We’ll be watching that level
closely. Quite often in markets when a price, or in this case yield, breaks through a resistance level on its third
attempt, it usually follows through in meaningful way. If we get through 3%, we could very well see 3.5% before
too long.