January 2015

The ad hoc monetary policy of the Global Central Banks and their “beggar thy neighbor” currency policies turned downright bizarre in January resulting in a sharp and unexpected rally in bond prices.

On the morning of January 14^th, the Swiss National Bank (SNB) shocked the capital markets by abandoning its exchange peg against the Euro currency. Since 2011, the SNB has consistently intervened in the currency market, selling the Swiss Franc against the Euro to prevent their currency from appreciating versus that of their neighbors. On a comparative basis, Switzerland is considered a bastion of stability amid the single currency mess in which Europe finds itself. However, demand for the Swiss Franc had become so great that the SNB could no longer afford to support the peg, which involves selling the Franc and buying Euro’s. Essentially, their Euro position had grown too large. In the moments after the move was announced, the Franc appreciated by nearly 30% versus the Euro before closing the day 14% higher. The rate movement against the U.S. Dollar was similar, as one would expect.

One week later, Central bank policy shocked the markets again when the European Central Bank, the Bank of Canada, and the Banco Central do Brazil all intervened. The economies of Brazil and Canada, both highly dependent on commodity exporting, have suffered with the plunge in the price of crude oil. As a result, the currencies of both nations have plunged versus their major trading partners. The Loonie, as the Canadian dollar is known, has fallen sharply in value versus the U.S. dollar, dragged down with the fall in commodities prices. In response, the BOC cut interest rates from 1% to 0.75% in a move that surprised investors and caused the currency to plunge nearly 7% versus the dollar for the month. The Brazilian Central Bank, while suffering a similar downward trajectory in the value of the Real, also due to a falloff in commodity exports, took the opposite tack and raised the overnight lending rate from 11.75% to 12.25%. The Brazilians have always been manipulators of their currency, concerned that a falling currency would raise the cost of servicing their non-Real denominated debt, while also worried that an expensive currency would have a detrimental impact on growth.

On the same day, the European Central Bank leaked news that the Quantitative Easing (Money Printing) exercise they were expected to announce on the following day would amount to 50 Billion Euros a month. Investors were cheered by the rumor as it had been anticipated that the monthly purchases would be approximately 30 billion Euros. However, at the post-meeting press conference, Chairman Draghi further surprised investors by communicating that the rate of monthly purchases would actually be 60 billion and would run at least until October 2016, but could be extended beyond that date if required. In essence the ECB is flooding the markets with newly minted Euros in an effort to achieve sustainable economic growth. In doing so, the Europeans join the Bank of Japan and the Federal Reserve in the practice of printing money and using it to buy government debt. We’ve been critical of the practice and have written about it on numerous occasions, and are no less so in the case of Europe. Arguably, the challenges facing the European economies are much different than those that the U.S. faced. The level of indebtedness, social programs, and work ethic, vary across member countries posing a structural challenge to the continent’s economic advance. Moreover, consumption is constrained by the high level of value-added taxes. With interest rates already at very low levels, and in some cases negative levels, the ECB hopes that the program will encourage banks to make loans with the newly printed Euros and hopefully a virtuous circle of business and job growth would ensue, much as has occurred in the U.S. However, the big question is what will the unintended consequences will be?

November 2014

November witnessed a barrage of better than expected economic data that ordinarily would have pushed interest rates higher. Instead, rates fell as bond prices rallied.

In evaluating what went wrong, the obvious culprit is our misjudgment of the demand for U.S. Government securities. We anticipated that the steadily improving economic backdrop would have spooked investors and caused them to sell bonds in advance of a tightening of monetary policy. However, buyers seemed convinced that monetary policy would remain unchanged at least until 2016, despite comments from Federal Reserve members indicating a rate hike in 2015. The primary driver of that view has been the stagnant Consumer Price index. As measured by U.S. government statistics, inflation is running just below 2%, the rate targeted by the Federal Reserve. Our forecast had been that the measure would have been closer to 3% and that would have prompted the Federal Reserve to raise rates. It didn’t and with many investors holding short positions in Treasury bonds, a short squeeze ensued. Exacerbating the squeeze has been a lack of liquidity among banks and brokers.

Ironically, our forecast for economic activity was mostly correct. As extended unemployment insurance benefits expired last year, we were of the opinion that the change would be beneficial for employment. Our rational had been that those recipients of the extended benefits would be forced to get a job and that would be supportive for the economy. As it turned out, that view was correct as witnessed by the 2.6 million jobs that have been created during the first 11 months of this year. That rapid job growth has driven the unemployment rate to 5.8% from 6.7%, where it stood 12 months ago. Despite that better than expected outturn, some cite the somewhat anemic wage growth as an indication that the jobs are not quality, high paying jobs. Again, we take the opposite side of that opinion and argue that wage growth is a lagging indicator and will soon rise. First, the demand for Science, Technology, Engineering, and Mathematic jobs continues to tighten. Demand for workers in those areas has created shortages with employers forced to offer higher wages to attract talent. Secondly, as profits continue to rise as they have over the last several years, those with jobs for more than a year or two can expect to see annual merit raises. That means that the 2.6 million net new jobs created this year are likely to enjoy such raises next year.

The automobile industry is a sector that should be quite supportive for job growth. Prior to the crisis, the average run rate for automobile production was 15 million units per year. Following the crisis, that rate fell to a low of 10 million units per year, as fearful consumer postponed new car purchases. That postponement has resulted in a significantly older auto fleet. The average age of a car on the road today is 11 years. While car quality is far higher today than in decades past, the fleet, nonetheless, is old and will need to be updated. That leads us to conclude that auto sales should consistently exceed 16 million units annually for the foreseeable future.

The housing industry is similar to that of automobiles. The average inventory of new homes over the last twenty years has been approximately 300 thousands, before spiking to a high of 550 thousand units in 2006. That inventory plunged to 150 thousand after the crisis, and while it has corrected somewhat, it currently stands at a lean 200 thousand. We expect as the job force continues to expand the demand for new homes will also continue to expand.

While we have been on the wrong side of the market recently, we have not lost our conviction that rates will rise. In recent client meetings, we present a chart which compares the price of the S&P 500 with the yield of the 10-year note over the last ten years. The equity index is in record territory, supported by strong top and bottom line growth, while the 10-year Treasury note is just above the level at which it stood in the depths of the financial crisis. One of those indices does not reflect economic reality and with GDP growing in excess of 4%, we argue that the mispricing lies in bonds. While we are extremely disappointed to report a fourth monthly loss, our thesis has not changed and we remain convinced that the bond market is wildly overvalued.

September 2014

Bond investors turned cautious last month, reversing the upward trend in price witnessed for much of this year.

As the Federal Reserve meeting concluded on September 17th, investors were hungry for clues as to when the FOMC would move to raise interest rates. Instead, the Fed further confused matters with the announcement that they would expand the Overnight Reverse Repurchase program (ON RRP) to $30 billion per counterparty, but cap the overall size at $300 billion. Prior to the change, each of the 140 counterparties was allowed to lend $10 billion overnight to the Fed at a fixed 5 basis points, with the program potentially totaling $1.40 trillion dollars. We consider the reduction in the program cap to be a significant policy departure. Investors had anticipated that the program would be the Fed’s solution to mopping up the enormous amount of liquidity quantitative easing has created. The Fed’s concern was that such a large program could potentially destabilize the money markets during times of financial instability, as investors sold credit and deposited the money at the Fed. That was a very real risk, especially given the recent regulatory changes imposed on money market funds. However, by capping the size, they’re tacitly indicating that ON RRP will not be the primary tool for draining liquidity.   While we’re pleased that they’re talking about raising interest rates, it seems as though they’re still trying to figure out the means for reaching that end.

Following the meeting, Chair Yellen delivered her post FOMC press conference and seemed ill prepared for the task. Despite the Fed’s stated policy of transparency, she was highly evasive during the question and answer period. The press asked a number of pointed questions including how much time was represented by the phrase “considerable period,” what tools the Fed has at its disposal to raise interest rates, and where in the range of forecasts did Madam Yellen’s prognostication fall. Arguably, a transparent Fed would communicate that information and allow the capital markets to adjust accordingly, but Yellen was vague with her answers. Two days later she added to the confusion by commenting that markets were not adequately synced with the Fed forecast. Given that comment we ran a simulation to get an idea of how far out of sync the market may be. In doing so, we assumed that the Fed will first raise rates at the April 2015 meeting, which is current consensus, and will follow a Greenspan-like path of 25 basis points hikes for each of the six meetings of 2015. Based upon that assumption, the Fed Funds rate would stand at 1.75% and the 3-month LIBOR, upon which our hedging program is based, would likely close out the year at 2.25%. Currently, the December 2015 LIBOR future is priced at 1.00%, representing a 125 basis point deviation from the forecast. If the Fed continued to raises rates at each meeting through September 2016, the deviation widens to 180 basis points. Clearly the market is out of sync with the likely path of interest rates.

The panic in the high yield market that we wrote about last month reemerged with a fierce selloff in September that drove junk bond prices to new lows for the year. While there has been a material correction in that sector, we have not added to our high yield holdings and believe that prices will be slow to improve. As we’ve discussed before, the small size of the market make it vulnerable to the illiquidity of an investor rush for the exit and that illiquidity is worsened by the Volker rule constraints on proprietary trading by banks and brokers.

Continued improvement in the economy and the realization that interest rates may rise sooner than expected resulted in a mild upward drift in interest rates in July as trading volume slowed.

The headline news during the month was that after nearly two years of wrangling and resistance, the Securities and Exchange Commission on July 23^rd changed the operational rules for money market funds.  The next day the Wall Street Journal reported that “U.S. regulators approved rules intended to prevent a repeat of an investor exodus out of money market funds during the financial crisis.”  We think that the rule change does the exact opposite and is likely to worsen an exodus, and perhaps even before the next crisis.  The significant change, at least initially, is that Institutional money market funds will no longer be allowed to maintain a stable NAV and will, instead, be required to allow the NAV to float.  In addition, all fund companies, individual as well as institutional, will be allowed to temporarily block investor redemptions and impose a redemption fee of as much as 2% in the event of a mass exodus, defined as 10% outflow over the course of one week.  Money market funds that invest in only U.S. Government debt will be required to hold at least 99.5% of their assets in government paper, that’s an increase from the current minimum of 80% and will not be subject to the redemption suspension or fee.  That is, however, unless the fund board decides otherwise.  If so, then those funds may also impose a gate.

Institutional money market funds are the default solution for Corporations, Endowments, Retirement Funds, and virtually every other entity having cash on hand.  Because the NAV doesn’t float and the cash can be redeemed or invested on a daily basis, the funds are considered cash.  However, if there’s a possibility that investors may not be able to access the cash when needed, it no longer meets that definition.  Moreover, should the fund management decide to charge a 2% redemption, that would result in a material loss on cash that would impact earnings and need to be reflected on a corporation’s financial statement.  Because of that risk, corporate treasurers and chief investment officers are likely to shed Prime money market funds en masse.

The likely alternative to prime funds would be government money market funds.  In the massive, liquid Treasury Bill and Note market, such a gate is not likely to be needed.  However, simply the possibility of an exodus may be enough to discourage investors from using government funds.  Especially when just two years ago, Congress threatened to default on maturing Treasury notes.  While they avoided default, had they not, it’s likely that we’d have seen a mass exodus out of Treasury paper and a flight from government money market funds.

The catalyst for the change is the fact that despite the presumption of being safe, stable investments, money market funds are not very well managed.  Based upon SEC rule 2a-7, which is the standard for all money market funds, the funds are allowed to hold up to 5% of a single issue and up to 10% exposure to a single guarantor, an intolerably high level of concentration for a fixed income portfolio.  In an attempt to understand the riskiness of the money market funds, we analyzed one of the largest, “household name” fund and were shocked by its composition.  The top 10 holdings of the fund totaled 49% of the portfolio, with 15% of the fund invested in Japanese banks (including 7.1% invested in Sumitomo Mitsui Bank alone), 20% invested in 10 different European banks, and 10% invested in Canadian and Australian banks.  When the next financial crisis hits, it’s entirely possible that the 20% allocation to European banks sag in price.  Similarly, should the Japanese stimulus program fail and bank defaults rise, the large Sumitomo position may impact the fund negatively.  That, and any number of possible scenarios, is likely to test the resolve of the fund management to maintain liquidity and resist the temptation to impose a 2% redemption fee.

While certainly biased, we think the Halyard Reserve Cash Management (RCM) strategy is a preferable alternative, both in structure and riskiness.  As the RCM is a separate account held in the client’s name it would never be subject to a gate or a redemption fee.  That point alone makes the strategy far superior to a money market fund.  Secondly the diversification cap of 3% per name significantly lowers the riskiness of the portfolio.  Finally, the strategy is fully customizable and fully transparent. In our opinion, the RCM strategy is a safer, more liquid alternative to a money market fund.

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.