With an acknowledgment that economic activity has consistently strengthened since the third quarter, Fed Chairman Bernanke announced at the December Federal Open Market Committee (FOMC) meeting that the Federal Reserve would begin to reduce emergency quantitative easing commencing in January.  Moreover, he said the FOMC expects quantitative easing to be fully concluded by the end of 2014.  While we are cheered to see the Fed retreat from what we deem to be irresponsible monetary policy, we see the measure as only a small step in the right direction.  While not apparent to those unfamiliar with the mechanics of the money markets, that marketplace is not operating as smoothly as it should and that’s directly attributable to QE.  Banks have not been able to lend and invest the $85 billion of freshly printed cash the Fed generates every month.  As a result, cash is flooding into the money market resulting in a shortage of Treasury Bills and money market instruments.  In the last week of 2013, the shortage became so acute that Treasury Bills were trading above their par maturity price, resulting in a negative yield for buyers.  On the 31^st of December, the Federal Reserve satisfied the Bill shortage with their Fixed Interest Rate Reverse Repo facility, which is their de facto deposit facility.  The facility is open to 139 counterparties including 94 mutual funds, the various government-sponsored enterprises, 21 primary dealers and the largest commercial banks.  The amount “deposited” at the Fed was an astounding $197.8 billion.  While it’s not unusual for interest rates to vacillate wildly at year-end as supply and demand for excess cash comes into equilibrium, such an amount is extraordinary.  Transaction volume in the facility remained elevated well into the New Year, with $60 billion trading on January 13^th.  That represents an enormous amount of excess liquidity, and likely a consideration in the FOMC’s decision to reduce the pace of QE.  As an aside, the Fixed Rate Reverse Repo is an arcane policy tool that, while not new, has been increasingly mentioned in the media.  We suspect that as the Federal Reserve ultimately moves to raise interest rates, the Fixed Rate Reverse Repo will be a more closely watched measure.

Since the announcement, rhetoric from the various Fed Presidents and Governors has taken a decidedly hawkish tone.  As we’ve speculated for some time, the change in Fed policy will occur in incremental steps, carried out through public debate via the media.  Since the taper announcement, that debate has intensified and the collective voice of the Fed has changed from nearly unanimous dovishness to a more conciliatory tone in which the majority are in agreement that less aggressive stimulus is desirable.  The most glaring change is evident in the “jaw-dropping” statement made by New York Fed President, and easy money advocate, Bill Dudley.  In a speech delivered to the American Economics Association on January 4^th, he remarked that “We don’t understand fully how large-scale asset purchase programs work to ease financial conditions…”.  After nearly $4 trillion dollars of money printing and interest rate manipulation one of the most ardent advocates of quantitative easing declares that he’s not sure he understands how the program works.  That certainly doesn’t engender confidence in our Central Bank!

Despite the pledge to taper, investors continue to believe that the first rate hike is still far off, as is evident in the muted movement in short term interest rates compared to longer maturities.  As we’ve described on numerous occasions, a pillar of the Halyard investment thesis is that short term interest rate options are too cheap and will rise in price as the Fed moves to normalize interest rates.  We continue to deem the position as offering a highly attractive reward/risk payoff and expect that as economic activity continues to grow at a robust pace, traders will begin to discount the Fed pledge to hold rates low and will push short-term interest rates higher.

Investors were clearly pleased with the end of the government shutdown, as the various “risk on” trades performed well in October.  Fixed income returns were driven entirely by a demand for credit, as the Treasury market was mostly unchanged for the period.

As the government returned to work late last month, investors debated what impact the political squabble would have on the economy.  Conventional wisdom was that the work stoppage and the collateral damage done to government-related business had weakened consumer and business confidence; especially since the squabble is likely to resume as the year comes to an end.  Reflecting that, many Wall Street economists have lowered their Q4 GDP forecasts to below 2%.  Surprisingly, the economic data released since the shutdown has been almost uniformly positive.  Weekly claims for unemployment insurance continue to fall and the manufacturing sector, as measured by the purchasing manager indices, has accelerated.  Most surprising has been the unexpected increase in Q3 GDP and the big jump in hiring as portrayed in the October jobs report.  The GDP report was boosted by an inventory buildup, which jibes with the jump in manufacturing and is widely seen as being a drag on future GDP growth.  However, due to unseasonably warm weather, the utility expenditure component of the report was down 0.3%, which is arguably beneficial for future expenditure and partial offsets the inventory effect.  Money saved on utilities becomes available for discretionary spending.  Unlike the “good news, bad news” GDP report, the non-farm payroll report was an unqualified positive.  Economists had been expecting an anemic gain of 120,000 new workers.  With more than 200,000 jobs added in October and an additional 60,000 in the August and September revisions was welcome good news.

Against that backdrop and with the fiscal uncertainty continuing to linger, investors were left to again debate the timing of the Fed’s taper plans.  On this matter, no clear consensus has emerged as comments from members of the committee continue to send conflicting signals.  Last week Atlanta Fed President Lockhard suggested that action could come as soon as December.  Given Chairman’s Bernanke’s penchant for preparing the market well in advance of any change, we think that’s unlikely.    The Fed has historically been loath to change policy in December when markets are materially less liquid and a policy change could have an outsized effect on asset prices.

While economists debated the timing of the policy change, corporations took advantage of the marginal fall in interest rates to issue debt.  During the month, 106 investment grade deals totaling $108 billion came to market.  That comes on the back of the $145 billion debt issued in September.  Of that $108 billion, nearly a third was issued by financial institutions, more than half was issued by “A” or lower rated issuers, and the maturity breakout was evenly split between three-, five-, and ten-year notes.  Despite the onslaught of new debt, investor appetite was voracious as evident in the narrowing in Barclays Credit Index from 137 to 126 basis points in the course of the month.  Despite than narrowing of the credit spread, we continue to see attractive value in the credit markets.

The fixed income market saw massive redemptions suffered by the largest fixed income mutual funds over the last several months.  The highly visible spokesmen for those funds have appeared in the media with increasing frequency stating and restating their bullish stance, while simultaneously selling bonds to meet rising redemptions.  That hefty selling need, approximately $41 Billion, or 14% of the assets of the flagship fund, over the last four months at the largest bond manager, has weighed on the fixed income market, and has resulted in mark-to-market losses on securities that we deem to be attractive investments.  Given our high conviction on the value of those securities, we expect that the spread widening will reverse in the coming months, turning those mark-to-market losses into gains.  As anticipated, our hedging program has offset the interest rate sensitivity of the portfolio, and we believe will continue to provide downside protection as interest rates rise.

The catalyst behind the selling has been the gradual realization that the Federal Reserve will announce in September a reduction in the purchase of Treasury bonds in the secondary market; the so-called taper.  Since first mentioned in May, investors have debated “will they or won’t they” taper, seemingly ignoring the consistently better than expected economic data witnessed with each successive release.  As it stands, we expect that Chairman Bernanke will confirm that the Open Market Committee will begin to taper purchases commencing in October and expect that those purchases will be trimmed by $15 to $20 Billion per month.  In addition, we’ll look for clues as to timing of further tapering and the Fed’s thinking on an ultimate rate hike, which is likely to be deemphasized by the Chairman.

Reacting to the anticipated tapering, emerging markets have continued to suffer significant collateral damage.  For the four months ending August 31^st, the two darlings of the emerging markets, Brazil and Mexico, have suffered significant losses in their bond markets and the value of their currency versus the U.S. Dollar.  For the period, the Brazilian Real and Mexican Peso have fallen, 19%, and 10.30%, respectively.  Similarly, the local currency denominated 10-year Treasury notes issued by Brazil and Mexico have fallen in price by 18% and 9.1%.  For dollar-denominated investors, that translates into losses of 37% and 19.4%.  Recall that earlier this year, money was pouring into those investments under the thesis that everything that was wrong with the developed markets was right with the emerging markets.  They were net exporters with budget surpluses, their economies were growing strongly, and after years of sky-high inflation, they had achieved relative price stability.  The inflow of cash was so great that on several occasions the Brazilian government took steps, including taxing the Real at time of conversion, to dissuade “hot money” speculators from buying into Real denominated investments.  That entire dynamic reversed when the Fed mentioned the prospect of tapering.  Much of the investment had been driven by macro hedge funds and the pursuit of yield in this world-wide low interest rate environment.  Those hedge funds deduced that the intention to taper open market purchases would be followed by an outright increase in interest rates.  With an increase in rates, the U.S. market would become attractive again so it would be prudent to sell emerging market debt and repatriate the currency back to U.S. dollars before other investors did so.  What transpired is similar to what happened when investors fled ETF’s earlier this year.  Sellers overwhelmed the market and buyers emerged only after valuations had plummeted.  While emerging market debt can, at times, play a role in the fixed income asset class, investors need to understand that liquidity can disappear in the blink of an eye.  Despite the fall in price of the bonds and the currencies, we do not view emerging market debt as a buy at this time.

As detailed in the last monthly update, we believe the normalization of interest rates has begun, as the vicious bear market witnessed in May continued into June.  During the month, the 10-year note reached a high yield of 2.61% before closing the month at a yield-to-maturity of 2.49%.  That’s nearly one hundred basis points higher than the 1.62% low touched in early May.  While we have been anticipating rising interest rates and had prepared for such a move with our hedges, we were surprised by the magnitude of the widening in credit spread that occurred during the month.  To the contrary, a central tenant of our investment thesis is that as interest rates rise credit spreads will contract to the point that some investment grade corporate issues will trade at a small discount to Treasury paper.  The fundamental rationale for that view is that corporate balance sheets are quite strong while the national debt has ballooned, causing an excess supply of Treasury debt.  We expect that excess supply will be unmanageable once the Federal Reserve ceases to buy Treasury notes in the secondary market.  Counter to that view, in June, corporate and municipal prices fell faster than Treasury notes due to a technical imbalance related to Exchange Traded Fund (ETF) liquidation.  The sharp rise in interest rates “spooked” investors, prompting overwhelming selling of fixed income ETF’s.  With the elimination of proprietary trading desks as a result of Dodd-Frank legislation, the risk appetite of Wall Street to absorb such selling has been severely reduced.  As a result, the number of outstanding shares in several fixed income ETF’s were forced to contract, which resulted in selling of the securities that comprised the ETF.  As the ETF selling cascaded and the float contracted, share prices fell to a substantial discount creating a vicious-circle of selling.  While the selling imbalance only lasted two days, the impact to the credit market remained through month end, as dealer desks struggled to digest their newly bloated inventory.  At the time of this writing, credit spreads have begun to tighten back to their pre-crisis valuations and we expect a full recovery.  As such, we are maintaining our current positions and have added exposure in several names.

Turning from trading technical’s to economic fundamentals, the U.S. economy continued to surprise to the upside during the month, led by robust sales of cars, homes, and retail goods.  In the housing sector, demand for homes is evident in the rise in prices.  As measured by the S&P/Case-Shiller Index of 20 cities, the average home price has risen 12.05% year-on-year.  The improving jobs market has been a driver of spending.  In the past 12 months, the U.S. economy has added an average of 195,000 jobs per month, with average hourly earnings rising more than 2%.  That mix of more people working and wages rising paired with the wealth effect of rising home prices and stock prices provides the foundation for a sustainable economic recovery.  From that foundation, we expect that the Federal Reserve will be able to begin “project taper” without severely destabilizing the capital markets or tipping the economy back into recession.  However, the path to normalized interest rates is likely to include periods of volatility as investors speculate as to when, and by how much the Fed program is amended.  Our expectation is that the Fed will announcement their intention to begin tapering purchases at the press conference following the September 18th FOMC meeting.

April 2013

In April, the stock market continued to climb “a wall of worry,” as investors feared that earnings would disappoint despite better than expected economic activity in the first quarter.  Compounding that fear was the 2-day 9.40% slide in the price of gold, which reminded investors that market panics occur from time to time.  Despite the worry, both the stock and the bond markets finished the month higher.

Much has been written speculating that the U.S. economy will sputter in the second quarter after showing promising growth in the first, repeating the pattern of the last two years.  Driving that worry is evidence that the manufacturing sector softened during the quarter, as witnessed in the purchasing manager surveys and the modest uptick in inventories.  We suspect that the softening was precautionary positioning by the sector in advance of the budget sequester, and not necessarily seasonal weakness.  Counterbalancing the manufacturing slowdown has been the housing market which continues to demonstrate an improving backdrop.  Driven by lean inventories of existing homes and a pickup in new home sales, prices are up 9.3% year-over-year as reported by Case-Shiller.  In press releases during the month, KB Home, Toll Brothers, and Pulte all communicated that they intend to limit sales in an effort to manage profitability and squeeze prices higher.  As investors, we like to hear comments like that.  By managing sales and inventory, the homebuilders will be able to maximize their margins and avoid the mistake of several years ago when buyers canceled pending sales en masse.  Also contradicting the slowdown fear is the employment situation.  The release of the April employment report showed a revision of the March new jobs report from a meager 88,000 to 138,000, while the April report showed a gain of 165,000 jobs, exceeding the 140,000 expectation.  Even more encouraging was the 293,000 jobs added for the month according to the household survey.  If job growth continues, we expect that the manufacturing sector will rebound before too long.

The Federal Reserve’s endeavor to depress interest rates by printing money and buying debt in the secondary market continues to be a resounding success.  The yield to maturity of Treasury notes across the yield curve continues to trade at the lower end of the post-crisis range.  Under the current program of quantitative easing, the Federal Reserve is buying $45 billion in Treasury notes and $40 billion in newly issued mortgage-backed securities each month.  At that pace, the Fed is buying approximately 90% of new mortgage issuance and about 70% of new Treasury issuance.  In driving down interest rates, the Fed is crowding out traditional fixed income investors and causing them to move into Treasury note substitutes.  In the quest for yield, investors are moving into more risky investments including, junk bonds, longer maturity debt, preferred stock, and high dividend paying stocks.  In each instance, the investor is assuming a degree of risk that we suspect is not fully understood.  Regardless of the heightened risk, each of the above alternatives is clearly benefiting from quantitative easing.  The junk bond market, in aggregate, now has a yield-to-maturity of less than 5.00%, the lowest it’s ever been.  From a valuation perspective, 5% is not nearly enough yield to offset the risk of default.  Similarly, in moving from an investment with a 5-year maturity to one with a 30-year maturity, an investor will boost the annual yield-to-maturity of the investment by 2.24%, however they will boost the magnitude of loss from a 100 basis point rise in interest rates from -4.85% to -19.36%.  Less prevalent, but certainly benefiting from QE is the preferred stock market, where structures are typically very long in maturity, but also have an imbedded call, usually five years or less.  Typically, preferred securities offer a higher yield than a corporate security of the same maturity, however the risks are greater than a corporate note.  Preferred notes are usually subordinate to corporate notes of the same issuer, and because the float of preferred securities tends to be small, they suffer from illiquidity which can be magnified during times of market stress.  As for equities, they are a very poor proxy for a fixed income investment.  While it’s clear that income hungry investors have become attracted to high dividend paying stocks, the risk of loss of principal is far greater, as is the price volatility.  For all the reasons listed above, we continue to position defensively.

While the Fed isn’t buying Treasury Bills as part of its quantitative easing program, it’s indirectly depressing the yield offered in the sector.  In some cases the interest rate on Treasury bills has fallen into negative territory.  An investor buying a 1-month bill at -0.01% is paying 100.001 in order to get 100.00 back one month later. The driver of the irrational price is the greater than expected tax receipts.  Tax receipts in April were 27% higher than that which was collected last April.  From that, the Treasury has borrowed a bit less in the bill market and with bank balance sheets flush with the newly printed cash from the Fed, the demand for T-bills is outweighing the somewhat reduced supply, thereby depressing yield to zero.