March 2017 – Monthly Commentary
March 2017
The Federal Reserve didn’t disappoint last month, delivering the third rate hike of this cycle, pushing the overnight Fed Funds rate to 0.90%. However, at the post-meeting press conference Chair Yellen delivered a “wishy washy” assessment of the economy which did little to instill fear in the bond market. In fact, instead of tightening policy, the move actually eased monetary conditions. Since raising overnight rates on March 15th, prices of Treasury notes and bonds have risen on all maturities two years and longer. Historically, a rate hike causes prices to fall. Even more bizarre, on the afternoon of the announcement stock prices soared by nearly one percent. Some dubbed the move a “buy the fact” short covering rally, which seems likely. But, the rally fizzled as the Republican effort to repeal ObamaCare, a central tenant in President Trump’s campaign agenda, began to go awry. The seemingly “half baked” Republican solution would cut government spending and many of the taxes associated with the current plan, but at the expense of millions of currently insured Americans. In what had been thought to be a “slam dunk” for the President became an embarrassment as the Republicans were forced to withdraw the legislation. Ironically, it was the conservative Republican bloc known as the Freedom Caucus that torpedoed the legislation. Given the failure to amend ObamaCare and his inability to implement the much touted travel ban, investors have begun to question Trump’s ability to successfully reform the tax code. The President would like to lower Corporate and personal tax rates, and lower taxes on repatriation of foreign-earned revenue. The thought is that by cutting corporate taxes, business would see more revenue fall to the bottom line, and the anticipation of that added revenue has been one of the catalysts for the sharp rise in equity prices since the election. With the probability of Trump tax reform being called into question, investors have been taking profits on what is arguably an overvalued stock market. However, continued favorable economic data offset some of that worry, resulting in a roughly unchanged S&P 500 for the month. As we begin earnings season anew, we anticipate that investors will scrutinize results closely to ascertain if the lofty price/earnings multiples are warranted.
Now that the Federal Reserve has begun to normalize interest rates in earnest, the next question is when the committee will begin to normalize their inflated balance sheet. Prior to the crisis, their portfolio of Treasury and Mortgage-Backed notes and bonds was less than $800 Billion. That amount has ballooned to $4.5 trillion since 2008. As the Fed takes in proceeds from coupons and the repayment of maturing issues that it owns, the Fed’s open market desk reinvests those proceeds back into the market. Historically, when the Fed wanted to raise interest rates, they did so by selling an amount of their Treasury holding into the market until supply and demand of overnight reserves rebalanced at their targeted interest rate. In this rate cycle the Fed has changed the methodology. Rather than selling securities and forcing the market to reprice, the Fed accomplishes the rate hike by crowding borrowers out. We’ve previously written about the Fed’s Reverse Repurchase (RRP) facility, a program in which the Fed pays qualified institutional lenders an interest rate equal to the lower bound of the 25 basis point Fed Funds range. After the latest rate hike, that rate stands at 0.75%. Without that facility, the Fed would be helpless at raising interest rates given the vast amounts of liquid reserves in the system. The U.S. T-Bill market is not large enough to absorb the liquidity and if the Fed simply suggested that they would like to see rates higher, nothing would happen. However, now that the Fed is paying 75 basis points for a risk free U.S. Government investment, the risk free investor is incentivized to sell T-Bills and invest in the higher yielding Fed RRP. Problem solved? At least in the short term! Longer term, however there are two problems. First, the goal of raising rates is to drain the excess supply of money from the system. The RRP operation doesn’t touch reserves so excess reserves are allowed to continue sloshing around in the system, keeping borrowing costs low and encouraging excess risk taking. Secondly, in paying interest on reserves, the Fed incurs a cost and that cost rises as they raise rates. All of this argues that the Fed should begin to normalize their balance sheet or, at the very least, end the reinvestment of coupons and maturities. They have begun to publicly discuss doing exactly that, but the question remains as to whether they will have the temerity to act?