Warning from the Money Markets
For several quarters now, a broad inventory of uncertainties has threatened to derail the present bull market in credit, ranging from volatile U.S. trade policy to a slowing U.S. manufacturing sector, to a China slow-down, or to the situation in Hong Kong. The news this quarter gave us two more:
- The Federal Reserve (Fed) has backed off its tightening trajectory from last year and seems to have run out of room to reduce its balance sheet. Meanwhile, rates abroad are negative, but growth and inflation remain elusive. Is monetary policy, both low rates and quantitative easing, working? Are the traditional transmission mechanisms functioning in the face of huge debt issuance and highly concentrated and regulated banks?
- Will impeachment proceedings, and impeachment-related dysfunction, further paralyze government and impair consumer confidence and spending in the U.S.?
With the arrival of these new uncertainties, credit market excess returns were much less impressive than in the first two quarters of the year. Ten-year U.S. Treasury rates, despite a brief rise in early September, rallied by 0.33% to 1.67%. Just in the first days of October, with weaker manufacturing and employment data, impeachment inquiries dominating the news, and China less likely to deliver a comprehensive agreement on trade, credit spreads have widened and rates have rallied another 13 basis points1.
The third quarter continues this year’s trend of mildly positive (and certainly non-recessionary) fundamental U.S. economic news and heavy flows into U.S. credit from abroad, both supportive of credit markets here. Offsetting the positive flows, however, are massive corporate and Treasury issuance, weaker growth in Europe, and our expanding list of geo-political uncertainties.
The quarter ended with investment grade credit (the non-Treasury components of the Bloomberg Barclays US Aggregate Index) outperforming Treasuries by a modest 4 basis points of excess return, most of it from BBB-rated corporates. A-rated corporate bonds underperformed Treasuries in the quarter. The non-Treasury holdings in our representative Core account earned excess returns (outperformance relative to Treasuries of similar duration) of 55 basis points in the quarter, thanks to strong security selection and a high allocation to structured credit (asset-backed securities [ABS] and commercial-mortgage-backed securities [CMBS]).
Credit solidly outperformed year-to-date (0.90% excess return), with corporate credit leading the way and the ABS sector taking up the rear. Only agency MBS lagged, as they have for most of the past five years. Fortunately, we’ve owned nearly nothing in agency MBS for the same period of time. Despite being tilted towards structured credit, our own core credit portfolio still outperformed the non-Treasury components of the index, thanks to excellent selection in corporates and ABS, and a preponderance of BBB-rated corporate credit. As a result, performance has been strong this year, with less-constrained accounts performing particularly well.
The top-performing securities in our Core and Limited Duration portfolios are individual value opportunities that have now seasoned in the market, such as Sirius International Group, Enstar Group, and Helix Generation. Others continue to prove themselves superior lenders, such as Credit Acceptance and Main Street Capital Corp. Dell continues to be a superb capital allocator and very strong at acquisition integration.
The largest negative contributors were pipelines and utilities such as Kestrel acquisition and BCP renaissance. Energy credits widened in the quarter due to plunging natural gas prices. Finally, three financial credits – Freedom Financial, Hercules Capital, and United Insurance were weak performers. All of these credits offer exceptionally high yields and remain durable to bad economic and sector conditions.
We also own inflation-protected Treasuries in place of conventional Treasuries in many portfolios. At breakeven inflation levels2 of 1.0% to 1.5% and inflation closer to 2%, we think there is room for outperformance here. However, this was the worst performing position in our Core strategy, subtracting over 7 basis points of excess return.
We were not able to pick up a large number of credits in the third quarter, which was to be expected given a market environment with record low credit spreads. However, we did have opportunities to alter positions sizes amid increasing volatility. As a rule, we do not enter into a position until it meets our valuation criteria. Then, as the valuation changes (the spread narrows or widens) we adjust our position size. The charts below, describing two holdings that have done well for our accounts this quarter, illustrate our investment process in action. Both of these bonds were first purchased several quarters ago, but you can see that we changed our position size over time, adding when spreads widened and selling as the spread contracts. We added to our Corporate Office Properties holdings back in 2015 when spreads widened dramatically, and sold completely last quarter. Kinder Morgan spreads widened last winter amid uncertainty about the company’s borrowing intentions, and have compressed steadily in 2019, causing us to halve the position in May and sell in the third quarter.
The political situation should create volatility and opportunity
It remains difficult to anticipate and predict the effects of the Trump administration’s policies on the economy and markets. With China and Europe, the administration seems to be playing “chicken” over global trade and strategic relationships. This should create volatility, but investors have thus far taken it in stride. The prospect of what will clearly be a very nasty and polarizing impeachment fight adds additional uncertainty. In response, 10-year Treasury yields, after recovering in the early part of September, resumed their decline in mid-September, and are just 6 basis points off their recent low.
In addition to large swings in bond and stock markets, consumer sentiment has become more volatile over the last four quarters, with large dips in the fall of 2018 and again this past summer. The Conference Board Consumer Expectations less Present Situation3, a measure of consumer optimism/pessimism about the immediate future, is approaching its all-time lows, similar to levels prior to the 2001-02 recession.
Are we seeing the limits of monetary policy?
Unexpectedly, in September all eyes turned to money markets, specifically the overnight collateralized repurchase (“Repo”) market. On September 17, the Repo rate soared to more than 5% intra-day, diverging significantly from the target Federal Funds rate (1.75%), falling back just as rapidly as the Fed intervened via open market operations. The sharp rise surprised nearly everyone. Shortages of overnight cash had appeared before at quarter ends, when banks clean up their balance sheets. This was the first significant intra-month dislocation (see the middle chart on the right).
The media has spilled a lot of ink debating whether this was just a matter of the Fed’s Open Market Desk being out of practice or understaffed. While both might be true, we think it reveals some disturbing underlying dynamics in money markets and may have implications for the effectiveness of monetary policy in the future.
The purpose of monetary policy easing, i.e., pushing rates lower and injecting cash into the banking system, is to stimulate lending and investment. When the Fed purchases securities, it injects cash liquidity into the economy which increases excess bank reserves. These reserves, together with currency, form the Monetary Base. With a larger Monetary Base, banks should direct their investing towards higher yields available in securities and lending, expanding other measures of money supply, prompting non-bank investors to take more investment risk, and thereby increasing economic activity.
In the years after the financial crisis, the Fed injected liquidity in unprecedented scale with a quantitative easing program (“QE”) of Treasury and agency MBS from 2009-14, peaking at $4.5 trillion of holdings. Banks lent out much, but not all of this liquidity, accumulating $2.5 trillion in excess reserves over their reserve requirements (see chart on the right). While even Fed bankers admitted they did not fully understand all the potential consequences of QE, nearly everyone considered the combination of negative real rates and $4.5 trillion of extra liquidity an extraordinary, but necessary, crisis-level intervention.
After a great deal of foreshadowing, the Fed began to try to ‘normalize’ its position in 2016. First, the Fed raised rates several times, then began to taper off its QE holdings in early 2018. Excess reserves decreased to $1.5 trillion by the end of 2018. Extraordinary measures were coming to an end.
In early 2019, amid growth concerns, the Fed reversed course on rates. In the third quarter, it reversed course on its portfolio unwind as well, with $3.75 trillion of crisis-era stimulus still in the system. The reason? To retain control over the Effective Fed Funds Rate by providing funding to overnight, Treasury-secured transactions, or Repo, the low-risk bedrock of the money markets and monetary policy.
Banks still hold nearly $1.3 trillion of reserves at the Fed. Presumably this funding could easily be redeployed into Repo given a rate advantage. In fact, in a sign that liquidity was getting tighter, the Repo rate has generally been higher than the Fed’s interest on overnight reserves for two years, ever since reserve balances declined below $2 trillion, with significant spikes at quarter-ends and in mid-September, and many smaller spikes in between.
While these balances have decreased substantially, the lack of interest in arbitraging a higher Repo rate clearly indicates that either excess reserves have hit a regulatory minimum, or the concentration of reserves in a few banks is creating some liquidity gaps4.
A large part of the responsibility probably lies with bank regulation, in particular internal liquidity stress tests and the global systemically important banks (G-SIB) regulations. The vast majority of these excess reserves is held by large money center banks (so-called G-SIBs) and foreign banking operations. JPMorgan Chase alone has over $300 billion. Apparently, under the internal stress tests that banks must maintain, all Treasuries, including those held in Repo collateral, are subject to a presumed liquidation discount. Moving from reserves to Repo reduces regulatory liquidity. Furthermore, transacting large amounts in the Repo market, particularly with foreign counterparties, both increases leverage measures, and can subject G-SIBs to an incremental increase in the G-SIB surcharge to capital requirements. The latter move in 0.5% increments, so even a small overage can have a large impact on the excess capital reported by a G-SIB.
The Bank Policy Institute has explained these factors in a white paper5, and conducted a survey of banks that demonstrated that liquidity requirements are a key determinant of banks’ demand for excess reserves. In fact, the Institute predicted the Repo shock several weeks before it happened6.
As this Strategy Update goes to print, the Fed has announced a new $60 billion purchase program, specifically aimed at Treasury Bills, a market foreign investors have been ignoring (see chart on the right).
We believe this is more than a money market technical phenomenon:
- First of all, it means that the pace of tapering crisis-era QE has to be much slower than we expected in order to preserve the Fed’s target Fed Funds rate.
- Second, large U.S. banks cannot be relied upon in this regulatory environment to arbitrage away large, secured money market rate differentials, let alone put more money at risk in the lending markets. The fact that banks won’t engage in this activity suggests that monetary policy via the banking system may becoming less effective, and/or that this environment still requires a lot of Fed-supplied liquidity.
We aren’t the only ones concerned about the marginal effectiveness of monetary policy. Academic studies have been gradually decreasing their estimates of the impact of monetary policy over the entire post-crisis era. Deutsche Bank helpfully summarizes this progression in the following table.
One explanation of the need for liquidity is the huge funding demand from other channels. We have seen dramatic growth in the debt markets, primarily Treasury debt. Treasuries now make up 24% of all $US debt outstanding, up from 11% in 2008. In the accompanying exhibit, you can see that over the time the Fed was attempting to taper reserves (2017-18), total annual bond issuance grew by over $1 trillion, more than offsetting the tapering. With the yield curve flattening, foreign buyers, particularly central banks, have stopped adding to their Treasury stores. Treasury supply is increasingly falling on domestic markets, soaking up liquidity that might go elsewhere. Domestic buyers have increased their ownership share of Treasuries by five percentage points in the last three years, with foreigners dropping five points. In addition, it appears that foreign buyers are reluctant to buy the most plentiful form of U.S. Government financing – Treasury Bills.
The implications of this are as follows:
- To some extent, the traditional bank monetary policy liquidity channels are gummed up, absent the injection of new liquidity by the Fed and, possibly, some relaxation of bank liquidity regulations.
- Massive Treasury issuance is creating some of this liquidity need, but corporate debt (particularly financials) is also driving it.
- We are increasingly reliant on overseas flows as the marginal buyer of this large debt issuance. Foreign investors tend to move in and out faster, and require positive hedging dynamics to invest in the U.S. Yet foreign investors are changing their investment patterns. This suggests increased volatility in credit spreads and rates in the coming years.
- The increasingly unpredictable geo-political and economic environment can only enhance this volatility.
Given the relatively poor compensation on offer from much of the credit markets, we are positioned mostly in shorter, higher quality corporate issues and ABS. As always, our account positioning will reflect valuations, not any macro predictions, but higher volatility should produce more valuation opportunities. If investors begin to question the effectiveness of monetary policy, fundamentals will then rapidly become more critical. For these reasons we find our conservative current positioning is well suited to the increasingly uncertain investment environment, and we look forward to the opportunities the next quarters will create.
We also look forward to meeting with you and discussing all of this further. Thank you for investing with us.
Opinions, forecasts, and discussions about investment strategies represent the author’s views as of the date of this commentary and are subject to change without notice. The securities discussed do not represent all of the securities purchased, sold, or recommended for advisory clients and you should not assume that investments in the securities were or will be profitable.
Past performance does not guarantee future results, and current performance may be lower or higher than the past performance data quoted. The investment return and principal value will fluctuate, and shares, when sold, may be worth more or less than the original cost.
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IM-07033-2019-10-14 Exp. Date 01/31/2020
1 A basis points is a unit that is equal to 1/100th of 1% and is used to denote the change in price or yield of a financial instrument.
2 An inflation-protected security outperforms if actual inflation exceeds its break-even inflation level.
3 Conference Board Consumer Confidence Expectations Index less the Conference Board Consumer Confidence Present Situation Index: the difference between consumer expectations of the future less their assessment of the past. This is more negative the more consumers expect things to get worse.
4 For more on this possibility see https://streetwiseprofessor.com/the-repo-spike-the-money-trust-revisited/