Why Are Rates So Low?

The Fed’s flow of funds data released last week go a long way toward explaining why rates have stayed so low so long.  The standard explanation focuses on the uber-stimulative monetary policies–very low fed funds targets and quantitative easing.  But, if this were a typical cyclical recovery/expansion, those policies would, by now, have encouraged strong private-sector borrowing, a consequent rapid growth in the money supply and, possibly, a significant increase in inflation.  That, in fact was what was being predicted nine or ten years ago by those who were screaming that the Fed was printing money.  In fact, over the past 10 years, despite the explosion in bank reserves, growth rates for M1 and M2 have been in the 2-4% and 4-6% ranges, respectively–approximately half the rates seen in earlier economic expansions.

The flow of funds data help explain this “conundrum”.  Borrowing by the private sectors (households and business) has been unusually slow since 2009.  Even with the big increase in borrowing by the Federal Government, total funds raised in the credit markets increased only 4.5% last year.  That rate has been in the 3.5%-4.5% range since 2010.  In contrast, it averaged almost 6% per year in the 1990’s and almost 8% per year during 2001-2007.

A collapse in mortgage borrowing is by far the main reason for the weakness in total borrowing.  There were net declines in mortgage debt outstanding in the years 2010-2012, a first for this series.  The volume of mortgage debt outstanding is till lower today that in 2009.  Mortgage borrowing is now growing at a 2-3% annual rate, far less than the 7% average during the 1990’s and the 10%-15% annual rates seen in 2001-2006.  Business borrowing also collapsed in 2009-2011, but it has recovered to a moderate pace in recent years.  Mortgage borrowing has not posted such a recovery.

A very slow recovery in the housing sector has been a salient feature of this cyclical recovery.  It helps explain why this has been s slow recovery in economic activity.  It also helps to explain the anemic growth in mortgage borrowing.  The housing sector is a huge user of borrowed money.  And, if the demand is relatively weak, the price of borrowed money should be relatively low.

These data suggest that until the pace of housing construction and mortgage borrowing strengthens, interest rates in the U.S. are likely to remain unusually low.  They could easily rise from current levels, but perhaps not substantially.  One would expect housing activity to continue to gradually strengthen as memories of the financial crisis fade.  But it may be quite some time until we see housing starts above the 2 million rate and the attendant strong growth in mortgage borrowing that we saw prior to the crisis.

Round Trip (Almost)

Like stocks, corporate bonds have recovered most of the ground lost during the fourth-quarter selloff.  Investment grade and high yield corporates have been, by far, the best performers thus far this year.  The high yield market has recorded a total return of 6.4% and the investment grade sector a return of 2.5% for the first two months of 2019.  Returns from the Treasury and muni markets are 0.19% and 1.3%, respectively.  The 30-year Treasury produced very strong returns last quarter, but had returns of -1.2% in February and -0.6% for the past two months.

The strong performance by high yield thus far this year is another reminder that unless we see signs of recession, selloffs such as that of the fourth quarter are buying opportunities.  The yields on the ICE high yield market index (formerly the Merrill Lynch Index) reached 8.10% in early January.  It is around 6.60% now.  The spread to Treasuries for that index reached almost 550 basis points.  At 390 bps now, that spread is back within the 350-450 bps range that is typical for periods of sustained GDP growth.  Thus, the high yield market now offers reasonable value.  The same might be said of investment grade corporates.

Municipal-Treasury yield ratios are OK, but not generous.  At near 0.80, the ratio of 10-year AAA muni yields to 10-year Treasury yields is near the traditional average.  The problem is that 10-year Treasury yields reflect expectations that the Fed will not be raising rates for the rest of this cycle.  That optimism has been sustained by Fedspeak these past several weeks.  There is, in my view, a significant risk that the Fed officials will need to revise those comments before too long.  The tone of the Beige Book tomorrow and the employment data on Friday could upset a Treasury market that is ill-prepared for any bad news.  Data released thus far in March, including the ISM indices and sales of new cars and trucks, do not point to a sustained slowdown in GDP growth.

Fed officials are simply talking too much.  There was a time when they would never comment on the outlook for monetary policy.  Now, they can’t stop talking about the outlook for the fed funds rate.  If, as seems likely, the first-quarter slowdown in GDP growth is due to transitory factors, and growth returns to the 2%-3% range, those same Fed officials will need to “communicate” to the markets that prospects for more rate increases have increased.  They will then be criticized for misleading the markets once again.  And, they will have only themselves to blame for that criticism.



The Old Flip/Flop

First he says he will (raise rates), then he says he won’t, and the 10-year yield jumps to 3 1/4% and then drops below 2.70%.  Now Chair Powell must consider the implications of a second consecutive blockbuster employment report.  Big increases in payroll and household employment and in the labor force.  The economy appears to be much healthier than the hand-wringers at the Fed are suggesting.  Will Mr. Powell now be forced to warn of the possibility of a rate increase in March or May?  Or, are the FOMC members not concerned that they might be too timid in the face of full employment.  The markets are likely to continue to be plagued by swings in the outlook for Fed policy.

FOMC statement

The FOMC surprised the markets somewhat by issuing two policy statements, not only one as in the past.  But, the second statement was merely a reminder that the fed funds rate is the primary policy tool, not the size of the balance sheet.  With a huge volume of reserves in the banking system, control of the fed funds rate is accomplished with the Fed’s administered rates–meaning the rates paid on those reserves.  Managing the volume of reserves is not a viable strategy for controlling the funds rate.  Balance sheet normalization (draining $50 billion per month by not reinvesting all the cash flow from its holdings of Treasuries and mortgage backed securities) will continue.  But the Committee is prepared to adjust the normalization process if economic fundamentals were to change.

The traditional policy statement read as expected.  No change in the fed funds rate but also no meaningful change in their view of the economy.  They cited strong labor markets and healthy consumer spending as reasons for expecting continued solid growth.  They will be patient as it decides on future increases in the funds rate.  That change in the statement was a reaction to the “global economic and financial developments”  in December and early January.  They dropped the line that said that further gradual rate increases in rates were likely.  This is viewed as a signal that there will be no increase in the funds rate at the March meeting.

In sum, the reduction in the balance sheet will continue at around the current pace.  If a near-term policy adjustment is needed, it will be a change in the fed funds rate, not in the balance sheet strategy.  No surprise here.  The majority of the Committee still appears prepared to approve several more increases in the fed funds rate, but those increases will probably occur in May or June.  That policy path will be data dependent (as always) so data such as employment, spending and the YOY core PCE deflator will continue to be crucial.

Chair Powell also cited weakness in foreign economies as another factor they will be monitoring.  He also said that in recent weeks the case for raising rates has weakened some.  That was probably the most important statement of the day.  They will want to be sure that some of the “crosscurrents”  have eased before they consider another rate increase.  It will take several months of healthy data to convince the Committee that another rate increase is appropriate.

2018 Returns

The fourth-quarter selloff in equities upended the bond market total return rankings.  Prior to last quarter, corporate high yield was performing best, while long Treasuries were the poorest performers.  The high yield market had a -4.7% total return in the fourth quarter, led by a brutal -10.4% return for the CCC and weaker credits.  The BB and B credits returned -3% and -4.8%, respectively.  For the year 2018, high yield returned -2.3%.  The 2018 returns were -2.5% for BBs, -1.5% for Bs and -4.2% for CCCs.

The full Treasury market eked out a positive return of 0.80% in 2018, but the 10-year and 30-year maturities had negative returns of -0.03% and -2.71%.  Surprisingly, TIPS posted a negative return of -1.50% for the year.  Investment grade corporates returned -2.25% for the year, with the BBB credits posting the poorest returns.

The municipal market also eked out a positive return in 2018.  The 1.04% return was led by a 1.81% return from the BBB credits.  The best 2018 return by far was the 7.2% return from high yield munis, thanks to the partial recovery in prices of Puerto Rico bonds.  The second-best performing sector was asset backed securities.  This sector has a very short duration.  Short-duration strategies were clearly the most successful in 2018!!!

Looking ahead, I expect the best performing sectors in 2019 to be those that performed worst in the fourth quarter.  The selloff in high yield pushed yield on the BofAML market index from 6.25% in early October over 8% at year-end.  It is still around 8%, or approximately 525 basis points over the yield on the Treasury index.  That spread was as narrow as 320 bps in October.  A spread beyond 450 bps is, in my view, very generous for a period of good economic growth and relatively low default rates.

Speaking of economic growth, the media is now full of forecasts of slow growth in 2019 and a recession in 2020.  The first reaction to that stuff is how can we take seriously any forecasts for the year 2020?  That is too far off to allow anyone to make a useful forecast.  Of the reasonably reliable forward indicators, only stocks might be forecasting a slowdown.  But as Paul Samuelson used to say, stocks have predicted 10 of the last five recessions.  Other indicators such as initial claims, the ISM indices, consumer confidence and home sales are still predicting moderate growth.  Those are the data to watch in the months ahead.

Just when the Treasury and muni markets were beginning to offer decent value, they rallied to the point where there is now little value beyond the 5-year maturities.  The longer notes and bonds are priced as if there will be no additional increases in the fed funds rate.  That leaves those issues extremely vulnerable to any stronger-than-expected economic data or other “good news”.

Such news should, of course, be positive for the equity market and, therefore, for the high yield corporate market.  That is the basis for my view that those markets are likely to substantially outperform the Treasury market in the months ahead.

High Yield On Sale

Just in time for the holidays, the high yield market is holding a sale–lower prices.  Actually this market has been cheap for several weeks, but now that the stock and oil markets seem to be steadying, it is a good time to assess relative values.

In the past month, the yield on the 10-year Treasury has dropped 30 basis points.  Since mid-October, the yield on the BofAML high yield market index has increased from 6.25% to 7.40%.  The spread between the high yield and Treasury index yields, which is commonly used as the measure of value in high yield, has increased from a low of 320 basis points to around 450 bps now.  I have used a spread of 350 to 450 bps as the range that is typical for periods of relatively low default rates.  By this measure, the high yield market is now very attractive.

Investment grade spreads have also increased to attractive levels.  Typical A rated 10-year corporates now yield around 100 bps more than Treasuries.  That is at the top of the typical range of 75-100 bps.  But the high yield spreads are more compelling.

The stock market swoon, the drop in oil prices and concerns that the economy might be weakening are given as reasons for the poor performance by high yield.  The easiest to dismiss is the argument that the economy might be weakening.  Nothing in such key data series as the ISM indices, employment growth, new orders, auto sales, consumer confidence and income growth suggests an economy that is in a cyclical slowdown.  The stock market might now be recognizing this, after having gone through a serious correction.

I should not comment on oil prices, as that is a market I have never truly understood.  If, however, those prices have touched or are close to the lows for this correction, one could argue that default fears are peaking.  Managers of well diversified portfolios, supported by good credit research, would be expected to have performed somewhat better than the market indices these past two months.  Starting at current valuations, those portfolios should, in my opinion, solidly outperform Treasury and investment grade portfolios in the months ahead.

Leveraged Loans–Oversold?

It seems that at least once every week we see an article extolling the virtues of leveraged loans.  They offer generous yields and, via the floating rate features, protection from rising rates.  What could be better?  Two days ago the WSJ reported that the loan index has posted a YTD return of 4.3% while almost all other bond sectors have negative YTD returns.  The strongest classes of CLOs have YTD returns of around 2%.

Those are impressive returns for a period in which Treasuries have returned -2.5% and investment grade corporates -3.3%.  Even the high yield market’s return of 1.5% cannot match the loan returns–or can it.  Loans are regarded as short duration securities.  In the high yield bond sector, the shorter durations have produced returns comparable to those from the loans.  The 1-3-years high yield index posts a YTD return of 4.2%.  The 3-5-year index has a return of 3.2%.  And, I would argue that those segments of the bond market entail much less risk than the loan market.

In high yield, the major risk is credit risk, not the risk of rising rates.  If, some day, the economy falters and/or there is a credit event, loans would be expected to perform far worse than high yield bonds, especially short-duration bonds.  Recall the terrible returns from loans in 2008-09.  In the event of a credit scare, loans become illiquid much more rapidly than bonds.  And we know what happens to bids for relatively illiquid risky  securities.

There is much speculation about what will be the next financial crisis.  Some market observers point to the corproate debt market because so many companies have become very highly leveraged.  If there is any merit to that argument, one should be especially wary about the loan markets, where covenant protection has vanished and issuance has been exploding.  Much of that issuance has gone into CLOs and ETFs.  I worry more about the ETFs.  Buyers of the CLOs are usually professional managers who can assess risks and have some staying power.  Buyers of ETFs are less sophisticated and might sell at the first signs of trouble.  Then, the relative illiquidity of the loans could become a big problem.

For now, the outlook for the economy appears favorable to high yield loans and bonds.  But, by the time we recognize that the outlook has deteriorated, those markets will probably already have begun to weaken.  It might be prudent for those investors who have captured the good returns from loans to begin switching to the less risky segments of the high yield market.  Short-duration bonds are a sensible alternative.

The Fed, The Curve and Total Returns

The FOMC last week was almost unanimous that the funds rate will increase in December.  In addition, the median estimate of the rate at year-end 2019 was 3 1/8%.  If these estimates prove correct, the rate outlook for next year is essentially a repeat of 2018–a 75 to 100 basis point increase in short-term rates and, probably, more flattening of the Treasury curve.

The median estimate of the long-run and, presumably, the neutral funds rate is 3%.  So, someone asked Chairman Powell why the 2019-2020 projections have the rate above 3%.  Would that mean a restrictive policy setting?  His answer was interesting.  He said that perhaps the neutral rate is actually higher than they had been assuming.  Thus, he believes that the economy could withstand a funds rate above 3%.

What does a 100 bps increase in the funds rate imply for the bond markets over the next 12 months?  The easy answer is that it would produce negative returns in the long-duration sectors.  Thus far in 2018, a 75 bps increase in the funds rate and a significant flattening in the curve has resulted in negative returns on Treasuries with 5-years and longer maturities. For the 10- and 30-year issues, YTD returns are -3.7% and -6.5%.  Even the TIPS market has negative YTD returns.  The same is true for the longest IG corporates and munis.  Only the high yield corporate and muni sectors have recorded positive returns.

This record suggests that further curve flattening would not be sufficient to “protect” long duration sectors from negative returns.  For example, if the yield on the 30-year Treasury bond were to rise only an additional 20 bps over the next 12 months, the total return would be negative.  The same is true for the longest munis.

But, the story is better for the shorter maturities.  The steady rise in the funds rate has pushed the 1-5-year Treasury yields to levels that could produce positive returns.  The yield on the 5-year note could rise almost 90 bps before total returns would be negative.  The 5-7 year corporate note yields could rise more than 100 bps before returns would be negative.  Munis rated A and BBB out to 7-year maturities now have a good chance of producing positive returns over the next 12 months.

As always, credit risk, not interest rate risk, is the major concern in high yield.  Spreads are somewhat narrower than I would prefer and covenants are getting weaker by the day.  But spreads could stay narrow as long as the economic outlook is favorable.  Nevertheless, in view of the weakening of covenant protection, a more conservative approach to credit quality within the high yield sector is now appropriate.

Finally, the argument that a flat or inverted curve would guarantee a recession is too simplistic.  We need to ask what level of the fed funds rate might cause a recession.  Nobody knows but, as Chairman Powell suggested, it is probably not 3%.


Vacation is Over

Back to work after summer vacation, and facing a tough month for bonds?  September is supposed to be a cruel month for stocks, but this year it could also be difficult for bonds–primarily because of the relative optimism that emerged in August.  There was talk of an economic slowdown and thus, no fed funds rate increase in December.  The Treasury market sold off only in the midst of auctions, but then rebounded.  Record short positions also buoyed the Treasury market last month.  Many of those shorts were probably covered late last month.

If the ISM index today is any guide, market rebounds might be difficult to sustain during September.  The manufacturing index and the key new orders component were totally inconsistent with the economic slowdown thesis.  If the employment report on Friday is as strong as this index, hopes of only one more rate increase in 2018 will likely evaporate.

The report this morning was a reminder that the fundamentals–above-trend GDP growth, an exceptionally tight labor market, modestly higher inflation and a crushing pace of Treasury auctions at a time when the Fed is reducing its holdings– are not favorable to bond prices.  Add a probable 50 basis point increase in the fed funds rate by year end, and a 10-year Treasury yield above 3% in the weeks ahead appears far more likely than it did during August.

YTD Returns

Here is a sampling of total returns thus far in 2018:

Broad Market Index  -1.7%  Investment Grade Corporate Index  -2.6%

Treasury market Index  –2.1%  Mortgage Index  -1.1%

High Yield Corporate Index  1.1%  CCC Index  5.4%  Muni Market Index -0.01%

5 Yr. Treas. -1.4%  10 Yr. Treas.  -3.5%  30-Yr. Treas.  -5.4%  Long munis  -0.6%

Despite the very gradual nature of Fed “policy normalization”, the long-duration segments of all the markets recorded significantly negative returns.  Only the weaker credits have performed reasonably well.

Now we very likely face another 50 basis points increase in the fed funds rate over the next five months.  We must also confront a much heavier pace of Treasury borrowing than during the past seven months.  The refunding announcement yesterday was a stark reminder of how much the note and bond auctions will be increased.

The FOMC statement today provided no support to speculation that the Fed might pause to assess the impact of tariffs on the economy.  Rate increases in September and December remain the most likely policy path.

Should we expect bond yields to rise another 50 basis point by year end?  Perhaps not that much because yields are approaching levels that insurance companies and pension funds can live with.  For total return managers, however, it is probably still too early to move much beyond 5-year durations.  Negative returns on the longer durations are much more probable than positive returns.

The more difficult question is how to approach the high yield market.  The outlook for the economy remains favorable, so default rates should remain low.  Thus, it is probably too early to scale back exposure to that market.  But it might not be too early to scale back exposure to the CCC and weaker credits.  They have performed very strongly over the past 18 months, so spreads to Treasuries have become relatively narrow.  Not owning those credits could hurt performance over the short-term, but could prove prescient over the longer run.