Issue 102 – September 22, 2015
On September 17th, The Federal Reserve Open Market
Committee voted 9 to 1 to maintain the interest rate posture that has now
been in place since 2009. While breathless financial commentators had spent
the better part of the summer debating the timing of any “potential lift-off”
of short term rates, they rather obviously missed the main event: the
potential trajectory of US Treasury rates is far shallower than widely
predicted and will take far longer to implement.
Throughout 2015, investors have moved decidedly away from income
producing assets for fear of an imminent rate increase. We have seen
remarkable performance differentials develop for example between growth and
value stocks. For many who came of age in the financial markets of the 1980’s
and 1990’s, the subdued interest rates of the post financial crisis are
unfathomable and unacceptable. Many have argued that this state of affairs
will lead to hyper-inflation and lead to unsustainable asset bubbles and must
therefore be corrected quickly. This frustrated cohort has at the same time
largely ignored the complexity of trying to manage a short term balance sheet
of $3+ Trillion, assuming that the pre 2008 tool box will somehow suffice.
The pundit’s post-announcement commentary derided Chairman Janet Yellen for
missing an opportunity to act and stomped their collective feet as they tried
to come to grips with what they called her “moving of the goal posts”. But
perhaps it is this community who grew up with double digit rates whose “group
think” fails to consider the landscape as it is in 2015 rather than what they
think it should be.
We have spoken about the complexity of managing the current balance sheet on numerous occasions. The New York Times did a thorough job of addressing this in their Sunday, September 13th article, “The Fed’s Policy Mechanics Retool for a Rise in Interest Rates”.
The potential disruption to short term corporate financing markets given the size of the “reverse repo” program necessary to move rates is a very real worry. The Federal Reserve has practiced with a program of $300 Billion and we know that this size facility has not been sufficient to make any changes in short rates. How will they know then how much additional repo to put out on offer to raise rates 25 basis points? They can’t. They will have to experiment and this could very well lead to instability on any given day. Short term liquidity is the oxygen of financial markets, just ask Lehman Brothers. Given the asymmetric risks facing the Committee at this time, keeping rates steady would certainly seem a more sober choice.
Since the early days of the financial crisis in 2008, there have been those pundits who have predicted an imminent return to 20th century levels of measured growth and interest rates. Let’s call them the “green shoots” crowd in reference to those who thought what had transpired in 2008 was a garden variety recession that would be naturally followed with a sharp return to growth. Despite their being consistently wrong, they somehow collectively continue to get incredible amounts of air time for their forecasts to this day. On the other hand, there are those who have begun to consider the possibility that the process of “normalizing” interest rates this time will look very much like the mirror image of what confronted those who followed in the footsteps of Paul Volker. Bob Michele, Global Head of Fixed Income, Currency, & Commodities Group of JP Morgan Funds wrote back in July the following:
“Just as Volker was confronted with “normalizing” policy from a then 20% fed funds rate, it appears that Chair Yellen is faced with “normalizing” policy from a current 0% fed funds rate. Given the unprecedented use of the current set of tools, the Fed is wise to start the long journey cautiously and on an intentionally shallow path.”
Why should it not take 10-15 years to unwind the current policy when it took that long to unwind Volker’s? Ken Rogoff, the Harvard professor and author of “This Time is Different” was on Bloomberg Radio this past week further mused that the Committee should not begin to raise rates unless that is the exact course they were prepared to continue. The notion that they would raise once and then promise to leave it there going forward was always unrealistic. There is simply too much at play in order to turn the financial ship of state to take anything other than well considered and deliberate steps.
We have for some time argued that we have a dynamic and evolving economy that is in many ways quite distinct from that which preceded it. As a result, we have economic tools designed to measure a world we no longer live in. Employment, retail sales, and productivity are all examples of economic measures which need to be redesigned to be of any meaningful value in today’s economy. Consider productivity. The Wall Street Journal wrote in a piece dated July 16th of this year that “Silicon Valley Doesn’t Believe US Productivity is Down”. The authors from Stanford and Google argue that is not that productivity is down – it is that we don’t know how to measure it. We only measure that which we pay for. Upgrades that come as part of a cell phone or computer are not counted. Much of what improves productivity in our day to day lives is therefore technically not counted. That’s why the Bureau of Labor Statistics (BLS) can say with a straight face that productivity is down. Technically correct and practically useless.
Structural changes to both stock and bond markets in recent years are just now flowing through into the day to day activity. Consider that the percentage of US Treasuries with coupons greater than 2.50% dropped to less than 20% this past June. Coupons are the natural shock absorbers for the bond market. They help to insulate price movements. This contrasts with a 0% coupon bond where all the changes in yield flow directly to the price. These past years of low rates have led to many higher coupon bonds being called and maturing bonds have been replaced with lower coupons. There can be no meaningful increase in the amount of shock absorbers in the bond market until we see a much higher rate regime for an extended period in order to restore what we have retired. This will have powerful consequences. Consider if you are a total return fixed income manager. If you were staying short in 2009 and 2010 for fear of higher rates, at least you had larger coupons to fall back on. Now, those coupons are gone and volatility is that much higher. True long term investors, on the other hand, are being offered compelling yields on municipal bonds and Master Limited Partnerships as another attractive income alternative.
On the equity side of the ledger, exchange traded funds (ETF’s) have come to make up some 50% or more of the daily volume. Now as you know, we are users of ETF’s and we think they are an important evolution in the world of indexing. That being said, they are having an impact on the volatility of the markets which was on clear display in August. Exchange traded funds are meant to emulate a sector of a given market in a cost efficient manner. But they were never advertised as being more liquid than those underlying segments that they were meant to replicate. This phenomenon has been further complicated by those ETF’s which attempt to mirror highly illiquid segments or to act with leverage. ETF volatility is further heightened by the relatively new addition of what have come to be known as “Robo” advisors. These are automated, algorithmic investment solutions that have become popular with many of the online brokers. On the morning of Monday, August 24th, many of the online broker’s systems were simply overwhelmed by their own order volume. Further complicating matters are stock exchange rules which call for the orderly opening of individual issues. If you can’t open the underlying stocks, you certainly can’t open the ETFs. This led to some unfortunate executions in the early going and will clearly require the attention of the exchanges to consider if their policies for trading individual stocks are completely appropriate in an area where those executions are no longer in the majority.
A final and perhaps most important point to touch upon is the role of financial institutions as market makers in the post 2008 world. Congress passed a sweeping rule known as Dodd Frank in 2010. One of the main tenants was known as the Volker Rule which restricted the ability of US banks in making certain types of “speculative” investments. This effectively eliminated firms “arbitrage” desks and without “arb” desks, the banks dramatically dialed down their principal holdings of both stocks and bonds. This, however, did not repeal volatility. Instead, we took it out of the financial institutions, and we put it back into the market place.
So consider the entirety of what has changed since 2008. We have a Federal Reserve working to unwind extraordinary measures, a process which clearly will take far longer than many had ever imagined. We have outdated economic data that reads like a AAA road pamphlet rather than Google Maps. We have a lower coupon bond market for years to come. We have structural changes to equity securities which offer more efficiency in exchange for less liquidity, and we have reduced the market making participants. In sum, we have a market which is vastly changed over the past 7 years and these evolutions are likely not lost upon the Federal Reserve either.
The Committee has received withering criticism since their September 17th press conference. The Chair’s discussion of global cross currents felt to many as being outside of the Fed’s specified purview. Perhaps they have an argument but we no longer live in a nicely compartmentalized world. Perhaps if the ECB had begun their QE programs when the US did, then the Eurozone recovery would be further along. But they didn’t. Hampering the nascent recovery in Europe is not in the interest of the US economy. The critics fail to note, along with their obliviousness towards the money market mechanics, that the strengthening dollar has already provided a certain dose of financial tightening. The Federal Reserve understands that until such time as they are ready to begin a tightening program, not a one off 25 basis point change, and to take on the massive challenge of running a $500 Billion + overnight repo program, then they should hold off. The Committee should work on improving their communications. They have too many people speaking too frequently with no consistent message. Hosting press conferences at each meeting rather than creating so much drama and pressure around any one meeting would be a welcome change. However, at this point in time, it falls to Janet Yellen to keep a steady hand on an economic recovery that may just be in the early innings. As we have said before, she is woefully underpaid.
Jen & Patsy
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