Download - UNPROFITABLE RISKS SM - Capital One the challenges in returning the banking system to a more normal state is the delicate task of draining the excess reserves from the banking system

September 19, 2016 | FED BRIEF 1

FED BRIEF

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September 30, 2016

PROFITABLE RISKS / SM

UNPROFITABLE RISKS

Loss avoidance is a key to long term investment success. We deem certain risks profitable, to be exploited with sound research, while other risks are inherently unprofitable and should be avoided.

OUR RISK MANAGEMENT TENETS

A rigorous top-down approach toforecasting liquidity conditions is

an essential ingredient in fixed-income risk management

Active management of interest rate risk within modest limits is a cornerstone of successful fixed income portfolio management

Extreme variation from bench-mark duration is counter-productive

Yield curve, sector positioningand careful employment of creditrisk offer attractive cyclicalopportunities to add relativevalue

Opportunistic and modest em-ployment of high yield andinternational debt elements canadd significant value to a coreinvestment grade mandate

CAN THE FED PULL A HOUDINI? Paul Teten, CFA© Chief Investment Officer September 19, 2016

The Federal Reserve’s interest rate policy-making Federal Open Market Committee meets this week and Chair Janet Yellen will report on the deliberations Wednesday. Ms. Yellen announced with great fanfare last December that the FOMC intended to raise the Fed Funds rate by 1.0% this year, from the near zero rate of 0.13% that had prevailed since 2008. They call this policy normalization, an acknowledgement that near zero money market rates are highly abnormal in modern history, and distort the balance between spending, savings and investment. The Fed raised the Funds rate 0.25% in December to 0.38%, where it has stayed all year, as the global economy has continued to display sluggish growth and the specter of unstable markets has cowed the Fed toward caution.

The Fed’s conundrum is exemplified by the fact that U.S. economic growth has slowed sharply this year, to 1.2% over the last 12 months, slower even than Europe’s stagnant 1.6% growth rate; pointing to the disconnect between Fed policy that aims to increase rates while Europe continues to pursue aggressive quantitative easing amid a prevalence of negative interest rates. A growing consensus is developing that negative and near zero interest rates are counter-productive, driving a misallocation of resources on a massive scale and unmercifully punishing the thrifty and frugal among us who have built retirement nest eggs. A large part of those retirement funds exist in the form of municipal pension funds and cities across the country are drowning in the debt resulting from chronic underfunding of the plans, now compounded by the crushing reality of long-term return assumptions that have proven wildly optimistic.

Economic theory holds that if a central bank lowers the return on savings, consumers would be incentivized to spend more and save less. The evidence is becoming compelling, however, in both the U.S. and Europe, that the reverse is occurring as consumers, alarmed by the radical behavior of central banks, are increasing precautionary savings balances; and retirees and those near it are increasing their retirement set-asides in recognition that their savings are unlikely to grow as had been previously anticipated. It’s likely that these undesirable and unintended consequences are behind the Fed’s desire for normalization, but they have created a very difficult trap from which they wish to escape. Whenever Ms. Yellen or other influential FOMC members indicates publicly a growing likelihood that the Fed may soon deliver on its promise of a rising Funds rate, risk aversion spreads quickly in the well-integrated global markets. Consequently, this has been a very frustrating year for the Fed, characterized by repeated blinking and no biting the bullet.

The markets have low expectations for a rate increase this week as the U.S. economic data has turned weak again lately. The markets’ expectations for Fed '''''''''




policy over the next year appear to be about evenly split been one 0.25% increase in the Funds rate by December, and possibly one more similar increase next year. That’s a pretty cold shower compared to the Fed’s insistence last year that they would raise the Funds rate up to 3% over the next few years. It’s probably going to take the European Central Bank to tacitly admit defeat and terminate their QE program, which could happen in the next year and would likely drive global interest rates up 1% or so. But then the inconvenient question would be if the ECB stopped buying the government bonds of Italy, Spain and France, who would buy them? The ECB has an equally difficult trap from which to escape, and both it and the Fed will need to hone their escape-artist skills.

CURRENT RISK ASSESSMENTS

Duration strategies modestly longv. benchmarks

ATTRACTIVE SECTORS: 5-7 Yr Treasuries for optimum

roll-down returns Investment grade Finance credits Super-senior commercial

mortgage-backed securities Short duration high-yield

corporate bonds High quality Municipals with no

pension funding challenges

UNATTRACTIVE SECTORS: Emerging Market credit and

currency exposure Developed Market credit

exposure Long duration high yield

corporate bonds

September 26, 2016 THE INCREDIBLE SHRINKING INTEREST RATES: Is a return to normal even possible?

More to the box the Fed has put itself in with its highly abnormal monetary policy known as quantitative easing. This goes into the weeds of the banking system a bit, but it’s relatively short and hopefully not too dense, and casts some light on whether the Fed really can return monetary policy to something like pre-2008 normal. The Fed has injected an enormous amount of liquid assets into the financial system by buying U.S. Treasury bonds on the open market, which had the effect of pushing bond yields to historic lows. Some of that liquidity also found its way into the stock market, driving equity indexes to historic highs, even with an anemic economy and slumping earnings over the last couple of years. The Fed has invested a lot of energy over the last few years insisting that the time has come to move back toward a more normal monetary policy, meaning interest rates significantly greater than zero. The essential problem is how to do that without crashing the markets in the process. First, a few basics on the banking system to put the predicament into context.

The banking system is a fractional reserve system, meaning that banks take in deposits, lend a lot of that money back out, and have to keep a fraction of the funds liquid in order to handle the ebb and flow of normal checking transactions. In the U.S. the required reserve ratio for the medium-size and large banks is 10%. Required reserves can be either vault cash or reserves held on account at the Fed, which until 2009 earned nothing. The U.S. banking system has evolved over time to carefully monitor and project its cash flows and is very efficient in keeping its excess liquidity either loaned out or invested to earn a return. Prior to 2009, banks would rarely if ever hold reserves at the Fed in excess of what was required, but if they do for some temporary period those reserves are known as excess reserves. As the financial system was crashing in the fall of 2008, the Fed essentially bought the problem and allowed any bank to sell any asset to the Fed in exchange for reserves on account at the Fed. A bank could convert those reserves to vault cash to handle withdrawals as need be, but the main effect was to reassure the public that questionable assets had been removed from the bank’s balance sheet and replaced with liquidity supplied by the Fed. This and other critical forms of financial triage were central to averting a full blown economic depression, and the markets began to recover in the spring of 2009. As the Fed Funds rate had already been pushed


pushed to near zero by December 2008, the provision of liquidity directly to the banks became known as quantitative easing, in that it was extra-curricular to the Fed’s normal method of monetary stimulus, the manipulation of the overnight lending rate to banks. The Fed followed up with additional rounds of QE in 2011 and 2013, in these subsequent rounds buying high quality assets, U.S. Treasury bonds and government-guaranteed mortgage-backed securities, instead of distressed assets. But the effect was the same in providing a huge liquidity cushion to the banks in the form of reserve balances held at the Fed. QE was also known as balance sheet expansion, since both the Fed’s assets and liabilities grew in parallel, adding deposit accounts owed to the banks on the liability side and a gigantic pile of Treasury securities on the asset side. For context, the Fed’s total assets grew at a slow, steady rate from $750 billion to $900 billion between 2003-2008, a 3.3% annual rate of growth over the period, roughly in parallel to growth in the economy. Since 2008, through three rounds of QE, the Fed’s asset holdings have ballooned to $4.5 trillion, a surge of $3.6 trillion in the six years through 2014, about 75% of which is represented in excess reserve accounts at the Fed. As described above, historically banks were loath to hold non-earning excess reserves, and the Fed has had to institute an interest rate to be paid on excess reserves, 0.50% today; higher than the Fed Funds rate of 0.38%, by design to keep those reserves from flooding the financial system with a chaotic inflationary impulse. Among the challenges in returning the banking system to a more normal state is the delicate task of draining the excess reserves from the banking system without upsetting the money markets or destabilizing the broader financial system. The Fed seems destined to continue to pay interest on excess reserves in order to control them, possibly a much bigger premium over the Funds rate if loan demand were to accelerate.

Hand in glove with the excess reserve challenge is the Fed’s asset holdings. Extinguishing excess reserve liabilities means selling Treasury bonds back into the market; or just letting them mature, in which case Treasury would refinance them in the public market. So far the Fed has been holding its balance sheet relatively steady, reinvesting interest, maturities and mortgage principal paydowns back into securities. The scope of the challenge in shrinking the Fed’s balance sheet back to normal proportions is illuminated by the fact that the Fed’s asset holdings in 2008 amounted to 6.2% of GDP, the total national output of goods and services in that year. Today the Fed’s assets holdings are a whopping 24.4% of GDP. Selling enough assets to reduce the balance sheet back to 2008 levels in relation to the economy would be catastrophic for the stock and bond markets. Conventional wisdom in the financial markets assumes that the Fed will go very slow in selling assets and that the workout schedule to close the book on QE is a very long one. For a glimpse of how long, consider this: if the U.S. economy grows at 4% per year indefinitely, close to what our experience has been in recent years; and the Fed doesn’t sell any assets and just lets the economy slowly catch up to its balance sheet size, it will take 35 years for the Fed’s assets to decline to the 2008 level of 6.2% of the economy.

Every quarter the Fed’s policy-making Federal Open Market Committee updates its economic projections and releases a survey of FOMC members’ expectations on '''''''




where the long-term neutral Fed Funds rate should eventually rise to, neutral meaning neither tight nor easy policy. These projections have steadily drifted lower in recent years, and last week’s update indicated a median expectation for 2.875% as the long-term normal rate, down from 4.0% in 2014. The U.S. Treasury 10-year bond currently trades at a 1.62% yield in the bond market, a relatively low premium of 1.24% over the current Funds rate. The Fed is essentially telling us that over the next few years, markets should prepare for the Treasury 10-year yield to rise to 4 or 5% as the Funds rate moves up. Such a move would indeed be catastrophic for bond investors, with longer bonds losing more than half their value in such a rising rate scenario. With the European Central Bank and the Bank of Japan continuing to double down on QE, negative interest rates prevalent and deflationary currents persisting in the global markets, investors are notably unfazed by the Fed’s projections and betting on a different, much lower interest rate outcome. The tide could turn though if foreign central banks begin to move toward normalization like the Fed. That is the game-changer markets will be alert to.





Un less otherwise noted, all return data sourced fr om Bloomberg, LP, September 30, 2016

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Download - UNPROFITABLE RISKS SM - Capital One the challenges in returning the banking system to a more normal state is the delicate task of draining the excess reserves from the banking system

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