The View from the Lake
Grand Lake Stream | One of the great things about fishing is that it provides an opportunity to reset perspectives, both through conversation with new friends and inspection of the surrounding terrain. We talk, we listen, we learn.
Ponder the large mouth bass (image below), which is considered an invasive species in Maine. Some knucklehead threw some large mouths into a lake a few years back and now they are embedded into the Maine wildlife system. The small mouth bass is considered the home town fish, a sacred native species, but in truth the small mouth was also introduced to Maine by humans a century and more ago. Which fish is the illegal immigrant, which the native? Of note, we can testify that small mouth bass have been citizens of the State of Virginia for many years.
One topic of conversation this past week was the troubling evolution of the US financial markets, where artificially interest rate floors and federal REPO programs have replaced investors and markets. Risk is now a function of the whims and caprices of the Federal Open Market Committee. The dysfunction in financial markets, in turn, colors our perspective on deteriorating credits – like the "AAA/AA" rated sovereign known as the United States of America.
During Camp Kotok in August of 2011, S&P decided to downgrade the credit of the US to "AA," causing great consternation in the credit markets. Without a "AAA" rated exemplar at the top of the post-WWII financial global credit food chain, things get messy in the world of sovereign credit. The approaching fiscal train wreck of Social Security provides a case in point and may be complemented by a default by at least one large state, which could essentially hold Washington hostage in order to extract a bailout.
One manager offers that the major public sector unions in states like Illinois, for example, are playing for precisely that outcome, as evidenced in the legislation passed to restructure Puerto Rico. The pressures building for a fiscal surprise in the US a few years hence – maybe just five years -- are massive and provide us with an excuse to revisit the earlier discussion of “quantitative tightening” or QT.
As we noted in a previous issue of The IRA, when the US Treasury redeems a bond held by its alter-ego at the Federal Reserve Board, the effect is to reduce liquidity because the government is running a deficit. Treasury must immediately raise a new dollar for every dollar in net redemption. Thus the final effect of “quantitative easing,” which involves purchases of Treasury securities by the FOMC, is a tightening of policy via QT, as we can see even today unless the Fed reinvests the Treasury bond repayments indefinitely.
The economists who fashion the narrative in the investment world got it badly wrong when they suggested a cut in target rates in 2019. Last week, we pondered the number of economists who’s reputations may lie in tatters when not one rate cut materializes this year. We even started to make a list, assisted by, wait for it, artificial intelligence. Pardon us, but is there enough plain vanilla human smarts such that we need unnatural augmentation?
Chairman Jerome Powell, we believe, will first end the runoff of the Fed’s balance sheet, known as the System Open Market Account or SOMA. This is what Chairman Powell has said several times. Then the Fed will assess the situation and relevant data. One thing we can say, however, is that the FOMC better pay a little more attention to credit spreads and related market dynamics, a lapse that almost cause a credit market collapse last December. The volatility seen in the market for fixed income securities reflects a level of unease in the world of credit that begs the question, our colleagues commented. The chart below shows the yield spread on Fannie Mae 4s (aka FNMA residential mortgage pass through securities with average coupons ~ 4%) vs the 10 year Treasury note.
Spreads on Fannie Mae securities and the Treasury 10-year note have migrated steadily higher since 2017, when Fannie 4.5% coupons were almost even yield with government debt. But since January agency spreads have compressed by nearly 25bp, back well-inside of a point over the Treasury curve. The bad news is that as investors have bid-up the price of agency paper, the rate of loan prepayments on these premium securities has accelerated, increasing cash losses to investors and shortening the effective average lives of this “risk free” asset. The price differential between premium and discount coupons in residential mortgage assets is vast.
Agency securities are not the only source of market and interest rate risk emanating from the Fed’s radical policy of QE. You could say that the US economy, like the banks, is entirely rate dependent and correlated, only the moves in rates seem to be causing more harm than good. We noted last week that the sharp downward move in interest rates has set up Q2 2019 earnings to be a bit of a downer in terms of losses on negative-duration positions like mortgage servicing assets. Hopefully the interest rate hedge was effective. Some tickers to ponder when it comes to falling interest rates: NRZ, PMT, ANLY, WFC, BAC.
Those kind souls that actually believed at the end of 2018 that interest rates would continue higher were not paying attention to the shift in spreads for agency securities and mortgage servicing rights or MSRs last Fall. Now however, with spreads headed lower for government, investment grade and high-yield debt, the proverbial roller coaster lurches the other direction. But for how long?
After peaking in early June, spreads have rallied with the fall in interest rates. And the growing market volatility, as former Fed Chairs Ben Bernanke and Janet Yellen predicted, is the end result of QE. Q: Will credit spreads continue to tighten once the markets realize that no Fed rate cut impends in 2019?
With little prospect of improvement in the fiscal posture of Washington prior to the 2020 election, Treasury is approaching the day of reckoning with respect to Social Security. On that day several years hence, when the $2.8 trillion of non-marketable Treasury debt held by the Social Security trust funds starts to be redeemed,
Treasury will be forced to raise $2 for every dollar in payments to beneficiaries. One dollar to make the payment and another to refinance the past spending that was financed with the Social Security surplus when Bill Clinton occupied the White House. This will be QT on steroids. The FOMC will be compelled to employ hyperinflation via QE in response to Treasury's bid for new funds.
As with QT, when the Treasury redeems the debt held by the Social Security trust fund the net effect on the market will be to tighten liquidity and bank deposits. Thus this past week at Camp Kotok we discussed the fact that the Fed must eventually start to inflate its balance sheet to keep up with Treasury debt issuance and offset this negative monetary effect on the US economy. The Treasury is the dog in the world of monetary affairs, the Fed is merely the tail.
Today the markets seems to be able to absorb endless amounts of new Treasury debt, but that may not always be the case. As we bid farewell to our friends in Grand Lake Stream, we wonder how the world will look five years hence. We assume that the second term of President Donald Trump will be ending and the US fiscal situation will be rapidly deteriorating.
Will we have seen another credit downgrade of the United States, as happened in August 2011 when a lot of economists and financial media were very literally caught in their canoes? Or will President Trump and Congress get serious and begin to raise some revenue to quench the massive spending and, more, cash flow gap that faces the Treasury over the next decade? Only time will tell. Tight lines.
David Kotok on West Grand Lake