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Don't Assume Dollar Market Stability

New York | Many of the readers of The Institutional Risk Analyst probably hoped to see a more peaceful year in 2021. Sadly the first week in January is feeling pretty much like the last week of December. But we’re happy to note the publication of our latest bank profile in our Premium Service, with a “neutral” risk rating on that sadly under-levered institution known as Bank of America (NYSE:BAC). We write:

"The bank’s funding base and liquidity are strong and credit expenses likewise are well under control, but our concern is that BAC does not seem to have the earnings potential commensurate with its size. The second largest US bank is a low-risk counterparty but also a mediocre equity investment. Given the risk averse nature of Mr. Moynihan and his board, BAC is unlikely to take the sort of tough decisions that would restore sustained profitability, including reducing the size of the bank and asset sales.”

Source: FFIEC

Americans await the start of a new and hopefully more steady government under President-elect Joe Biden, but the assumption of market stability is not a given. The obvious good news is that the markets worked through the year-end without any major mishaps. Stocks generally ended 2020 on or near 52-week highs, making for a heady start of the year, while corporate credit spreads continue to dance sideways.

But even as stocks move higher and benchmark bonds slip, the credit markets remain very short of collateral, a fact that may cause the next “taper tantrum,” albeit this time due to the shedding of Treasury cash balances. The 10-year Treasury note has risen in yield above 1% for the first time since March of 2020. Buy high yield spreads have still not recovered to pre-COVID levels.

Rising long term rates is not the end of the world by any means, but it does mean that the Fed-fueled boom of 2020 is ending as the Democrats take control in Washington. This perhaps augurs a return to more traditional market correlations? Does Janet Yellen demand the same respect from global markets as deal guy Steven Mnuchin? Like Alan Greenspan, Chair Yellen may be tested very soon in her tenure.

Meanwhile, the short end of the yield curve is getting forced down by the unrelenting global demand for Treasury collateral and dollar credit, which is basically at zero offshore. Can the incoming Biden Administration authorize and spend another $1 trillion in the next 90 days? The answer to that question holds the attention of bond investors (See “Wag the Fed: Will the TGA force Rates Negative?”).

Our pal @Stimpyz1 maintains that real interest rates remain “WAY too high. The Fed's own models show it. R* is negative. Shadow funds are 0%, and they were NEGATIVE 4% in 2014--when things were not NEARLY as bad then as now…” Looking at the collateral markets, he’s probably right. Of note, the FOMC minutes show the central bank remains committed to continuing QE “at least at the current pace.”

While members of the FOMC openly discuss allowing inflation to go as high as 3% before taking action to stay within the second part of the Humphrey-Hawkins dual mandate, namely price stability, the central bank’s own models suggest that even today's monetary policy remains too restrictive. The prospect of the Treasury returning hundreds of billions in cash to the Street over the next quarter, may actually drive market yields down toward the Fed’s theoretical R*.

Meanwhile in the mortgage sector, there is mounting evidence that the interest rate party is ending early – at least in terms of heady equity market valuations. KBW published a decidedly bearish note on Rocket Companies (NYSE:RKT), predicting that refinance volumes are likely to fall dramatically in 2021. (See our earlier comment, “Nonbank Update: Rocket Companies.”)

The folks at KBW are good analysts, but many people on Wall Street don't seem to recognize that the Mortgage Bankers Association (MBA's) estimates are very conservative and subject to upward revision as we go. For years we have started the year with the baseline estimates in the model, only to see open market bond purchases by the Federal Open Market Committee render the model pretty much useless as a predictive