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The Institutional Risk Analyst

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Terminal Rates & Conflicted Economists

November 2, 2022 | Former Fed Chair and now Treasury Secretary Janet Yellen is said to be monitoring the ebbing liquidity in the Treasury market “closely.” Since the author of “Operation Twist” and other acts of idiocy by the FOMC during Yellen’s tenure is now the cause of illiquidity in the market for government debt, it is good to know that she is still on the case.


In our view, Secretary Yellen should be sent into well-earned retirement to spare the nation the cost of more of her good works. So badly have the Federal Reserve Board under Jerome Powell and the Yellen Treasury screwed up the term structure of interest rates in the US that the Treasury may now be forced to buy-back low coupon debt to set things right.


By manipulating the Treasury bond market, Yellen and Powell have created yet another problem. The ignominy of the US taxpayer exchanging low-interest bonds for current coupons merely to suit the convenience of institutional investors should provoke outrage in Congress, but not a sound is heard from the world's only permanent criminal class. Members of Congress are largely clueless about the ways of means of the FOMC.


As readers of The Institutional Risk Analyst know, the Treasury debt and MBS issued in 2020-2021 comprise an illiquid ghetto that nobody wants to own save a few unfortunate central banks. The hedging cost on GNMA 2% MBS is 3x current coupons and, even then, may not be effective. Similar problems are seen with low-coupon US Treasury debt. No surprise, the Fed is now running a negative funding spread, paying out more in interest on reserves than it earns from those low-coupon bonds it created during QE.


Some central banks may be needing some liquidity rather soon. Over the weekend we were struck by a report in the Financial Times that suggests that the EU is finally unravelling, with the stronger fleeing the weaker credits. German Finance minister Christian Lindner says it is cheaper for many countries to raise their own debt rather than borrow jointly to address energy subsidies. Why? Because the growing pile of unsecured EU debt is trading at higher yields than the debt of the member states.


“The financial advantage the commission, and many member states once hoped for from common European debt, as opposed to issuing debt on a national basis, no longer exists,” Linder said. With EU debt trading just shy of 3% and Germany close to 2%, Linder made the obvious calculation. The table below shows yields on various government debt.


Source: Financial Times


Part of the reason for the poor performance of EU debt is the fact that ECB Governor Christine Lagarde is foundering badly in the growing political storm in Europe. Her comments about inflation “appearing out of nowhere” made her a laughing stock in European financial circles, but few people in Europe are laughing in public.


With total EU debt now approaching 100% of GDP, Lagarde has dug a financial hole that may eventually fracture the EU. The more basic problem faced by the EU and Japan is that the US is headed for a 5% fed funds rate by year-end. The U.S. yield curve and swaps remain inverted, however, with 10-year Treasury notes above 4%. The 30-year Treasury bond is below 3.75% and 50-year swaps below 3%.


The inverted yield curve is not so much a signal for impending domestic recession, but rather highlights the entrenched belief by investors that U.S. interest rates will soon fall. Demand for dollars, as evidence by the deeply inverted curve for dollar fixed-to-floating rate swaps, remains brisk. A swap collateralized by US Treasury debt is the functional equivalent of the collateral, less fees of course.


The inverted yield curve also displays the rather serious bias of economist surveys, which see the fed funds rate reaching 5% by February 2023 and remaining elevated through December of next year. The consensus survey of economists then sees fed funds falling to ~ 3.5% before the November 2024 general election. This is called a "soft landing" in the parlance of the Buy Side asset gatherers.


Most of the economists surveyed, of course, work for Buy Side firms that earn a living by gathering and managing assets in a predictably mediocre fashion. Yet like Pavlov’s Dog, investors are now hard-wired to buy stocks when they fall by a certain amount. No additional conditioning is required. Edward Chancellor writes in The New York Review of Books:


“Professional investors, who fear that clients will leave them if they underperform, may be forced to buy overpriced stocks to preserve their jobs—that is, they rationally choose to make seemingly irrational decisions. This problem becomes acute when investment performance is measured over the short term; as Keynes observed in his General Theory, most money managers are concerned ‘not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public.’ Such behavior makes markets inherently unstable.”


Do Buy Side investment managers and their pet economists cause market volatility? Former Treasury Secretary Larry Summers said as much in a Bloomberg interview, calling out the “growing chorus” of the “consensus of economists who have a track record, since COVID, of being dismally wrong on inflation. I believe this advice is badly misguided.”


The cult of ever falling interest rates goes back 50 years and spans the terms of Fed chairs back to Alan Greenspan and Paul Volcker, who only fought inflation after President Ronald Reagan was elected in 1980. Neither the economists nor the advisors they serve would ever recommend that clients move to cash, as illustrated by the equity market selloff in 2022.


The faithful expectation of a Fed-induced rally in both stocks and bonds drives the projections of an impending pivot. Like earnings projections, the purpose of projecting falling interest rates this side of the Fed event horizon is to convince investors to go back into equities early, before the actual fact. This strategy is easily predicted because all of us have seen that same movie before, with the FOMC coming to the rescue of a swooning economy.


Most of the pundits and prognosticators are basically following the consensus view, with interest rates falling in Q1 2024. Exhibit A is the rally in financials over the past month, with Raymond James Financial (RJF) leading the group and such dogs as Deutsche Bank (DB) and Bank of America (BAC) galloping at 20-30% annual rates. But is this the time to be buying financials?


It is fair to say that few of the managers buying these bank names for client portfolios has any idea about the risk that lies ahead. Specifically, the FOMC has kept fed funds artificially low since the 2008 financial crisis. The conflicted consensus view says fed funds will eventually settle back to 2019 levels of 3%, this after the Fed slays the inflation dragon. Mortgage rates, in this view, will fall back into the 5s.


But what if the “reset” in interest rates is more like 4-5% fed funds, as was the case prior to 2008? And what does a 4-5% terminal rate say about future credit costs?



One big reason why we think that any interest rate ease will be modest and grudging is the issue of volatility and related losses to investors and financial institutions. The growing clamor by investors for the US Treasury to repurchase low coupon bonds is a very real concern driven by real market realities like volatility and hedging costs, which directly impact new securities issuance. But the cost of fixing the handiwork of Janet Yellen and Jerome Powell may be very high indeed.


Both because of concerns about inflation and also the FOMC’s growing awareness of the extent of the damage to markets done by QE, we expect the Fed to move very slowly to change interest rates once the necessary increases have been made. We expect the “ease” in FOMC policy to be merely a cessation of rate increases. That could be quite a surprise to the comfortable and entirely biased Wall Street economic consensus.



Institutional Risk Analyst is published by Whalen Global Advisors LLC and is provided for general informational purposes only and is not intended for trading purposes or financial advice. By making use of The Institutional Risk Analyst web site and content, the recipient thereof acknowledges and agrees to our copyright and the matters set forth below in this disclaimer. Whalen Global Advisors LLC makes no representation or warranty (express or implied) regarding the adequacy, accuracy or completeness of any information in The Institutional Risk Analyst. Information contained herein is obtained from public and private sources deemed reliable. Any analysis or statements contained in The Institutional Risk Analyst are preliminary and are not intended to be complete, and such information is qualified in its entirety. Any opinions or estimates contained in The Institutional Risk Analyst represent the judgment of Whalen Global Advisors LLC at this time, and is subject to change without notice. The Institutional Risk Analyst is not an offer to sell, or a solicitation of an offer to buy, any securities or instruments named or described herein. The Institutional Risk Analyst is not intended to provide, and must not be relied on for, accounting, legal, regulatory, tax, business, financial or related advice or investment recommendations. Whalen Global Advisors LLC is not acting as fiduciary or advisor with respect to the information contained herein. You must consult with your own advisors as to the legal, regulatory, tax, business, financial, investment and other aspects of the subjects addressed in The Institutional Risk Analyst. Interested parties are advised to contact Whalen Global Advisors LLC for more information.

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