Interest Rates Spike Higher
Strategy
This article typically begins with a few comments about the pandemic, but cases have fallen sharply, and many more restrictions are being lifted. We are learning to live with it on some level. The big story from the 1st quarter of 2022 is the sharp rise in rates. The 2-year maturity Treasury yield increased 160 basis points. The five-year maturity yield rose 120 basis points and the 30-year Treasury was 54 basis points higher than on 12/31/21. From a total return standpoint, it was the worst quarter in over 40 years. The Bloomberg Aggregate Bond Index fell 6.0% for the quarter. An index comprised of U.S. Treasury securities and high-grade corporate bonds with a 5-year maximum maturity declined 3.5% for the 1st quarter. Major equity indices declined 5% to 9% making the start of 2022 rough for investors.
GDP in the second quarter should be an improvement from the first quarter. The war in Ukraine shocked the world and resulted in further disruptions to the supply chain and higher energy prices. Wheat prices, which is widely grown in Ukraine, spiked higher and some predict food shortages later this year. Fewer headwinds caused by the pandemic will allow the economy to reopen fully. Consumers are flush with cash and are excited to travel, dine out etc. Jobs are plentiful with openings around 11 million and a very low unemployment rate leads us to conclude anyone who wants to work, is working. The housing market remains out of balance with demand exceeding supply, leading to higher prices. There is a fairly high correlation between a low unemployment rate and strong GDP. Inflation is the fly in the ointment and will not be falling until the 3rd quarter.
The biggest headwind for the economy in 2022 is going to be very restrictive monetary policy. The number of expected rate hikes seems to increase weekly as does the magnitude of each hike. The Fed raised the short-term interest rate by 25 basis points on March 16th. Many believe the next few rate hikes should be 50 basis points each. The market expects 210 basis points of additional rate increases by the end of the year. Much has been written about an inverted yield curve. It’s an important indicator (the 2-year 10-year yield differential) but it has given false signals that a recession was imminent in the past. The main issue is when will inflation peak and how quickly will it decline. The current view is that inflation will peak in the next quarter or two and be moving lower by the 4th quarter. Until there is evidence that inflation will be under control, expect the market to assume additional rate hikes are coming.
With rates moving higher many investors are concerned about extension risk. One way to mitigate extension risk is with well-structured CMOs. Let’s look at an example. Generically, we will look at one that is a sequential providing much more average life stability and more yield than a 15-year passthrough. There are essentially 3 tranches. One is short, one is long, and one is the support tranche. This CMO has a base case average life of 4.33 years but only extends to a 5.11 year in a very slow prepayment environment. The yield spread is 52 basis points whereas 15-year passthroughs are priced at a yield spread of 11 – 15 basis points. This CMO is also priced at a small discount ($99.50) and the yield is 3.10%. In the up/down 300 basis point range the average life varies from 3.67 year to 5.11 years. As an added bonus, the cash flow principal window begins in 2022 and ends in 2033. In this example, this bond would be a good addition to many fixed income portfolios.
"This creates a fantastic opportunity to buy municipal bonds."
When interest rates rise sharply causing bond prices to fall, retail investors see the drop in value of their municipal bonds and then sell. We have seen it happen numerous times. This creates a fantastic opportunity to buy municipal bonds. Here is a recent example: A large city issuer’s general obligation due in 2036 with a AAA credit rating. The bond was priced to yield 3.00% (tax exempt) and grosses up to 3.78% for an entity using a 21% tax rate. The bond is callable beginning 2-1-2031. The yield on the 10-year Treasury that day was 2.46%. The buyer of the municipal earned 1.32% more than the yield on the Treasury (3.78% - 2.46%). This is an excellent value as the ratio of the muni yield is greater than 100% of the Treasury yield (3.00% / 2.46%). It wasn’t that long ago when this ratio was below 80%.
We mentioned asset backed securities (ABS) last quarter as an area to explore. Let’s look at a subprime auto ABS issue that is performing very well. A current example is rated AAA by both Moody’s and S&P. Credit support at issuance was 54% and has increased to 65%. The A1 tranche has completely paid off, the A2 tranche will be fully retired by this October and the A3 tranche will be fully retired by July 2023. There are numerous support tranches which absorb losses. The average life is 0.74 years, and the yield is 2.65%. These are not prime borrowers, but the generous amount of credit support if there is a recession in the future.
Our final area for contemplation is a security we have used many times. It is a privately issued mortgage-backed security, or what we call an RMBS (Residential Mortgage-Backed Security). This example bond was issued in March of 2020 by an issuer who’s underwriting process is so refined that many of their deals have no delinquencies. This security had 15% credit support when it was issued and now has 21%. It is rated AAA by Fitch. The coupon is 3.00% but it is priced at $94.75 to yield 3.93% at 15 CPR. The average life is 6.62 years. If prepayment speeds increase the yield can increase to over 5.0%! Most of the mortgages have an interest rate between 3.25% and 4.00%. Over half of the mortgages have paid off and there have been no losses. Yield spreads are extremely wide ranging from 125 bps to over 200 bps.
We have entered a very restrictive period for monetary policy. The last time the Fed raised rates numerous times was December 2016 to December 2018. They eased rates finally in July of 2019. The fed funds rate increased to 2.50% from 0.50%. The two-year Treasury note yield peaked in November 2018 at 3.00%. Probably not coincidence that the two-year Treasury yield peaked at a level near the fed funds rate. Reinvestment yields are the highest they have been in years.
Observations and Outlook – Curve Inversions and Quantitative Tightening (QT)
We must admit the financial news coverage addressing whether the inversion was a fraction of a basis point, or a commanding handful of basis points has been gripping. Some will say that it is a poor indicator of recessions and others believe with the intensity of 1,000 suns that a recession is now a foregone conclusion. We have heard people discuss the 2-year Treasury as compared to the 10-year Treasury, the 3-month Treasury Bill as compared to the 10-year Treasury and several mixes ranging from 3-month Treasuries to 30-year Treasuries. An unscientific examination of the relationship between curve inversions and subsequent recessions is that a relationship of sorts must exist. Sure, the 2-year Treasury versus 10-year Treasury inversion has offered false signals (but not many) and the 3-month Treasury as compared to the 10-year Treasury inversion has been a near perfect indicator of subsequent recessions in modern history (until it doesn’t). The real reflection is whether cause or correlation is the relationship between inversions and recessions. The unsatisfactory answer is that at times it may be causal and other times it may be correlation.
Since the inversion is the talk of the market right now, we will indulge with some additional “curve talk.” First, the Fed has quickly addressed the inversion. In a recent appearance before the Senate Banking Committee, Fed Chair Powell recently said he isn’t convinced an inverted yield curve suggests a recession is coming (Source: Thinkadvisor.com). In a speech to the Economic Club of New York, Kansas City Fed President Esther George said, “My concern about an inverted yield curve does not reflect its intensely debated value as a predictor of recession” (Source: CNBC). Her view is “an inverted curve has implications for financial stability with incentives for reach-for-yield behavior.” We can see how an inverted curve places pressure on the banking system (that simplistically borrows short term and lends longer term), but given it is a widely watched indicator of upcoming recessions, we would expect that a curve inversion could precipitate “risk-off” behavior. Interestingly, Fed policy makers consider the spread between the current 3-month Treasury bill and the forward market for the 3-month Treasury bill in 18 months to be a superior indicator of looming recessions. Oddly enough, that indicator gave the same false indication as the 2-year Treasury versus the 10-year Treasury inversion did in 1998, and it gave the same correct indications prior to the 1991, 2002, 2008 and 2020 recessions.
Our suggestion is to be aware of curve inversions and study the past behavior of various asset classes around the time of inversions and recessions but understand that central banks around the world have manipulated markets since at least 2008. In 2008, the Federal Reserve had as “little” as $500 billion of securities on its balance sheet, as of March 31st that number has ballooned to more than $8.5 trillion (source: Yardeni Research at yardini.com). The same balance sheet that soothed markets during the Great Recession and the Covid pandemic through the Quantitative Easing efforts (buying securities to support prices or prop up market liquidity) may very well be the source of yield curve manipulation, through QT (allowing securities to mature from their portfolio, or outright selling). Indications have suggested that the pace and amount of the QT will be ramping up rapidly to a number that is more aggressive than the last QT effort. In Fed meeting notes, released during the writing of this piece, they have indicated that the pace of roll-off will approach $95 billion per month. This has been a nimble Fed and if a need to adjust the yield curve presents itself, while making progress on the dual mandate of full employment and price stability, asset sales are a possibility, we expect outright asset sales could quickly sober up markets and dampen the faint animal spirits in the market. In truth, this doesn’t seem like an animal spirits-driven inflationary episode, it feels like a hesitant bottleneck laden economy with zombie companies and consumers being propped up by cheap borrowing and a deluge of stimulus cash. While curve shape is certainly worth noting, curve consequences are the indicator we will be watching.
"...a flat curve creates challenges for traditional financial institutions as they source funds in the short part of the yield curve and lend or buy investments farther along the curve."
There will likely be consequences to the removal of cheap short-term borrowing costs, challenges with a flatter yield curve and economic headwinds caused by the recent increase in longer-term borrowing rates. Rising short-term borrowing will likely drag on consumers and high-yield corporate borrowers. Prior to the start of Fed rate hikes, at the end of 2021, consumer debt service payments for financial obligations as a percent of disposable income rose at the fastest pace since 1980. Zombie companies are allowed to remain undead due to modest risk spreads and artificially low short rates (compliments of the Fed). As input and operating costs put pressure on margins, some of these companies will likely fail or be acquired. As mentioned earlier, a flat curve creates challenges for traditional financial institutions as they source funds in the short part of the yield curve and lend or buy investments farther along the curve. The misery of these groups, along with the interplay among them, may determine if an elusive “soft landing” can be engineered by the Fed, or if a recession falls upon us.
A key barometer of where this is all headed should be the unemployment rate, along with analysis of where wage growth persists, and the areas of the labor market where job openings remain, along with where they evaporate. Chair Powell has indicated the employment environment is too tight. If inflation collides with widely felt economic uncertainty, the unemployment rate could climb. An indicator of recessions, developed by Federal Reserve economist Claudia Sahm, The Sahm Recession Indicator, says that if the three-month moving average of national unemployment rises by .5% or more, relative to its low during the previous year, a recession is underway. Note it is not a predictive indicator, rather, it tends to identify early in a recession that you are in a recession. If the unemployment rate increases by 2% (two percentage points) it is expected a deep recession is upon you. As rising costs take their toll on people, we can’t see how consumers won’t reduce dinners out, cancel trips, and reduce transportation expenses. The consumer discretionary area, the hospitality and service industries, could be poised for job losses once again.
Last quarter we introduced concerns about the lack of collaboration between employers and employees about how to run a profitable and competitive corporation that is made up of satisfied and motivated people. The recent unionization developments at Starbucks and Amazon seem to be a natural reaction to the devalued human capital issue (and in our opinion both sides of the equation own this problem). We have a lot of workers with low to moderate skill sets and seemingly the relationship between employees and employers has become increasingly adversarial, or at a minimum, apathetic. Overconfidence is a common behavioral flaw in economic decision-making. Our hope is that neither side overplays their hand but realizes that both the employee and the employer benefit from a relationship of mutual respect and concern. If the labor environment becomes increasingly hostile, quality or utility of goods and services could decline, and customers may change tastes. Then, both the employer and employee lose. The Fed’s tightening plans very likely mean that the labor market of the near future will not look like the market of the recent past.
We anticipate that 10-year Treasury yields will flirt with something close to 3% in the second quarter, before heading lower as the year ends. We believe the muni market has experienced most of the pain it will experience in 2022, so we may see 10-year high quality muni bond yields top out at 2.50% and move to 2% or lower, later in the year. The Fed raises rates to slow the economy down. They have been clear in their resolve to wring the inflation feedback loop out of the economy, and the employment environment is so tight, they can introduce more discomfort than previously thought to achieve their goals. We continue to expect the volatility and yield updrafts of the second quarter will represent the bond market buying opportunity of the year.
We don’t anticipate an eventual soft landing. Prepare to brace for impact.