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Observation Deck: Changing of the guard

 |  December 05, 2017

SVB Asset Management's monthly Observation Deck newsletter covers current topics on portfolio management, credit considerations and market events that influence investment strategy.

Changing of the guard

Jose Sevilla, Senior Portfolio Manager

The times they are a changing. President Donald Trump recently selected Jerome Powell to be the new Federal Reserve chairman, replacing Janet Yellen whose term ends in February 2018. Powell, a former investment banker, has served as a Fed governor since 2012. He also held senior roles in the Treasury Department during George H.W. Bush’s presidency, as well as for the Carlyle Group and the Bipartisan Policy Center. Interestingly, he has a law degree instead of an economics degree, which is unusual for this leadership position that shapes monetary policy. However, economists still consider him a safe pick because he has worked in similar positions before, and like Yellen, is expected to continue the current trajectory of gradually raising interest rates while shrinking the Fed’s balance sheet.

The larger impact for Powell as new Fed chair will be how he helps shape the bank regulatory landscape. Yellen strongly supports Dodd-Frank and believes it should remain in place. President Trump has already appointed Randal Quarles as the vice chair of supervision. In this role, Quarles will be responsible for the direction of the Fed’s regulatory efforts and will work in conjunction with the Office of the Comptroller of the Currency (OCC) and the FDIC to implement some of the Treasury Department’s proposed deregulation measures. Experts believe Powell and Quarles will keep the core of Dodd-Frank Act in place but will be open to reducing, if not revising, portions of the Act that would be deemed safe for the banking industry.

Another major change at the Fed will be the replacement of Bill Dudley, who is retiring in mid-2018 as the head of the Federal Reserve Bank of New York. Replacing Dudley bears some level of significance because he is considered “Yellen’s right hand man.” The New York Fed is different from the other regional banks. It is the operational arm of the Federal Open Market Committee (FOMC), meaning when the board in Washington makes a policy change, it is the responsibility of the New York Fed and the person who leads it to execute on those policy changes. There is also a particular stature to being the president of New York Fed compared to other regional bank presidents. The New York Fed president votes on policies at every single FOMC meeting, while most regional bank presidents vote on a rotating basis. Therefore, the expected change at the New York Fed has greater implications and impacts policy more than leadership changes at other regional banks.

With the resignation of Vice Chair Stanley Fischer this past October, there is a high potential that the recent changes at the Fed could alter central bank policies drastically. Fischer’s departure leaves four of the seven seats on the Fed Board of Governors vacant (not including Dudley & Powell). It is possible the new regime will shift its mindset from a committee that targets full employment and stable inflation to one more focused on U.S. economic growth targets, which is something that appears higher in the Trump administration’s agenda.

2017 FOMC Members
Janet Yellen Chair, Board of Governors replaced by Jerome Powell*
Stanley Fischer Vice Chair, Board of Governors Open seat
William C. Dudley (Bill) New York Fed President Open seat
Lael Brainard Board of Governors  
Jerome H. Powell (Jay) Board of Governors Open seat
Daniel K. Tarullo Board of Governors replaced by Randal Quarles
Charles L. Evans Chicago Fed President  
Patrick Harker Philadelphia Fed President  
Robert Kaplan Dallas Fed President  
Neel Kashkari Minneapolis Fed President  
2017 Alternate Members
Raphael W. Bostic Atlanta Fed President  
Loretta J. Mester Cleveland Fed President  
Mark L. Mullinix Richmond Fed Vice President  
Michael Strine New York Fed Vice President  
John C. Williams San Francisco Fed Vice President  

*Pending Senate Approval
Source: www.federalreserve.gov 

We still don’t know who will be appointed vice chairman and who will fill the three open seats on the board. With Yellen, Dudley, and Fischer leaving, the Fed is losing 33 years of combined experience. What we are certain of, despite these departures, is that there is still significant experience among the remaining board members. The Fed remains data driven and policies will continue to be determined by its forecasts. Therefore, we continue to expect interest rates will continue to move higher as the Fed tightens monetary policy gradually. For our portfolios, we continue to focus on maintaining our portfolio duration targets and taking advantage of front-end rate opportunities in order to remain reinvestment flexible while managing potential interest rate volatility.

Markets
Treasury Rates  
 
Total Returns:  
3-Month 1.26%
 
ML 3-Month Treasury 0.08%
6-Month 1.44%
 
ML 6-Month Treasury 0.08%
1-Year 1.61%
 
ML 12-Month Treasury -0.05%
2-Year 1.78%
 
S&P 500 3.07%
3-Year 1.89%
 
Nasdaq 2.35%
5-Year 2.14%
 

 

 
7-Year 2.31%
 

 

 
10-Year 2.41%
 

 

 

Source: Bloomberg, Silicon Valley Bank as of 11/30/17  

Credit Vista: Randy’s rules

Nilani Murthy, Senior Credit Risk & Research Officer

Randal Quarles has been appointed to be the Federal Reserve’s vice chair for supervision. OK, so what does that mean? The vice chairman for supervision is a new role created after the 2008 financial crises though it was never filled during the Obama administration. This is effectively a banking supervision role. Former Fed Governor Daniel Tarullo was responsible for bank supervision until he stepped down in April, and now this new appointment is likely to loosen some regulations facing the banking industry. Consider some of the differences between Daniel Tarullo’s approach and how the new vice chairman for supervision might approach the role:

Tarullo Quarles
  • Stepped down in April, after Trump took action to start easing regulation on the financial industry
  • Advocated for strict financial regulation
  • Believed bank regulators must defend tough rules governing financial institutions and resist diluting rules that may prevent a future financial crisis
 
  • Confirmed as vice chair for supervision in October (first person to officially hold this position)
  • Expected to soften existing bank regulation
  • Believes bank regulation, specifically the Dodd-Frank Act, is too restrictive and repealing some aspects will fuel economic growth
 

Heightened global regulations and an improved operating environment have led to many positive rating actions across the banking industry globally. In the U.S., while there have been efforts to roll back the Dodd- Frank Act (DFA) under the Trump Administration, major legislative changes to completely repeal the DFA have proven to be very difficult. But some easing of regulations may have merit. For example, U.S. regulators have proposed giving concessions to smaller banks, such as easing their burdensome reporting requirements on governance and compliance. Often, smaller banks have a simpler business model and do not require such strict oversight.

However, relaxation of well-constructed and established regulation of large highly complex banks is credit negative. Having rules in place to ensure that banks hold sufficient capital and liquidity for stressed situations is pertinent to a safe banking system. While some rules prevent banks from maximizing their returns (in a risky manner), they restrict all peer banks in the same manner. Those banks that are nimble and can adjust to the stipulated rules will be the winners. In other words, there’s no need to entirely change the rules of the game, just be more tactical about the way you play it. The ultimate impact of banks’ credit profiles will be determined by the response to any implemented changes. We will closely monitor how the banks on our Approved List adjust their operations according to Randy’s Rules.

Economic Vista: Humming along

Paula Solanes, Senior Portfolio Manager

The year may be winding down, but the economy keeps humming along, thus allowing the Federal Reserve to proceed on its well-telegraphed action plan. November kicked off with the Federal Open Market Committee (FMOC) meeting, and as widely expected the Fed left the benchmark rate unchanged in the range of 1.00 to 1.25 percent. There were no surprises in the statement, and the Fed believes that the soft core inflation reading will stabilize closer to the 2.0 percent objective in the medium term. Another rate hike before year-end seems a certainty. However, FOMC participants also noted that the continued low inflation readings could prove to be more persistent, driving up Treasuries once again. Also in November, the administration nominated Jerome Powell as the new Fed chair. Powell is widely expected to continue the current gradual monetary tightening, with one key difference being that he favors more lenient financial regulation.

On the economic front, any adverse effects of the hurricanes have largely dissipated. The payroll numbers revealed that the U.S. job market rebounded by adding 261,000 jobs, although that was below expectations. The prior month’s reading was initially negative, but it was revised to a positive 18,000 jobs, re-establishing a seven-year trend of positive job growth. The unemployment rate fell to 4.1 percent, while the labor participation rate also dropped to 62.7 percent, reflecting in part an increase in retirees. Average hourly wages, which spiked to 2.9 percent following the hurricanes, came in well below expectations at 2.4 percent.

The latest consumer price index (CPI) numbers showed that in October, price data also began to shake off the effects of the hurricanes, and on a year-over-year basis there was a modest increase to core inflation from 1.7 to 1.8 percent. As expected, both core CPI and headline inflation rose 0.2 percent. The Fed’s preferred measure, core personal consumption expenditure (PCE), increased 0.2 percent on a month-over-month basis and 1.4 percent on a year-over-year basis. The positive change adds comfort to the Fed’s messaging that a rate increase is imminent.

Entering the holiday season, retail sales inched up 0.2 percent, and the prior month also was revised upwards to 1.9 percent. The retail-control group, which the Fed monitors closely and is used to calculate GDP, increased by 0.3 percent and follows an upward revision of 0.5 percent in September. Finally, nine out of 13 major retail categories showed month-over-month increases. The momentum in retail should help support the strong consumer spending contribution to GDP in the final quarter of the year.

The housing sector also continues to show resilience thanks to a strong labor force, rising incomes and relatively low mortgage rates. Housing starts increased 13.7 percent to seasonally adjusted 1.29 million new units, while existing home sales increased slightly by 0.2 percent to 5.4 million on a month-over-month basis. New home sales were up 6.2 percent, while home prices increased 6.15 percent, as lean inventories continue to support prices. The resumption of rebuilding and other real estate activity in the aftermath of the hurricanes should provide a boost to fourth quarter GDP.

The revised GDP release for the third quarter showed an upward revision to a third estimate of 3.3 percent from 3.0 percent with business investment improvements, trade and inventories to help improve the estimate. However, the increase caused by trade and inventories could very well be due to hurricanes effects. On a year-over-year basis the rate of growth has been steady at 2.3 percent.

Overall, the economy continues to hum along and a December rate hike by the Fed is highly anticipated. Subsequent rate hikes in 2018 are likely to be met with more scrutiny, and the Fed will keep a keen eye on future economic data releases as it plans the next course of gradual rate hikes under the helm of new Fed Chairman Jerome Powell.

Trading Vista: The right mix

Jason Graveley, Trader

As we pass through the post-Thanksgiving lull and investors awake from their tryptophan- and carb-induced naps, the market shifts its focus to the next scheduled Federal Open Market Committee meeting – set for December 12 and 13. The U.S. economy continued to pick up steam through November, with encouraging economic data highlighted by an unexpected gain in retail sales and an uptick in inflation readings. As a result, the Federal Reserve is widely expected to continue on its path to tighten monetary policy and raise its benchmark interest rate target to between 1.25 and 1.50 percent. This expectation, coupled with the prospect of tax reform, has pushed front-end benchmark yields higher. Two-year Treasury yields, considered to be the most sensitive to shifts in monetary policy, have increased over 20 percent in the last two months, while the future implied probability of a rate-hike has moved from 63 percent to over 95 percent. In other words, it is virtually a done deal as far as the market is concerned.

Credit spreads have reflected the effects of tax reform and tightening monetary policy as well. The increased uncertainty around tax legislation, as well as the current low interest-rate environment, has motivated many companies to issue new debt. In October, after the Trump administration first outlined the potential for tax reform, monthly investment grade issuance levels jumped close to 14 percent year-over-year. This tax- and rate-driven near-term supply has weighed on markets at a time when dealers typically reduce balance sheets ahead of year-end. The result for our clients has been additional supply, higher overall yields, and stable credit fundamentals, which we believe is an ideal mix for constructing balanced client portfolios.


 


 

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The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates. This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decisions. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction.

SVB Asset Management, a registered investment advisor, is a non-bank affiliate of Silicon Valley Bank and member of SVB Financial Group. 

Products offered by SVB Asset Management:

Are Not insured by the FDIC or any other federal government agency
Are Not deposits of or guaranteed by a Bank
May Lose Value


About the Author

Jose Sevilla is a portfolio manager for SVB Asset Management. He has more than 15 years of fixed income portfolio management and trading experience.

In his previous position, he served for four and a half years as a senior portfolio manager and head of fixed income trading, for Mellon Transition Management, a division of Bank of New York Mellon. Jose also held positions at Robertson Stephens, Inc. and Wells Capital Management. His trading and portfolio management experience includes institutional cash management and structured products.

Sevilla earned his undergraduate and MBA degrees from UC Davis.
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