- The Power of Three
- Economic Vista: Cutting to ensure growth
- Credit Vista: 2019 stress tests - banks share the wealth
- Trading Vista: Digesting the non-news
Eric Souza, Senior Portfolio Manager
It is widely known the Federal Reserve has long had a dual mandate from Congress: maximize employment and keep prices stable. But is the Fed adopting a third mandate, and, if so, how might this affect investors?
Based on current data and comments from Fed Chair Powell, it appears that the Fed has a firm handle on its two well-established mandates. A quick peek at the statistics says it all. The unemployment rate is near a half-century low of 3.7 percent, and at the recent Federal Open Market Committee (FOMC) meeting, Powell explained that inflation is near its symmetric 2.0 percent objective.
But now, it is becoming clear that the Fed is managing to another mandate — not from Congress but from the FOMC itself. And this third mandate might be its toughest yet: sustaining the current economic expansion. In fact, at the June FOMC meeting press conference, Powell led with this reference: “My colleagues and I have one overarching goal: to sustain the economic expansion, with a strong job market and stable prices, for the benefit of the American people.” This certainly sounds like the Fed is not backing away from its newest mandate.
By now, we all know that in July the FOMC lowered the target for the federal funds rate by 25 basis points (bps) to 2.00 to 2.25 percent, largely to sustain the expansion here in the US. Although not without controversy, the rationale for the cut was to provide some downside protection from weaker global growth, uncertainties surrounding trade policies and muted inflation. Although there was some vagueness in communication from Powell at the press conference, which frankly, many have come to expect, the main takeaway is that the Fed is not forecasting a recession.
Immediately following the FOMC meeting, the market was forecasting the probability of another cut in September at approximately 60 percent. But the market is dynamic and can move rapidly, as we’ve witnessed these past few weeks. After Trump announced his intention to impose a 10 percent tariff on the remaining $300 billion in Chinese imports — an action that could further impede global growth — the probability of a September rate cut of 25 bps spiked to 95 percent. This probability could shift, depending on other events and how trade tensions with China evolve. For example, just after China allowed the yuan to cross the 7 yuan per US dollar level for the first time in 11 years, the probability of a September cut increased to 100 percent amid currency war concerns.
For now, we anticipate further reductions in the federal funds rate this year, but the frequency and magnitude will be based on both incoming economic data and resolution (or lack thereof) of global uncertainties, including trade talks and Brexit negotiations, among others.
Given the current environment, how should investors reposition? Based on the Fed’s famous pivot from rate increases to a neutral stance to a rate-cutting environment, we have been shifting our duration strategy but not our sector allocation. In 2018, it was imperative to protect against a rising rate environment, which translated into a defensive duration stance. The 2019 theme has shifted to one of monetary easing and lower interest rates, which translates into adding duration and extending maturities to lock in current yields for a longer holding period.
Since we are not forecasting a recession in the US and corporate fundamentals remain strong, we still feel very comfortable with spread product and are advocating a slight overweight allocation in our client portfolios. As always, we remain strong advocates of portfolio diversification — not only at the sector level, but also from a duration standpoint, with a mix of longer duration investments and short-term securities. This allows for continued flexibility and creates a better risk profile in an uncertain market.
Paula Solanes, Senior Portfolio Manager
It appears that the Federal Reserve is a believer in “insurance.” The Fed made its first interest rate cut in over a decade on July 31, lowering the federal funds rate by a quarter of a percent to a range of 2.00 to 2.25 percent. The cut was widely anticipated by the market, given the ongoing challenges facing the global economy and muted domestic inflation. Fed Chairman Powell mentioned that the cut is intended to help sustain economic growth; however, uncertainties remain, and the Fed will continue to monitor data as it assesses the path of future monetary policy. For now, the door is open for additional rate cuts, and the recent escalating trade tensions have raised the probability for another cut as soon as September.
Recent labor market data suggests that economic momentum may be slowing, even with solid job growth. In July, the US economy added 164,000 jobs vs. expectations for 165,000. The unemployment rate remains steady at 3.7 percent, while the labor participation rate ticked up slightly to 63 percent. In addition, wages improved by 0.3 percent on a month-over-month basis and 3.2 percent year-over-year. The six- and 12-month moving averages for nonfarm payrolls have been relatively strong at 139,000 and 187,000, respectively, but the downward trajectory in job growth confirms the diminishing strength in the labor market.
The ongoing escalation of trade tensions continues to weigh on the manufacturing sector. The Institute for Supply Management (ISM) Manufacturing Index declined to 51.2 in July, its lowest level in almost three years. While readings over 50 show expansion in the manufacturing sector, the downward trend is worrisome and reflects fading producer outlook, slower global growth and uncertain supply chains as companies navigate the evolving trade policy.
Focusing on the engine of the US economy, the consumer continues on firm footing. The University of Michigan Consumer Sentiment Index (MCSI) remains steady at 98.4, illustrating just how resilient consumers have been. In addition, retail sales were strong in June, rising 0.4 percent vs. expectations of a 0.2 percent increase. This pushes the second quarter annualized rate to 7.5 percent, making it the best quarter since 2017.
Looking at the other component of the Fed’s dual mandate, price stability, shows the core consumer price index (CPI) increasing almost 0.3 percent in June. This was above expectations and pushes up this measure of inflation, which excludes the volatile food and energy components, to 2.1 percent on an annualized basis. The increase was driven by medical services and shelter, but it also reflects some upward pressure from tariffs. However, looking at the Fed’s preferred measure for inflation, core personal consumption expenditures (PCE), is more muted and shows no change at 1.6 percent.
Finally, second quarter GDP surprised to the upside at 2.1 percent vs. expectations of 1.8 percent. The increase was driven by strong consumer spending, the highest since the fourth quarter of 2017. Despite the robust consumption, overall GDP was weighed down by inventories and net exports. In addition, private residential investment decreased, while government spending increased by the greatest amount since the second quarter of 2009. Overall, the recent data reflects a relatively healthy domestic economy, even as we acknowledge ample headwinds of slower global growth and escalating trade tensions.
Fiona Nguyen, Senior Credit Risk & Research Officer
A decade has passed since the depth of the financial crisis. Since then, the US banking system has become substantially safer as a result of enhanced supervisory actions and banks’ own prudent risk management.
This year marks the 10th anniversary of the annual bank stress tests, which were created by the Federal Reserve to measure the strength and solvency of the largest US bank holding companies and also to restore confidence in the banking system. As expected, all 18 firms subject to the tests have passed with flying colors, thanks to their increased capital cushion.
Notably, this year’s class has shrunk to 18 bank and bank holding companies, down from 35 in 2018, as the asset threshold for inclusion has been raised from $100 billion to $250 billion. Typically, the results of the stress tests are released through two phases: the Dodd-Frank Act Stress Test (DFAST) and the Comprehensive Capital Analysis and Review (CCAR). DFAST stresses the banks’ capital resiliency in various economic scenarios, while CCAR goes a step further and tests the effects of proposed capital plans, such as issuance or redemption of capital instruments on stressed ratios. Passing the second leg also means these firms receive the Fed’s approval to increase capital returns to shareholders through share buybacks or dividends.
Both tests put the banks through two sets of assumptions over a nine-quarter testing period: Adverse Stress and Severely Adverse Stress. The Severely Adverse Stress scenario exposed the banks to crisis-like conditions, including severe global recession, heightened corporate financial stress and significant market disruptions. The six US banks with large trading operations must account for severe global market shocks, while eight Global Systemic Important Banks (G-SIBs) are tested for the default of their largest counterparty. Nevertheless, all 18 banks passed, with the majority posting improvement in capital buffer over last year’s results. As a result, these banks get the nod from the Fed and are slated to distribute a record amount of excess capital to shareholders — the most since the financial crisis. The average total share buybacks and quarterly dividends for US banks increased 20 and 16 percent, year-over-year, respectively. From shareholders’ perspectives, these results are nothing short of the summer fireworks.
While large shareholder payout is generally not welcome in the eyes of bondholders, they need not worry as banks’ capital is proving to be more than robust in recent years. Even with a substantial increase in payouts, banks remain well-capitalized under the Fed’s most severe macro assumptions. All in all, the takeaway for credit investors is that the stress tests, once again, underscore the fundamental strength of the US banking sector.
Hiroshi Ikemoto, Fixed Income Trader
As widely expected, the Federal Reserve lowered its target interest rate by 25 basis points (bps) at its most recent meeting on July 31. Still, this action prompted an immediate volatility spike in the Treasury market, which persisted throughout Fed Chairman Powell’s press conference. Yields on the two-year benchmark note jumped to 1.95 percent but later closed at 1.87 percent. By the following day, however, the markets seemed to have fully digested the news, and most yields across the curve retraced back to where they were before the announcement. More than anything, this illustrates that the Fed decision was a nonevent for the bond market.
What seems to be more of a focus, from the perspective of money market traders, is the anticipation of increased Treasury bill issuance, pending the Senate’s approval to suspend the US debt ceiling. With primary dealers already saturated with Treasury inventory, many traders believe — even expect — to see a spike in bill rates, as dealers try to lighten their holdings. Furthermore, the increase in supply is likely to put pressure on the repurchase agreement (repo) market. As supply ramps up, repo dealers will have to boost rates to attract more buyers.
The corporate bond market was well-bid throughout the month of July, and spreads to benchmarks were largely unchanged. Even with healthy flows, the high cost of funding dealer inventories has forced many sell-side traders to show bid lists. This is a process whereby bonds quickly pass through dealers’ balance sheets, as opposed to an outright purchase and sale. This virtually eliminates the risk of needing to pay interest to hold the securities on their books. Commercial paper offerings have remained light, and expensive, as many issuers are finding alternative means to funding their operational needs. Currently, rates are roughly eight to 12 bps higher than like-maturing Treasuries, as compared to corporate bonds, which are 15 to 25 bps higher.
With the Fed cutting its target rate, not to mention the bond market pricing in further cuts in the near future, we have shifted our strategy by extending the average duration of our portfolios to the higher end of targeted benchmarks. This shift will lock in book yields and help to protect against declining rates. We continue to emphasize portfolio liquidity by purchasing high-quality securities and keeping an allocation in overnight investments. This allows us to be opportunistic should there be any short-term market price dislocations from future volatility.
|Treasury Rates:||Total Returns:|
|3-Month||2.06%||ML 3-Month Treasury||0.18%|
|6-Month||2.07%||ML 6-Month Treasury||0.19%|
|1-Year||1.99%||ML 12-Month Treasury||0.06%|
Source: Bloomberg, Silicon Valley Bank as of 7/31/19