Observation Deck is a monthly newsletter published by the SVB Asset Management team. In this February 2014 issue our headline commentary, What Investors Can Expect in 2014, covers what to anticipate from the Fed in the year ahead with the confirmation of Janet Yellen as the new head of the central bank.
What Investors Can Expect in 2014
Ninh Chung, Head of Portfolio Management
For fixed income investors 2013 was another fantastic year. Total return performance across all sectors in the short duration spectrum experienced positive returns with treasury bringing up the rear and mortgage-backed securities (MBS) as the lone sector with negative performance. Despite rate volatility stemming from fear of Fed tapering, for the most part investors were incrementally rewarded for stepping further out onto the risk curve.
We should see a similar outcome in 2014, although old and new challenges are expected. During the year, we look for the Fed to maintain an accommodative posture, although in different forms. While new bank regulations will strengthen bank balance sheets and leverage ratios going forward, it may come at the cost to the already dwindling supply of money markets.
Predicting the Fed’s Moves
As our trader, Hiroshi Ikemoto, noted in last month’s publication, Overthinking the Fed, we expect more of the same market overreactions, especially with a makeover at the Federal Open Market Committee (FOMC). Due to the confirmation of Janet Yellen on January 6 as the new head of the central bank and annual rotation of Fed presidents as voting members, the composition of the committee looks to be notably different from 2013. Second in line at the Fed is the nomination of Stanley Fischer as the vice chairman. With an impressive pedigree ranging from academia to the public and private sector, Mr. Fischer’s hawkish reputation should help to balance an otherwise relatively dovish board.
While the dual mandate of the Fed to maintain price stability and maximizing output has not changed, Ms. Yellen’s challenges are dramatically different, at least initially, from those of Bernanke’s tenure. Fed policy will shift away from quantitative easing programs to removal or replacement of monetary accommodations. After ballooning its balance sheet to over $4 trillion through purchases of treasury and MBS, the cost of anchoring long-term rates appears to outweigh its benefits. Perhaps the December 18 FOMC announcement of a reduction of net securities purchases to $75 billion from $85 billion of treasury and MBS purchases, or tapering, has set the precedent for Ms. Yellen to prescribe the right level of future drawbacks without stalling economic growth.
In addition to removal of bond purchases, the Fed is challenged with removing additional excess liquidity in the financial system. We look for Ms. Yellen to further solidify the committee’s forward guidance policy and to limit undue overreactions by market participants particularly as the Fed increases its tapering target. Nevertheless, we believe the Fed will exhaust all other options before embarking on outright asset sales as this action could dramatically devalue fixed assets.
Another option the Fed may exercise in removing additional liquidity involves manipulation of the wholesale funding market. With a balance sheet in excess of $4 trillion the Fed could actively increase its engagement in the repurchase agreement (repo) market by pledging its assets in exchange for cash. Additionally, the Fed could raise the rate of Interest on Excess Reserves (IOER) to incentivize excess bank deposits at the Fed. The end game of these programs is for the Fed to maintain its ability to anchor the federal funds rate at current levels of 0-25bp while it winds down its balance sheet. Regardless, Fed spectators will judge the Fed’s every move and the new voting members will be closely scrutinized and the markets are guaranteed to overact. We’ll look for investment opportunities from market overreaction to add value to client portfolios.
Paula Solanes, Portfolio Manager
Frigid weather across the U.S. affected a lot of the economy in the final month of the year. The month kicked off with a lackluster jobs report to cap 2013.Data showed that non-farm payrolls increased 74K, the weakest reading in almost two years due to the “polar vortex” in some areas of the U.S. However, the November figure was revised upwards by 38K offsetting the weak December read. Despite the weak jobs report, the unemployment rate fell to 6.7 percent from 7 percent. The significant drop in the unemployment rate was mainly due to a 35-year low in the participation rate.
Extra chilly weather also affected the housing front with new homes sales decreasing 7 percent to 414K: despite the weak number, the industry still had its best year since 2008.Extraordinary cold weather also impacted housing starts which fell 9.8 percent to 999K.Last on the housing front, existing homes sales climbed 1 percent to a 4.87 million pace in December topping off the best year since 2006.
Abnormally low temperatures took a bite out of a potentially good month in retail. Retail purchases increased 0.2 percent as more consumers did their holiday shopping online and tried to protect themselves from frigid temperatures by buying discounted winter clothes.
In this first FOMC meeting of the year and Bernanke’s last, rates were kept unchanged and there was a second taper announcement taking asset purchases down to $65 billion from $75 billion sticking to its plan for gradual withdrawal of stimulus.
Finally, Q4 GDP came in right in line with expectations at 3.2 percent propelled by consumer spending which rose 3.3 percent. For all of 2013, the economy expanded 1.9 percent year over year versus 2.8 percent increase the prior year.
Kyle Balough, Credit Research Analyst
U.S. commercial paper issuance has been on the rise (excluding ABCP) driven by the need of non-financial issuers. Year-over-year non-financial CP outstanding is up 16.0 percent, while financials are up 11.1 percent. Borrowing costs have been low and if it were not for the implementation of a Fed reverse repo facility they would have tightened even further. Non-financial issuers are building a cash cushion to pay-down CP maturities (if they don’t utilize the capital for new projects) in preparation for reduced market access during the upcoming debt ceiling negotiation and possible increase to borrowing costs. Many issuers are paying up to extend out the curve. Those high CP issuances could see decline, in the near future, if the Baucus proposed tax holiday is enacted thus allowing non-financial issuers to pay down CP programs with repatriated cash, but that is uncertain.
Financials have also been picking up the pace of issuance increasing $13.1 billion or 2.3 percent the week of January 14,2014. Much of this is attributed to foreign financials ($10.7 billion of the $13.1 billion) taking advantage of inexpensive funding. Many financial issuers are parking that cash at the Fed to earn 25 bps.
The entire CP market is made up of 63.4 percent Tier-1 paper and Tier-2 only accounts for 5.0 percent. While Tier-2 CP is less liquid there is a significant amount in yield pickup. As of January 17, 2014 3-month Tier-2 CP has been trading 26 bps above domestic industrials and only 3 bps above Financials. Financial CP, however, has offering levels between 17 to 50 bps while domestic industrial CP levels are between 9 and 11 bps, a larger range due to the varying risk in domestic and foreign banks. Tier-2 CP has the potential to increase portfolio performance if investor mandates and risk tolerance allow.
Hiroshi Ikemoto, Money Market Trader
Many on the street expected yields to increase at the start of the year on the heels of the Fed’s announcement of $10 billion tapering in December, but with mixed U.S. economic data and worries about China’s economy, bonds were well-bid across the curve as the “flight-to-safety” trade was on. The two-year Treasury benchmark note ended the month at 0.33 percent, while overnight repo, collateralized by government securities were being offered at zero. This even after the Fed’s announced another $10 billion tapering during the January Federal Open Market Committee (FOMC) meeting, Ben Bernanke’s final as Chairman.
Although there was over $150 billion in new issuance, spreads on investment-grade bonds tightened against the benchmarks with some early 2015 maturing industrials being priced at negative spreads. Short-term yields should remain low for the near future as the fed funds target rate looks to remain unchanged at 0 to 0.25 percent for most of 2014.
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