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The ABCs of Reserve Management Purchases (RMPs)

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


The ABCs of reserve management purchases (RMPs)

Steve Johnson, CFA, Senior Portfolio Manager

Right in between delivering the second and third interest rate cuts of 2019, the Federal Reserve announced a new round of balance sheet expansion. Interest rate cuts and large-scale asset purchases probably sound familiar to many investors. Yet the Fed seems intent on pointing out differences with its latest tactics. Does it really matter? To answer that question, we need some perspective.

From 2008 to 2014, the Fed launched three separate quantitative easing (QE) programs aimed at lowering long-term borrowing costs, easing financial conditions and boosting confidence in the economy. To accomplish this, the Fed purchased Treasury, agency and mortgage-backed securities (MBS) across all tenors of the interest rate curve. In 2011, it also began “Operation Twist,” aimed at further lowering long-term borrowing costs by selling short-term securities in the Fed’s portfolio to buy longer-term Treasuries. As then–Federal Reserve Chair Ben Bernanke explained at the time, the goal of the QE programs was to ease financial conditions, support asset prices and lower mortgage rates to make housing more affordable and allow homeowners to refinance. Meanwhile, lower corporate bond rates created cheap borrowing to encourage investment, while resulting higher stock prices boosted consumer wealth and confidence. It was a multipronged approach for dire times.

  
timeline.jpg
Figure 1. Source: FRED Economic Data, St. Louis Fed, Economic Research – Federal Reserve Bank of St. Louis and SVB Asset Management. As of 10/16/2019.

The results of these large-scale asset purchases have been clear. The longest US bull market on record began in March 2009 and continues today, while unemployment has dropped to a 50-year low. So, with the benefit of hindsight, we can see Bernanke was right. These QE purchases, while causing the Fed’s balance sheet to swell from less than $1 trillion to nearly $4.5 trillion at the high, spurred the current bull market and helped the US economy recover from the Great Financial Crisis. Importantly, through these security purchases, primary dealers (banks approved to transact with the Fed) accumulated substantial reserves (cash held in commercial bank’s accounts at the Fed) in exchange for securities purchased.

Fast forward to today. With stocks near record highs and unemployment near record lows, why resume asset purchases? Are we in a financial crisis? Do financial conditions need easing and long-term borrowing costs need lowering, as Bernanke explained? The answer is no.

As the US economy has recovered, the Fed has slowly let its massive balance sheet unwind through a slow, planned and systematic maturing of Treasury and MBS that were amassed through years of QE. As these securities matured, the excess reserves accumulated by banks have been reduced. These reserves are held by banks and used to meet regulatory requirements, and when excess reserves above the required amounts are held, they can be used to lend to other institutions with reserve deficiencies in what’s called the federal funds market or other short-term borrowing markets such as the repurchase agreement (repo) market.

The result of a smaller Fed balance sheet and declining reserves is thus lower overall excess reserves and, consequently, less lending to any reserve-deficient institutions. The ramifications were evident last month, as supply and demand imbalances caused turbulence in short-term lending markets. Thus, the goal of the Fed’s most recent large-scale asset purchases is less about easing overall financial conditions and propping up the economy and more about the inner workings of the federal funds market.

On October 11, 2019, the Fed announced an asset purchase program beginning mid-October of an initial $60 billion per month in Treasury bills through the second quarter of 2020. The goal, in the Fed’s own words is “to maintain over time ample reserve balances at or above the level that prevailed in early September 2019.” These reserve management purchases (RMPs) are aimed at preventing the aggregate level of reserves in the system from leaking slowly below the level at which reserve-deficient institutions are constrained from borrowing from excess-reserve institutions. In aggregate, if maintained at $60 billion per month, this significant asset purchase package is expected to add a sufficient buffer above and beyond the level of total system reserves seen before the short-term borrowing market turbulence experienced in mid-September. This should facilitate smooth functioning of money markets going forward.

So, it does appear that the intent of these large-scale asset purchases differs from the QE of the past. To be specific, three notable differences stand out:

  • The type of assets purchased: The Fed has committed specifically to only purchasing Treasury bills, which are issued with an original maturity inside one year. By only utilizing short-term bills for RMPs, the Fed is communicating that it is not attempting to ease financial conditions or affect long-term borrowing costs by purchasing longer-duration Treasuries or MBS. Treasury bill yields declined over the course of October due to the increased demand from the Fed (see Fig. 2 below).
  • The timing of the announcement: The Fed specifically announced these purchases between its Federal Open Market Committee (FOMC) meetings. That’s significant, given that QE decisions in the past were typically communicated at an FOMC meeting and, therefore, were deliberately tied to a monetary policy decision. Announcing RMPs inter-meeting highlights to the market that this current form of balance sheet expansion differs from past QE.
  • No signaling in the communication: There was no signaling included in the RMP announcement. One powerful aspect of QE, as Bernanke highlighted, is the market’s anticipation of the positive effect of the asset purchases. The RMP announcement, on the other hand, was not accompanied by any communication around intent to stimulate the economy by any of the FOMC committee members.

All told, while asset purchases may look and feel familiar, this time around they are different on many levels. Therefore, investors should not jump to the wrong conclusions, since the Fed’s intent of this non-QE bond-buying is not meant to save the economy as it did 10 years ago. The current situation is markedly less dire, and that’s a good thing.

 

Treasury Bill

1 Year
(%)

6 Month
(%)

3 Month
(%)

Yield 10/30/2019

1.56

1.61

1.582

Yield 10/15/2019

1.633

1.663

1.657

Change Since 10/15th

-0.073

-0.053

-0.075

Figure 2. Source: Bloomberg as of 10/30/2019.

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Economic Vista: Down but not out

Jose Sevilla, Senior Portfolio Manager

Although the US economy continues to grow and financial markets have been largely optimistic during the third quarter, the most recent economic data has been mixed, at best. As expected, given current trade dynamics, the manufacturing sector is one soft spot. The Institute for Supply Management’s (ISM’s) manufacturing index slipped to 47.8 in September. This is the sixth consecutive monthly decline in manufacturing, putting the index at its lowest level since September 2008. The continued weakness was broad with all key subcomponents — new orders, production and employment — continuing to contract. Slowing global growth has dampened the demand for manufactured goods, both domestically and abroad, while the trade turmoil has disturbed supply chains and stalled hiring plans.

Despite the slowdown in manufacturing, the US economy added 128,000 jobs in October, which was well over expectations of 75,000 jobs. Wages picked up by 0.1% in October to a 3 percent year-over-year gain. The unemployment rate ticked up to 3.6% compared to 3.5 percent in September and continue to remain at a near 50-year low.

In terms of inflation, September’s core Consumer Price Index (CPI), which excludes food and energy, rose 0.1 percent after rising 0.3 percent during the last three months. Meanwhile, the broader CPI index was flat on the month. Year-over-year, CPI was up 1.7 percent, while the core was up 2.4 percent.

Perhaps reflecting the uncertainty in future growth and global trade, business investment weakened in September, as the durable goods report missed expectations on both the headline and core order components. Nonessential orders seem to be relegated to the back burner amid heightened global growth risks, while the soft result for capital goods shipments may be a negative harbinger for continued business spending.

Consumer spending, which has been a driving force for US growth, fell in September as retail sales fell 0.3 percent after rising 0.6 percent in August. The retail control group, which excludes food services, auto dealers, building-material stores and gasoline sales and is seen as the gauge for consumer demand, registered no change but was forecasted for a 0.3 percent increase. The surprise drop in retail sales was the first decline since February, indicating that spending might be slowing. Given that business investment and manufacturing is slowing and there is a lingering trade war, weaker consumption could increase the risks to future US economic growth.

On a positive note, the US economy expanded more than what was forecasted in the third quarter. US GDP grew at an annual rate of 1.9 percent after growing 2.0 percent in the second quarter. The gains largely reflected the strength in consumer spending, which increased at a 2.9 percent rate. However, business investment remains weak as it fell the most since 2015. The report did not change the outcome for the October FOMC meeting.

As widely expected, the Fed cut short-term interest rates by an additional 25 basis points at their October meeting. This was the third consecutive quarter-point rate cut this year. The Fed said to continue the economic expansion, it will continue to monitor incoming data and assess the appropriate path for interest rates.

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Credit Vista: US bank earnings: Fears overdone?

Fiona Nguyen, Senior Credit Risk & Research Officer

Heading into third-quarter earnings season, bank investors are grappling with the impact of the two rate cuts in July and September as well as the looming specter of additional easing. Many feared the cuts would mean the end to the multiyear rise in net interest income and mounting pressure to profitability. Not so fast.

As we discussed in a previous Credit Vista, lower interest rates can be both a curse and a blessing. On the one hand, revenue will grow slower in the face of shrinking asset yields. On the other hand, banks can soften the blow by resetting their funding costs almost instantaneously. And more often than not, low interest rates help companies and consumers remain on track of their debt coverage for longer, which in turn, support the sector’s asset quality.

So is the anxiety overdone? When it comes to banks’ bottom line, it’s important to remember there are several levers they can pull to help mitigate potential impact on the lending margin. Based on recent results, it appears US banks have proven that falling interest rates, while compressing spreads, have had a moderate impact on profitability. In fact, several global systemically important banks (G-SIBs) posted record earnings in the third quarter with solid credit quality statistics. Even for mid-sized banks, results have been favorable, as margin pressure has been partially offset by loan growth.

From an intrinsic standpoint, several factors contributed to a relatively impressive earnings season for the sector. First, US banks maintained robust earnings going into the first rate cut, which gave them ample cushion to absorb an immediate reduction in interest rates. Second, large banks are broadly diversified with revenues split nearly evenly between net interest income and fee income. On average, fee income represents 49 percent of revenue for the eight largest US banks*. And lastly, asset quality has been kept at near-pristine conditions with relatively muted loan losses after a decade of post-crisis prudent risk management. Banks can also optimize efficiency by lowering expenses and rationalizing their work forces.

There are also exogenous factors that contributed to this quarter’s results. A surge in corporate debt refinancing brought in more fee revenue and benefited banks with large capital markets operations, as corporations took advantage of falling rates. Smaller players, akin to consumer banks, were also in a position to gather strong fees from mortgage refinancing and credit card lending. The strength of the US consumer year-to-date has been reflected in robust credit demand at large and small to mid-size banks alike.

For now, investors can take a breather after spending much of the last three months worrying about the sector. But how long can the banks sustain their growth if the Fed moves forward with more cuts as seen with the third rate cut from the October FOMC meeting? While the sector proved its resiliency this quarter, the lower the rates go, the greater pressure there will be on the net interest margin and, ultimately, earnings. Low rates will also encourage more risk-taking behaviors, threatening to deteriorate the current sound credit conditions. Depending on the magnitude of any potential earnings decline and asset deterioration, odds are the risk of bank downgrades will rise if deeper rate cuts are in the cards. But for now, it seems investor fears have been overblown.

*CreditSights

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Trading Vista: Cautiously optimistic

Jason Graveley, Fixed Income Trader

Largely driven by reported progress toward a US-China trade deal, a risk-on tone has permeated markets for much of the month of October. And while the details have been light, mostly rumored to be centered on tariff reductions in exchange for agricultural purchases, they have been enough to revitalize markets. Although better in recent weeks, market sentiment remains cautiously optimistic, as investors remember that changes in trade policy can come quickly and unexpectedly. For now, however, markets seem to be embracing the improved rhetoric.

Benchmark yields have reacted in kind, rising dramatically during the month of October after hitting lows on the back of weak manufacturing data to start the month. Yields on the 2-year Treasury have moved more than 15 basis points (bps) intramonth, from a low of 1.39 percent to approximately 1.52 percent at the October month-end. Meanwhile, we have seen little change in credit spreads over the same period, thereby suggesting that investors have little concern regarding the creditworthiness of companies and are more focused on domestic and global growth prospects.

In terms of the high-grade, short-duration market where our focus lies, we continue to see robust demand from a full range of investors. This includes the Federal Reserve. The relative value profile of the market has dramatically shifted month-over-month, thanks largely to the recently announced Fed Treasury bill operation. The result of this operation, which outlines $60 billion in Treasury bill purchases per month into the second quarter of 2020, has increased the comparative value of credit purchases. Credit yields are now 25 to 30 bps better than like-dated Treasuries, up from 10 to 15 bps last month. And Treasury collateralized repurchase agreements (repos), which have been under scrutiny since the money market stress in September, remain 15 bps better than short-dated Treasuries at the time of this writing.

From our perspective, we will continue our disciplined approach to managing portfolios, while aiming to take advantage of any potential pricing dislocations. And while there are varying views regarding the future path of monetary policy — from mid-cycle adjustment to an easing cycle — we will continue to manage to the liquidity and risk profiles of our clients.

Markets

Treasury Rates: Total Returns:
3-Month 1.52% ML 3-Month Treasury 0.18%
6-Month 1.55% ML 6-Month Treasury 0.24%
1-Year 1.50% ML 12-Month Treasury 0.31%
2-Year 1.52% S&P 500 3.43%
3-Year 1.52% Nasdaq 4.89%
5-Year 1.52%    
7-Year 1.60%    
10-Year 1.69%    

Source: Bloomberg, Silicon Valley Bank as of 10/31/19

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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. Views expressed are as of the date of these articles and subject to change. 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.

This 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 decision. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation, offer or recommendation to acquire or dispose of any investment or to engage in any other transaction. None of the material, nor its content, nor any copy of it, may be altered in any way, transmitted to, copied or distributed to any other party, without the prior express written permission of SVB Asset Management.

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

Investment products and services offered by SVB Asset Management:

©2019 SVB Financial Group. All rights reserved. Silicon Valley Bank is a member of FDIC and Federal Reserve System. SVB, SVB FINANCIAL GROUP, SILICON VALLEY BANK, MAKE NEXT HAPPEN NOW and the chevron device are trademarks of SVB Financial Group, used under license. Silicon Valley Bank is the California bank subsidiary and commercial banking operation of SVB Financial Group.

About the Author

Steve Johnson, CFA, is a senior portfolio manager at SVB Asset Management (SAM) based in the San Francisco Bay Area, where he and his team are responsible for the overall strategy, security selection and risk management of client portfolios. His work combines two of his greatest passions: people and financial markets. Steve thrives on the process of getting to know each of his clients, developing a deep understanding of their unique set of financial challenges and coming up with strategies that allow them to achieve their goals.

Colleagues past and present recognize Steve as a proven communicator. Before joining SVB, he worked at Wells Fargo Asset Management as a portfolio specialist for the Montgomery Fixed Income team, a fixed income manager with an over 25-year history specializing in core fixed income, long duration credit, and short duration fixed income management. This involved distilling his team’s investment philosophy, processes, portfolio construction and portfolio positioning for current and prospective institutional clients. In this role, he worked with institutional consultants and institutional clients, including endowments and foundations, corporate defined benefit and contribution plans, and subadvisors among others. Prior to that, he worked at Morgan Stanley in an institutional fixed income sales role, covering fixed income money managers, corporate treasury groups, pension funds, endowments, and 2a7 money market funds in a sales and advisory capacity. This role involved expertise in all things fixed income from funding trades and securities lending, to outright primary and secondary market trading execution across fixed income cash, derivative and ETF products.

Steve holds a bachelor’s degree in economics from Duke University as well as a master’s degree in management studies from Duke’s Fuqua School of Business. He is a member of the CFA Society of San Francisco.

No matter where he lands, Steve finds his athletic niche. Growing up in Colorado, he enjoyed skiing, hiking and mountain biking. While at Duke, he played varsity basketball for the 2010 National Championship Duke Blue Devils and was a high jumper on the varsity track team. Now that he’s lived in California for a few years, he’s added beach volleyball, CrossFit and running to his list of pursuits. To stay in shape, he continues to play in a number of basketball leagues in San Francisco.
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