Don’t fight the Fed...
The Fed and the US Treasury combination sits like a heavyweight in the boxing ring of US fixed income. The ponderous moves open up ample opportunity for some quick jabs - but get on the wrong end of one of the swings and it’s a knockout. Joseph Mariathasan reports
The American Dream has always been that of a home-owning democracy - exemplified by the idealised image of a house with a picket fence with children playing in the garden. Enabling poorer segments of the population to live that American Dream has been an implicit and sometimes an explicit policy of US politicians. Arguably, the main thrust of the Clinton housing strategy was about increasing home ownership among lower-income groups, particularly African Americans and Hispanics - the spark that led to explosive growth in the sub-prime mortgage market on the back of low interest rates after 9/11.
Despite the crash in sub-prime and the consequent financial-led recession that we are now experiencing, the goal of spreading access to the American Dream is still central to the psyche of US politicians. In today’s world, that means undertaking policies that enable mortgage rates to be kept low and homeowners able to refinance affordably, keeping their homes without the spectre of massive foreclosures turning the Dream into an American Nightmare. But faced with a housing market collapse combined with a deep recession, that has meant unprecedented political intervention and, as a result, an unprecedented complexity in activities, outcomes and opportunities in fixed income and rates markets.
Policy also has to be geared towards increasing income, thereby increasing consumption and demand, and directing savings into riskier assets to provide liquidity in the credit markets and support the equity markets. This intervention has to be financed through a vast issuance of US Treasury bonds, for which domestic and foreign buyers need to be found.
As Mary Miller, head of fixed income at T Rowe Price points out, the Obama administration is still relatively new and learning how to operate in a political environment that can lead to unintended consequences from policies that might at first sight look sensible. “They have put in place a large menu of solutions, but they are still in the shake-out stage of finding out what works.”
For Brian Gevry, CEO of Boyd Watterson and co-head of fixed income with Titanium Asset Management, there are significant dangers in the interventionist approach that is currently being taken. “What really worries me is that there is not the demand to operate the economy at the capacity it had in 2006,” he warns. “For 30 years the US economy has been driven by an expansion of debt, whether government, consumer or corporate and, as a result, we have over-capacity everywhere. Cities such as Cleveland have contracted but still have the same number of firemen and police.”
Gevry sees the overcapacity as a function of the current deleveraging and argues that although the government can alleviate it in the short term, in the long term a higher return on capital will be needed to generate the extra wealth for consumption. “But the government is moving in the other direction, away from the US model of capitalism,” he observes. “What you get when the government directs investment will not be the most efficient allocation of resources.”
Robert Michele, CIO for fixed income at JP Morgan Asset Management, agrees. “Why buy auto and not health or aluminium?” he asks. “I remember that in 1996, Freddie Mac used capital to buy corporate bonds and bought Philip Morris and, suddenly, the government found itself supporting the tobacco industry - which caused a tremendous outcry from politicians.” Michele argues that there is a “socialisation” of debt occurring with the government guarantees.
The process of deleveraging means that there is now a big retrenchment going on that will take a long time to complete. In the meantime, the debt is being held in a safe pair of hands - the government’s - and the government can determine which industries get support and which do not. “But whatever percentage figure you think leverage added to GDP growth figure in the past, can now be subtracted from future GDP growth,” says Michele.
We are not in normal times
What does appear to be clear is that keeping US mortgage rates low has another critical ramification for the current economic scenario facing the US and indeed, the rest of the world. As Kent Wosepka, portfolio manager at Standish Mellon, points out, the consumer still accounts for 70% of the US economy. Trying to reinflate the economy to increase demand means putting more money into consumers’ pockets. But even when Fed funds are at rates as low as 0.25%, there has been no impact on the rates consumers pay on credit cards or mortgagess because of the huge widening of credit spreads.
“The most effective mechanism for the transmission of monetary policy is through the mortgage market and the ultimate aim is to get 30-year fixed-rate mortgages down to levels of 4%,” explains Wosepka. He points out that the Fed is by an order of magnitude the largest player in the US mortgage market currently, with purchases of $4-5bn (€3-3.7bn) daily. “It is buying standard current coupon 30-year mortgages. The goal is not to improve liquidity, but to lower the interest rate on mortgages. This won’t necessarily create a whole lot of new mortgages, but it does allow people to refinance existing mortgages at lower rates.”
The US authorities more than doubled the amount of US government mortgage-backed securities, adding another $700bn to the initial $500bn they had indicated they would purchase. As a result, as Wosepka explains, in the third quarter of 2008, when the credit markets seized up, 30-year fixed-rate mortgages were higher than 6%, and closer to 6.5%. As of April 2009, 30-year fixed-rate mortgages were at 5% or lower.
This form of quantitative easing through direct purchases in the marketplace is a direct function of the low level of short-term risk-free rates. “Five or 10 years ago, if the Fed were to lower policy rates from 5% to 4%, the mortgage rates would come down,” says Wosepka. “But we are not in normal times. Fed funds are at essentially zero per cent. So there is no other way to get mortgage rates down except through quantitative easing. It first bought mortgage bonds to lower spreads, but now US Treasury yields have gone up, so it is buying US Treasuries as well, which has lowered Treasury yields by 50bp as well.”
As a result, he sees that 10-year and 30-year US Treasuries yield 50bps less than they would have without quantitative easing, and mortgage rates around 50-75bps lower.
Stabilising the housing market through lower mortgage rates ties in well with increasing demand through giving the consumer reduced mortgage interest payments. Directing the extra income into investing in riskier assets, or else consumption, is proving to be more problematic. “Investors have been more concerned about return of capital than return on capital,” Michele comments wryly. But ultimately the combined effects of zero interest rates for Fed funds and quantitative easing bring down risk-free rates as low as possible and thereby encourage investors to move into riskier assets.
With very powerful forces pulling in opposite directions, deciding whether the world faces a deflationary or an inflationary spiral is not clear. “We believe we are in a deep, long-drawn-out recession, the biggest since the 1930s, and bonds throughout the developed worlds will likely be seeing sub-2.5% yields at all maturities before this is done,” says Vimal Gor, a fund manager at Aviva Investors running long-only and hedge funds.
Gor sees no alternative but quantitative easing on a much greater scale than has already occurred. “We are surprised that the Fed took so long before commencing the programme and has so far done it in such small size,” he says. “We fully expect the size to be raised substantially.”
As a result, Aviva Investors is leveraging its hedge fund portfolios to gain exposure to US Treasury long bonds, favouring them against bonds in countries that are not undertaking quantitative easing as yet, such as Germany.
It is clear that we have seen only the start of quantitative easing, agrees Ole-Petter Langeland, head of fixed income at Sweden’s AP Fonden 2. “There was an effect at the time of the announcement, but that disappeared and we have not seen much of an impact since then - and definitely not what people were expecting,” he says. “To have a more sustained impact, the Fed will have to increase the programme and maintain it for a longer time.”
However, although the short-term positive implications of quantitative easing on bonds can be debated, most fund managers would probably agree with Gevry, who says: “I do not think US Treasuries as an investment sector offer any value.”
As Bill Kohli, head of portfolio construction at Putnam, explains, the longer-term implications of quantitative easing can be hugely inflationary. “Quantitative easing is a wild card if you are trying to take a view on bond markets,” he warns. “In the near term, the counterbalancing forces are very dangerous in taking a view one way or another. At any time in the short term, the government could step in and move the market against you. But longer-term, in maybe six months or so, the sheer weight of issuance, the expansion of the money supply through quantitative easing and the resulting downward pressure on the dollar makes the market rate structure look highly vulnerable.”
The uncertainty level is high on both sides, Kohli adds, since if there are any policy mistakes and the world takes fright again, there could be another rush back into US Treasuries.
With the marketplace veering dramatically from fears of spiralling deflation to spiralling inflation, while real yields are subjected to massive shocks from both the flight away from risky assets and government intervention, it is not surprising that, as Kohli says, much of the marketplace does not understand US Treasury Inflation-Protected Securities (TIPS). It is perfectly possible to get rising inflation while TIPS fall in value because of a rise in real yields, which has produced confusion for retail investors in particular, according to Kohli.
“We think that TIPS are attractive now as substituting nominal rate risk by real rate risk is good,” he says. “But six months ago, it also looked good - and investors would have been burnt by the liquidity squeeze in October and November, with funds selling TIPS as their most liquid assets.”
Short-term, TIPS in particular look less attractive when deflation still seems a real possibility, although Jim Sarni, portfolio manager at Payden & Rygel, had exposure earlier in the year when the short end was expecting deflation of 6% or more within two years.
In contrast, Sarni sees the market currently expecting 1.5% inflation over 10 years. “The long end is where more opportunities could come later,” he suggests. “Ultimately, the stimulus effects and increased supply will translate to higher inflation and the TIPS market will really take off.”
Gor agrees, adding: “On a five-year view, the inflationary potential is huge. Will the Fed be able to correctly withdraw the stimulus packages before inflationary pressures take hold?”
The fact that the US Treasury market is now essentially subjected to manipulation on a vast scale makes any strategy highly dependent on second-guessing government actions, so perhaps it is not surprising that most managers see much better opportunities in the credit markets. As Sarni points out, since 1973 there have been only four distinct periods when investment-grade corporate spreads widened to above 200bps.
With each of the crises before today’s - the 1970s’ oil crisis, Savings & Loans, Enron - corporate spreads rallied significantly as the government intervened, through slashing rates, the creation of the Resolution Trust Corporation or the Sarbanes Oxley Act, and the economy improved. Today’s sub-prime and credit crisis has led to a series of actions, led by the Treasury’s $700bn Troubled Asset Relief Program (TARP), to stabilise the banking system and curtail further systemic risks.
For European investors, the immediate issue is whether they would follow the bears of Aviva into overweighting US Treasuries, in the expectation that quantitative easing will lead yields approaching 2% across the curve; or whether they decide that yields on corporate bonds are now so compelling that, even with a delayed recovery, they offer better value.
Langeland is underweight US Treasuries in the short and medium maturities, preferring high-grade credits, government guaranteed banks and sovereigns.
He also points out that, as a cash investor, the fact that derivatives are priced more expensively than cash instruments gives an opportunity that entities without a balance sheet cannot exploit. But he also articulates the big question that all investors face: “What do we do when the US economy is recovering, and the authorities end quantitative easing and have to reverse their strategy to keep the economy growing without stoking up inflation?” That is the potential sucker-punch that will keep bond investors on their toes for months to come.