A road trip is completed, and another one is underway. Besides the matter of the Trumpest in the Washington Teapot, the overriding majority of questions we encountered had to do with interest rates. Where are they going? What does that mean for my bonds? And, of course, for the stock market? And for the real estate boom that I see all around me, with cranes in the air and concrete forms being filled? Who is going to occupy all these dwelling units? How will they fill the hotel rooms? And if the people move here, what happens to the places they leave?
Lots of questions and limited answers triggered this writing, so we are alerting readers that this is a longer one. We are going to talk about short-term interest rates. By implication, that means we'll discuss longer-term rates too.
But first let's get distracted briefly by love and marriage. Here's a link to a thoughtful piece recently released by the American Enterprise Institute (AEI), entitled "Ties that bind." Let me quote the lead paragraph:
From the United States to the United Kingdom, from Peru to the Philippines, marriage is in retreat and cohabitation is on the advance. The implications of this shift for adults are much debated; some see it as an important indicator of liberation, others see it as a troubling sign of growing social isolation. But even more important might be the impact on kids."
This is a profound issue and its import extends way beyond affecting short-term changes in interest rates. Central bankers and monetary policymakers focus on money and are only slightly influenced by longer-term demographic trends. Moreover, they cannot influence the direction of those trends. Societal constructions are powerful and mostly immune from actions by central banks.
In our recent Florida East Coast travels we encountered a gathering of mothers and very young children assembling for lunch after a mother-child (and some fathers) swimming class. The prams and the moms became a traffic jam of maneuverings, as you can see in this photo here. We talked with a few of the participants. This mix of couples and single moms is only a single anecdotal event, yet it bolsters the AEI's case.
I had a conversation with Rose, a grandmother visiting from Auckland, New Zealand. She and I viewed this remarkable scene together and conversed about the world that these "littles" and their moms will inherit from us. I wished Rose safe journey home after comparing "our grands" and sharing photos. Rose asked, as she departed, what the "Trumpest" in Washington will mean for these swimming classes and the little kids who take them, since some of them are American citizens and others are children of green card holders, while still others face the daily risk of parents being deported. In the end we just don't know where this American immigration policy transition will lead. But we do sense from our anecdotal experience that fear exists among the younger generation who gathered for this swimming class, and among others like them.
Before we get to interest rates, let's end this portion of today's commentary with a quote sourced from AEI: "Unity in diversity is the highest possible attainment of a civilization" (former AEI scholar Michael Novak, who passed away on February 17, 2017, at age 83).
On to interest rates.
The first question we encounter at many meetings on our road trips is direct: Will the Fed hike two times or three times this year? Ok. It is normal for clients and their consultants to phrase the question that way. The financial TV is filled with Fedspeak, analysis, punditry and prognostication. Fed policy makers are always careful to hedge their comments. They have to do so, which is why Chair Yellen must always remind participants that Fed meetings are "live" and why Vice-Chair Stan Fischer crafts his answers painstakingly, so that the door remains open for a change in policy. BTW, if you have a Bloomberg terminal, the interview that Tom Keene conducted with Stan Fischer last week is worth a visit for its carefully phrased questions and nuanced answers.
The evidence supports two hikes this year. That is our expectation. The evidence also suggests that the Fed will maintain the size of its balance sheet and neither shrink nor expand it. The composition of the balance sheet asset side is as important this year as the two or three hikes in short-term rates are.
Short-term rates come first as we step through this three-part monetary policy system.
The Fed currently has a corridor of rates. The highest currently is 0.75%, which is the rate the Fed pays to banks that deposit excess reserves (OER) in overnight transactions with the Fed. These are viewed as riskless assets by the banking regulators and supervisors, so no bank capital is needed to support the OER asset class. The lower bound of the corridor is really defined by the rates on repurchase agreements (repo). Let's think of that as being at about 0.50%. The users of this riskless parking place for overnight money are those who are unable, by law, to access the excess reserve deposit rate (IOER). Federal Home Loan Banks and GSEs like Fannie Mae (OTCQB:FNMA) are among those who cannot get the higher IOER rate. The middle of the corridor is reflected by the Federal Funds rate, currently 0.66%. Technically that is the policy rate set by the FOMC at its meetings, although it is the IOER that has the ultimate power over short-term rates. Fed funds are traded among institutions through a government-supervised system. Banks that can buy money at a Fed Funds rate low enough to make a profit if they redeposit that money at the Fed will do so after they adjust the gross yield for the cost of doing this business and for the insurance fee they pay to the FDIC. Thus the IOER rate less costs is the basic foundation upon which short-term interest rates are built.
Private-sector borrowers have to go through one of these intermediaries for money. And lenders know that they can earn a riskless rate of 0.75% on IOER. So market-impacted rates are critical and they are higher than policy rates, as one would expect. There are many versions of market-based rates, so we will focus only on one of them, the single most commonly used reference rate. That is the three-month London Interbank Offering Rate (LIBOR). In America today, three-month LIBOR is about 1.06%. Most folks who borrow short-term from banks and other lenders reference the three-month LIBOR. Some reference the one-month LIBOR, which is currently about 0.80%. Globally, about $150 trillion in debt and derivative debt is tied to LIBOR, so every single-basis-point change in LIBOR has a very large impact on world finance.
Over the last three years, the changes in banking system rules (Basel 3) and US money market fund rules (October 2016) have combined to raise LIBOR rates more than have the interest rate increases made by policy makers. So while IOER went up 50 basis points, from 0.25% to 0.75%, three-month LIBOR went up from 0.25% on December 31, 2014, to its present 1.06%. In other words, rule changes amounted to the equivalent of an additional Fed rate hike. Does the Fed know this? Yes, of course it does. That explains why the Fed has moved slowly and continues to do so. We believe that caution will continue, which is why our estimate is for only two rate hikes in 2017. If readers want to follow the tightening or easing of rates in the real world, track the daily changes in LIBOR. We do that every day. BTW, LIBOR is now creeping higher, one basis point at a time.
The second part of the Fed's monetary policy tool set is the size of the Fed's balance sheet. It hasn't changed in over three years. The asset side is composed of short-term Treasury bills, intermediate-term Treasury notes and some longer-term Treasury bonds, while another large tranche is in federally backed mortgages originating in the GSEs. The entire list of holdings is available publicly to anyone who wishes to review thousands of CUSIPs. I am willing to bet that not one of the Congressmen who wants to "audit" the Fed has ever looked at them.
It is important in looking at the Fed's balance sheet size to examine the liability side as well as the asset side. Currency in circulation is one of those liabilities, and it is approaching $1.5 trillion. It is growing every day and more than half of US dollar currency is estimated to circulate outside of the United States. Hundred-dollar bill usage grows at a rate much faster than twenty-dollar bill usage. Twenties grow at roughly the rate of the nominal US economy, as one would expect. Hundreds grow faster, which suggests that they are a worldwide store of value and see deep usage in underground or illegal transactions. As other geographies (India, Eurozone) restrict their larger bill usage, the use of US C-notes seems to be accelerating. All this is occurring in an age of electronic payments growth, so one can actually derive some intuitive conclusions about the US dollar.
Remember that America is getting a free ride on this $1.5 trillion in currency. We print it at negligible cost. The world holds it and uses it. The US Treasury pays the interest to the Fed, which deducts its expenses and then pays the remaining interest back to the Treasury. That is how the currency portion of the Fed's balance sheet works. Its size is rising by about $100 billion a year and may be accelerating.
So by doing nothing but standing pat, the Fed is actually allowing its monetary policy to "tighten" with the internal transfer of liability from excess reserves to the currency component. We see that process gradually at work as the balance of OER slowly declines while the balance of currency in circulation rises. WARNING: Any shock that severely injures the valuation or perception of value of the US dollar carries with it the risk of flight from the dollar and subsequent large rises in interest rates. When Trump and company try to "talk down" the dollar, they pose a threat to our financial system if the markets take them seriously. So far that has not occurred, because markets are ignoring tweets about currency and are focused on the economic underpinnings of the foreign exchange markets and the real sources of US dollar strength.
Lastly, let's examine the composition of the assets held by the Fed. Here the issue can be summarized in a calculation of the duration of the entire holdings. Prior to the financial crisis, the Fed held an average duration of about 2. Think of it as an average of a two-year maturity, although duration is really more than just a maturity average as used in bond management circles. During the financial crisis and its aftermath, the Fed took duration up to 6. So it enlarged its balance sheet while concurrently lengthening the average maturity of the holdings.
When the Fed lengthens that duration, it withdraws it from the market. When the Fed shortens that duration, it puts it back into the market. We can see that longer-term and intermediate-term interest rates actually react to the Fed's changing the duration of its holdings. Recently the Fed has been lengthening duration for a variety of reasons, and the effect is to stop the rise in Treasury note and bond yields. Thus the market expects higher short-term interest rates, but the longer-term bond structure is responding to the Fed's changes in duration of holdings. Hence the yield curve (or term structure, technically) is actually flattening.
Let's sum this up.
The Fed has three instruments in its tool kit. First, it can raise or lower the short-term rate. Currently, the expectation is for two hikes in 2017. Next, it can reduce or increase the size of its balance sheet. Currently the expectation is for no change in 2017. Lastly, it can alter the composition of its balance sheet and move the duration of its holdings from longer to shorter or vice versa.
Here is a big unknown. The Fed would like to move away from holding mortgages and get back to holding only Treasury bills, notes and bonds. But doing so might impact mortgage interest rates and therefore slow down the growth of the housing market. Meanwhile, housing has recovered a great deal and there are even signs of housing bubbles in some places in the country. Does the Fed add to pressure on housing finance now, or wait? Is it seeding the next financial crisis by waiting, or is there still plenty of room before a construction or housing bubble develops?
Like issues of demographic change and the prognosis for swimming lessons, this is a profound question with no clear answer. What we do know is that balance sheet composition is little observed by the TV pundits but has a large impact on financial markets and bonds in particular. That is why we look at it every day. We expect only a modest upward movement in the longer- and intermediate-term interest rates. Short rates seem to be heading higher at a faster pace than longer rates are. We use a number of techniques to estimate them.
Perhaps we can think of the 10-year Treasury yield at 2.8% to 3% within a year as a guideline, but that is only a guess. We again saw some 4% tax-free bonds last week and bought some. They look cheap to us. No matter if the top tax bracket will be 33% or 35% or something else near it, the need for tax-free finance to rebuild the infrastructure of the United States is rooted in the 90,000 municipal bond issuers that range from the State of California as the largest entity to a fire district somewhere that buys only one fire truck every 20 years. We believe that the Muni sector is "safe" from attack by this Congress and has the stated support of President Trump. If those assumptions are correct, a 4% tax-free, high-grade municipal bond is a bargain and should be bought and held rather than sold and abandoned.