Barron’s – July Jobs Report: Better Than Expected, Better Than Feared

July Jobs Report: Better Than Expected, Better Than Feared

Excerpt from Barron’s – August 07, 2020

Cumberland Advisors Market Commentary by William "Bill" Witherell, Ph.D.

A portion of William Witherell, Ph.D.’s commentary, Why Investors Are Looking at Taiwan, was incorporated into Barron’s collective piece, “July Jobs Report: Better Than Expected, Better Than Feared“.

This commentary was issued recently by money managers, research firms, and market newsletter writers and has been edited by Barron’s.

Taiwan’s Prospects Brighten

Cumberland Advisors Market Commentary

Cumberland Advisors
Aug. 5: The Taiwanese economy is benefiting from both its success so far in combating the coronavirus and a $35.9 billion government stimulus program to help offset the headwind from the 4.9% decline projected for the global economy. Consumers started in July to spend government-issued vouchers for consumer goods and tourism, and several weeks ago the government tabled a second supplementary budget for 2020 of $7.13 billion to boost sectors hit by the pandemic. More important than these measures has been the resumption of strong demand for Taiwan’s high-quality telecommunications exports, helped by people around the globe working from home.

Taiwan’s manufacturing downturn in April and May eased in June, with the IHS Markit Taiwan Manufacturing PMI [purchasing managers index] rising to 46.2 from 41.9 in May. In July, the PMI moved into expansion territory at 50.6 with output stabilizing. Supply chains are still under pressure and employment continued to decline. Tourism and aviation have been hard hit….

Looking beyond 2020, Taiwan is well-situated to take advantage of the projected recovery of the global economy and continued outperformance of the technology sector. Its most important export is semiconductors, an industry key to the accelerating development of 5G technology. China, Taiwan’s most important export market, is expected to expand strongly next year.

Taiwan’s stock market has done better than most national markets this year. The iShares MSCI Taiwan ETF (EWR) has recovered from a sharp drop in March and is now up 9.8% year-to-date. In comparison, the iShares MSCI ACWI ex US ETF (ACWX) is still down 6.3%, and the advanced-country ex-US iShares MSCI EAFE ETF (EFA) is down 8.4%. The outperformance of EWT reflects the 54% weight of technology stocks in the ETF, with Taiwan Semiconductor Manufacturing (TSM) accounting for 23.3%.

Read the full collection of commentaries that make up this -article at Barron’s (Paywall): https://www.barrons.com/articles/july-jobs-report-better-than-expected-better-than-feared-51596843004


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Barron’s – The Unemployment Rate Is “Grossly” Understated. Here’s Why

The Unemployment Rate Is “Grossly” Understated. Here’s Why.

Excerpt from Barron’s – July 02, 2020

Cumberland Advisors John Mousseau

A portion of John Mousseau, CFA’s commentary, The Muni Selloff That Was, was incorporated into Barron’s editorial piece, “The Unemployment Rate Is ‘Grossly’ Understated. Here’s Why.

July 1: The infrastructure bill being considered by Congress contains two pluses for the muni market. The first is a resumption of the Build America Bonds program. This program enjoyed great success during the last recession, with the issuance program lasting from April 2009 through December 2010. It allowed issuers to issue bonds in the taxable bond market with a federal subsidy on the interest payments. The issues had to be for new projects, which was the stimulus part of the program. The resumed program may not have the same 35% subsidy that the original had, but rather may hard-code the subsidy at a lower level. Sequestrations at the federal level caused that original subsidy to go from 35% down to the mid-20% levels over time.

Another positive aspect in the infrastructure program is the return of advance refundings in the tax-free bond market. This practice was removed by the 2017 tax bill, but had been a way for municipalities to save money by refunding older higher-coupon bonds to their first call date. Anything that allows municipalities to lower their cost of future funding is a very big positive, in our opinion, as we move forward from the pandemic.

John R. Mousseau

Read the full article at Barron’s:  https://www.barrons.com/articles/the-unemployment-rate-for-june-is-grossly-understated-51593732640


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Barron’s – Wave Of COVID-19 Bankruptcies Poses Next Threat To US Economy

Wave Of COVID-19 Bankruptcies Poses Next Threat To US Economy

Excerpt from Barron’s (AFP News) – May 13, 2020
By John Biers

Cumberland-Advisors-David-Kotok-In-The-News

Larger companies have generally survived the initial blow from the coronavirus crisis, but still face existential challenges to get through what will probably be a long and grinding recovery.

Since COVID-19 shuttered much of the global economy, airlines, major retail chains, oil companies and other hard-hit businesses have been able to tap bank facilities and public debt markets for the funds they need to keep paying the bills and stay afloat.

The US Congress moved with remarkable speed to approve rescue measures for small businesses, large industries and workers, amounting to nearly $3 trillion.

But that infusion simply “bought time… it postponed” bankruptcies, David Kotok, cofounder of Cumberland Advisors, said of the massive federal push to support the economy.

Kotok — who thinks it will take around five years for the US economy to fully recover — expects casualties in other sectors, including travel, leisure, real estate, energy and “more that haven’t surfaced yet,” he told AFP this week.

Read the full article at Barron’s:  https://www.barrons.com/news/wave-of-covid-19-bankruptcies-poses-next-threat-to-us-economy-01589419806


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Cumberland Advisors Market Commentary – McConnell as Meredith Whitney

Senate Majority Leader McConnell yesterday was reported by Bloomberg News as saying that he “would certainly be in favor of allowing states to use the bankruptcy route” rather than giving them a Federal bailout. This reminded us of 2010 when Meredith Whitney, a noted bank analyst, predicted that there would be hundreds of billions of dollars of municipal defaults in 2011. She caused lots of market damage and outflows from municipal bond funds before sanity resumed and yields moved lower than they had been before she made her remarks. The Senator is trying to take a page from her playbook.

Market Commentary - Cumberland Advisors -McConnell as Meredith Whitney (Mousseau)

Cumberland wonders what the majority leader had in mind, in that his statement is at best disingenuous and at worst inflammatory at a time when both houses of Congress, the administration, and the Federal Reserve are all engaged in the business of helping all parts of the economy get through the economic downturn caused by Covid-19.

We did not notice any market reaction on Wednesday April 22, in the wake of McConnell’s statement, apart from a drop in price that was consistent with the drop in US Treasuries. This doesn’t mean that he cannot cause damage with ill-considered remarks.

There are also two legal problems with McConnell’s position. First, it is not possible for states to declare bankruptcy under current law. This means that laws would have to be changed. That is unlikely given the current makeup of Congress, especially when they are concentrated on getting the economy over the hump of the virus.
Secondly, to meet conditions of insolvency, states would have to prove they have exhausted all other means to satisfy debts. Those would include reducing their workforce, selling state-owned property, etc. In other words, the states could not prove they were insolvent.

Given the fact that the Treasury has committed to helping the municipal bond market by a purchase program and that the Federal Reserve has committed to buying notes out to two years issued by states, counties, and cities, the Senator’s remarks seem particularly counterproductive, given the need to restore economic stability to individuals, private businesses, and state and local governments.

If the muni market had any substantial sell-off based on these irresponsible remarks, it would be yet another opportunity to buy longer paper at extremely attractive yields. We will keep our readers informed of developments.

John R. Mousseau, CFA
President, Chief Executive Officer & Director of Fixed Income
Email | Bio


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Cumberland Advisors Market Commentary – The Muni Meltdown Timeline (and the Opportunity It Presents)

The Municipal Bond Market has suffered one of the most dramatic back-offs it has ever seen; and it was accomplished in about nine business days. The rise in yields has been dramatic and fierce and had lots of elements to it. This is a quick synopsis of some of the muni meltdown.

CA-Market-Commentary-The Muni Meltdown Timeline (and the Opportunity It Presents)

As of Monday March 9th, closing AAA yields for the muni market from Friday March 6th were as follows.

CA-Market-Commentary-The-Muni-Meltdown-Timeline-and-the-Opportunity-It-Presents

Here is the closing from March 19th. Clearly the muni/treasury ratios became grossly distorted, particularly on the short end, and yields on things other than AAA bonds were even cheaper.

CA-Market-Commentary-The-Muni-Meltdown-Timeline-and-the-Opportunity-It-Presents

As we all walked in the door on Monday morning, Mar 9th, 30-year US Treasury prices were up 9 points, and bond yields were down below 1 percent.

 

GIP 30-Year Yield from March 9


The culprit was oil prices, which fell as the emerging coronavirus pandemic slowed worldwide growth and reduced the demand for oil. We know that Saudi Arabia was aggressively selling oil and buying US Treasury bonds as a safe haven.

WTI Spot Oil from March with Emphasis on March 7–10


Tuesday March 10th

The meltup of Treasury prices had a terrible effect on most Wall Street dealers who could no longer hedge positions. Those kinds of movements meant that dealers could lose huge sums on even relatively small positions if they hedged. The result of that is that dealers pulled in their bids for corporate and municipal bonds or just gave throw away bids or no bids.

The next culprits are the bond evaluation services that price bonds daily for custodians, brokerage firms, mutual funds, private account managers, etc. The services use only the small proportion of the actual bonds that trade, plus dealer quotes, to construct a matrix of pricing based on coupons, maturities, ratings, call features etc. So, prices are essentially extrapolated from the few bonds that have traded, along with dealer quotes. With bids, dealer quotes, and industry scales being pulled back or non-existent, the evaluation services essentially took a meat-ax to previous prices. After the 2008–09 market crash, evaluation services took a lot of heat from regulatory agencies for keeping evaluations too high on bonds in general and on high-yield bonds in particular. So now they take the opposite approach and take the flamethrower to prices.

Bond Funds

Bond funds have had an enormous growth in 2019.

CA-Market-Commentary-The-Muni-Meltdown-Timeline-and-the-Opportunity-It-Presents


The upper chart shows the bond inflows and outflows over the past dozen years. Years with big inflows push markets higher, and years with big outflows have the opposite effect. The one thing we do know is that huge inflows like the ones we saw in 2019 (and other years) are the kindling for market meltdowns – as we have seen in 2008 (post-Lehman Brothers bankruptcy), 2010 (Meredith Whitney credit scare), 2013 (Taper Tantrum,) and 2016 (Trump election). The mechanics of all of these bond fund selloffs are similar to others. There is an initial drop in NAV (Net Asset Value), which begets redemptions. The redemptions force bond sales into a declining market, pushing prices down, which in turn lowers NAVs further, which forces yet more sales, and so on, in a negative feedback loop for bond fund investors.

The bottom chart shows the hemorrhaging of the municipal bond fund over the last 2-week period, from March 9th to March 20th, and has continued this week but to a lesser extent.

Effect on Muni Yields

It was nothing but a straight shot up across the board.

US General Obligation BBMY Index

 

The jump in yields was across the board and was not limited to the long end. We have seen that firsthand here at Cumberland, as 3- to 4-year maturity bonds were jumping just as long bonds did. You can see that there is some recovery this week. The other chart shows both the long Treasury yield as well as the Bond Buyer 40 (long-maturity bonds) yield. Earlier this year we had seen long-maturity muni yields move almost to Treasury yields by virtue of the demand fueled by the tax bill of 2017. That tax bill took away the federal deduction for state income taxes and local property taxes and left tax-free munis as one of the only ways to actually shelter income. This connection came apart violently as the bond funds unraveled.

What Is the Outlook?

Muni Feast or Famine

Performance of Muni Bond Market since 2006


Here is a chart we call “Muni Feast or Famine,” showing the muni-outflow crisis of the past dozen years. One similar pattern is that the upheaval in yields is sharp in all cases. The repair tends to be more gradual, but the important thing is that yields DO repair. We expect this to happen again as we start to get stability in markets.

What’s the Impact on Municipal Credit?

Clearly, there are stresses on municipal credit across the board. The essentiality of services looks different through the prism of the COVID-19. Rapid transit-, airport-, and subway-backed bonds will all see thinner debt-service coverage. State and local governments will also face stresses. Local property-tax-based bonds tend to hold up longer since property taxes are already paid and they are stable. Bonds backed by income taxes clearly will be more volatile from a debt-service-coverage standpoint. Will debt service coverage become thinner? Absolutely. Will there be rating downgrades on bonds? Certainly we expect to see some. Do we expect to see massive defaults? No. First, the economy was in very good shape heading into the COVID-19 event. Second, we expect the economy to be back at work within a couple months. And we expect the pent-up demand to be ENORMOUS.

There may be SOME interruptions of debt service on some credits. We would also expect to see resumption of debt service as soon as the entities are functioning again. In the worst economic period in this country, the Great Depression, about 1700 municipal entities actually stopped payment on their debt. All but a handful resumed payments and paid off debt in arrears. That is because of the monopolistic powers of municipalities and the essentiality of the services they provide.

What is Cumberland Doing?

We are trying to add longer bonds to the portfolio for the first time since 2018. A 3.5% to 4% yield on longer tax-free bonds represents a 5.5% to 6.35% taxable equivalent yield at today’s tax rates. This yield compares to the 30-year Treasury bond, which stands today at 1.35%. We think that, over time, Treasury yields will rise as both record monetary and fiscal stimulus hit the economy – and as yields on instruments other than Treasuries begin to come down.

John R. Mousseau, CFA
President, Chief Executive Officer & Director of Fixed Income
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Barron’s – Worried About a Bear Market? Bonds Pose More Danger Than Stocks.

Worried About a Bear Market? Bonds Pose More Danger Than Stocks.

Excerpt from Barron’s – Nov. 22, 2019
By Randall W. Forsyth

Cumberland Advisors John Mousseau

Andrew Bary contended that Treasury bonds are now riskier than stocks in this space a few months ago. Moreover, given their low yields, which don’t have much room to fall further, bonds are unlikely to provide as strong a hedge to stock-market declines as in past cycles, argues Adam Levine, investment director for pensions at Aberdeen Standard Investments.

That doesn’t mean there is no place for bonds to hedge a portfolio—only that the bonds used for this purpose should be municipals, which also could provide some protection against higher taxes should Elizabeth Warren become the next president. That’s the view of John R. Mousseau, president, CEO, and director of fixed income at Cumberland Advisors.

In addition to her proposal for the ultrarich to kick in “two cents” in a wealth tax, the Massachusetts senator has called for higher marginal income-tax rates. What the top rate, now 37%, would be depends as much on the makeup of Congress as on who wins the White House. But Mousseau expects that it would be higher than the 39.6% under President Barack Obama. He also notes that there’s already a 3.8% Medicare tax on investment income for families whose yearly modified adjusted gross income exceeds $250,000.

All of which would make the tax-exempt income from munis more valuable, and thus boost these bonds’ prices.

Read the full article with subscription (paywall) at: https://www.barrons.com/articles/worried-about-a-bear-market-bonds-pose-more-danger-than-stocks-51574441732


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Cumberland Advisors Market Commentary – The Bond Conundrum and How to Manage

The past couple of weeks have been breathtaking for bond investors and observers of the bond market. The yield on the 30-year Treasury bond is now at a record low – it dipped under 2% this week – and the 10-year Treasury is not far off its record low of 1.36% set in July 2016 – the yield now sits at 1.53%. With a little more than two weeks gone in August, we have seen the 10-year drop 47 basis points and the 30-year 53 basis points. This is more movement in two weeks than we sometimes see in six months.

 

There are many crosscurrents here. Most pundits are using the inversion of the yield curve as a forecast of a slowdown. But as we have noted in other pieces, economic slowdowns are far from synchronous with inversions. Growth continued for a year and a half after the yield curve inverted in 2006.

Looking at recent economic data, it’s pretty hard to find the slowdown:

– Retail sales advanced 0.7% month-over-month in July, versus an expectation of 0.3%.

– The Empire Manufacturing Index (New York survey of business conditions) advanced 4.8% versus an expectation of 2.0%.

– Core CPI is 2.2 % over the trailing 12-month level – right where it was at the end of December when the 10-year bond yield stood at 2.685% and the 30-year bond yield was 3.01%.

– The S&P 500 and the Dow Jones are still up double digits this year – even after this week’s turmoil.

– Second-quarter non-farm productivity is at 2.3% vs. a 1.4% expectation.

This does not look like an economy that is rolling over. Nor is it.

This is a bond market that has been buffeted by a number of factors that are not US-related.

Europe is mired in negative interest rates. The wisdom of having negative interest is strongly debated. One thing that is pretty clear to us is that negative rates have not helped the European banking system, and negative rates here do not help US banks, either – witness how poorly financials have done since the Federal Reserve changed its tune towards the end of last year.

The slowdown in China has pushed the yuan lower, and China’s growth rate has dropped. This has contributed to the rush into Treasuries. But we think there may be more playing out here, and it is symbolized by the protests in Hong Kong in recent weeks. Coming on top of the slowdown in Mainland China, the protests may herald the beginning of new freedom movements that the Chinese government will struggle to contend with.

How to manage bond assets
We continue to manage Cumberland total-return bond assets in a barbell method, accenting both shorter-term securities for liquidity and longer-term bonds to lock in yields, with what have been non-Treasury securities in the taxable world and longer tax-free bonds in munis. Indeed, with the fast rush down in Treasury yields, longer-dated munis, though at historical lows, offer value when you can get 3% higher grade in a world where long Treasuries are at 2%. We will take our chances with 160% yield ratios, knowing that defensiveness is built into the cheapness. The front end of the muni curve is VERY expensive relative to Treasuries, so even with a barbell and very low nominal yields, it’s been prudent to have exposure to the longer end of the market.The barbell strategy works less well when the Fed is at the end of a hiking cycle. We don’t believe the Fed is done yet: This is a pause in the Fed’s addressing the US economy. For all the change in talk from the Fed’s being on autopilot to now being data-dependent, the Fed has raised the fed funds target by 25 basis points in December and lowered it by 25 basis points last meeting; so from a fed funds target standpoint we are where we were last fall.

 

Equity markets are decently higher, and our economy continues to improve, yet the bond market has seen yields come down dramatically, in a manner that doesn’t square with US data but is more sympathetic towards the slower growth in Europe and China.

The trade war and concerns about slow growth notwithstanding, the US economy continues to do well. Our thoughts are that this race to the bottom in yields will slowly give way to a recognition that the US economy is on firm ground; the force of higher wages will push inflation higher; and the Fed will resume – albeit slowly – addressing the US economy. This is why Chairman Powell gave the markets a rate cut of only 25 bps last meeting though the markets were clamoring for 50.

Bond market yields here are high versus those in Europe, and that will keep a lid on things for a while. But the rush down has been overdone, in our opinion. My colleague David Kotok often likes to quote Herbert Stein, former chairman of the Council of Economic Advisers under Presidents Nixon and Ford. Stein’s commonsense “law” was that “If something cannot go on forever, it will stop.” We feel that’s true with long bond yields. The ride down in yields has helped portfolios. But backups can hurt, which is why we continue to get more defensive at the margin. The barbell is still in place.

John R. Mousseau, CFA
President, Chief Executive Officer & Director of Fixed Income
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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4Q2018 Review: Munis Turn It Around

Muni yields rose in the first six weeks of this quarter – mostly in sympathy with US Treasuries (UST). We saw the 10-year and 30-year Treasury bonds rise 20 and 25 basis points respectively. Since early November, AAA muni yields (AAA) have dropped across the board, and the 10-year Treasury yield has fallen a whopping 45 basis points in a matter of seven weeks.

 

The consternation and volatility in the stock market are the main reasons for yields doing a U-turn.

Some of the other themes affecting muni yields we discussed earlier this month:

(*) The housing market slowdown. Price gains have continued to slow for seven months in a row; and a number of Northeastern states and other previously “hot” markets have seen declines, especially at the higher end of the price range. This falloff is due to a combination of higher mortgage rates earlier this fall plus the specter of higher real estate taxes because of the lack of deductibility in the new tax bill.

(*) Concern about the rising level of debt and rising government debt service costs (see our piece “November Bond Market Bounce” from December 4thhttp://www.cumber.com/the-november-bond-market-bounce/).

(*) A general slowdown reflected by the price of oil. See graph below:

West Texas Crude per Barrel

(Source: Bloomberg)

 

The freefall in oil suggests that other prices may also be falling, so the combination of HIGHER yields earlier in November and stable-to-falling core CPI certainly made REAL yields seem much more attractive this fall.Now that yields have fallen, let’s survey the landscape.

37% Taxable Equivalent
(Source: Bloomberg)

The above graph shows the current muni AA curve and the Treasury yield curve. The curves demonstrate why we have used a barbell strategy, particularly on the tax-free side, where longer muni yields are CHEAPER than Treasuries yields. We believe those high yield ratios on the longer-maturity spectrum eventually go back to 100% or under – this outcome would be consistent with other Federal Reserve hiking cycles. For spread purposes we have also included a AA corporate bond yield curve and created a taxable-equivalent muni yield curve using the current top tax rate of 37%. This comparison demonstrates the advantage of munis over Treasuries for any level of taxpayer and the additional advantage of tax-free munis over corporates for high-tax payers, in the five-year tenor and beyond. The much lower default experience of munis versus corporates simply stretches this advantage.

The Federal Reserve last week raised the fed funds target yield range ¼% to 2.25%–2.5%.

The Fed also made mention of two possible increases next year and did so with less flexibility in the language, which helped to spook the equity market after the announcement last Wednesday. Our thoughts are that if core inflation remains where it has been, at 2.0–2.25%, and if there are more Fed hikes next year, the Fed will finally have gotten Fed funds to a positive spread over core inflation – where it has not been for 10 years. That would appear to be a good place for the Fed to pause. And as we get to that pause, we will begin to pick up the pace of moving very-low-duration assets out somewhat further on the yield curve to lock in rates, as shorter to intermediate rates most likely slowly work their way down.

Happy New Year to all our readers!

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
Email | Bio

Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Yogi Berra, the Fed’s Balance Sheet, and Liquidity

The story is that the Fed’s quantitative easing program injected large amounts of liquidity into financial markets, causing bond rates to fall and stock prices to accelerate. Consequently, the argument goes that, the shrinking of the Fed’s balance sheet through maturity runoff will cause bond rates to increase and, presumably, stock prices to retreat. But what are the essential mechanics of Federal Reserve asset purchases, and how might they affect liquidity in the market?

Market Commentary - Cumberland Advisors - Yogi Berra, the Fed’s Balance Sheet, and Liquidity - The Fed’s Quantitative Easing Program

When the Federal Reserve began its quantitative easing program, it purchased Treasury obligations in the marketplace through the primary dealer facility and paid for those securities by writing up the reserve accounts of the sellers’ banks, simultaneously increasing the sellers’ bank deposits. Effectively, the Fed created money in the purchase transactions, but as far as the public’s asset position is concerned, the purchases substituted demand liabilities for Treasury obligations. The sellers received deposits; their banks’ reserves increased by the same amount; and the sellers’ Treasury holdings were reduced.

From the perspective of the consolidated government balance, Treasuries were removed from the public; and on-demand Fed liabilities were substituted in their place, bearing a lower interest cost than the Treasuries they replaced. One form of very liquid asset (Treasury securities) was replaced by another (reserve deposits at the Fed, with corresponding deposits held by the public in its bank). The Fed’s purchasing Treasuries bid up bond prices and put downward pressure on interest rates.

One of the main effects of QE was to redistribute the ownership both of Treasuries and of bank reserves and their associated deposits. We can’t quantify or identify the sellers of securities, but we do know that a large portion of the excess reserves associated with those purchases ended up with US affiliates and subsidiaries of foreign banks. Presumably sellers were institutional investors, hedge funds, and money market mutual funds but could also include individuals.

Foreign banks’ share of reserves peaked at about 50% in the fall of 2014 and is presently about 35%. Those excess reserves in US and foreign subsidiaries were potentially available to generate a large increase in bank loans and the money supply. A dollar of excess reserves would support an estimated $20 increase in credit and the money supply if it were converted to required reserves as part of the bank credit creation process. But this obviously didn’t happen. Indeed, the ratio of bank loans and leases to bank reserves in Oct 2008 was 26.0, whereas that same ratio as of October 31, 2018, was only 5.6; so bank credit did not expand nearly to the same degree that bank reserves expanded. Interestingly, despite the series of QE experiments, in September 2014 a dollar of reserves was associated with only 2.9 dollars of bank loans and leases right before the Fed stopped adding to its portfolio in October 2014.

In short, the degree of stimulus, as far as bank lending was concerned, was muted. In fairness, business investment demand for credit was not great. The NFIB (National Federation of Independent Businesses) reported in March 2014 that 53% of its respondents indicated no need for a loan. Only 2% reported that financing was a major problem; and only 30% reported borrowing on a regular basis, a near-record low. One of the reasons was pessimism about investment and expansion prospects. The report stated that “The small business sector remains in maintenance mode, no expansion beyond a few firm starts in response to regional population growth.”

In December 2016 the Fed began a series of 25 bp increases in its target rate for federal funds, and in October of 2017 it began the process of shrinking its balance sheet by letting assets mature and run off naturally. As of December 19, 2018, the Fed’s balance sheet stood at $4.084 trillion, down from its peak of $4.5 trillion on October 14, 2015. Critics have complained that the balance sheet shrinkage process has contributed to a liquidity shortage; but they have not defined exactly what the nature of liquidity problem is, who is or is not constrained, and how that constraint is manifested.

The size of the Fed’s balance sheet is determined by the outstanding reserve balances (both required and excess reserves), the volume of currency in circulation (which is of course the most liquid of assets), the volume of funds in the Treasury’s account with the Fed, the volume of reverse repo transactions outstanding, deposits in foreign official accounts, and of course capital. The only way the Fed’s balance sheet can shrink in size is if outstanding currency declines, bank loans shrink, Treasury or other official balances decline, or assets are allowed to mature, in which case the Fed’s liability to the Treasury declines, offsetting the maturing assets.

Several factors have actually put upward pressure on the size of the Fed’s balance sheet since October 2014, including an increase of $330 billion in Treasury balances, an increase of $314 billion in added currency outstanding, and an increase of $82 million in foreign official and other deposits. This increase was offset by a decline of $1.07 trillion in bank reserves.

How can we explain the drop in reserves if other factors seem to be pointing to an increase in the balance sheet? The source of Treasury balances is tax revenues that are deposited in Treasury tax and loan accounts at commercial banks. When the Treasury transfers funds from those accounts, the reserve accounts at the affected commercial banks are drawn down. So, in fact, the increase in the Fed’s liability to the Treasury is offset by a decrease in the reserves of the tax and loan account banks. Similarly, when bank customers withdraw funds in the form of currency, currency demand increases. That currency is obtained from the Fed in exchange for a reduction in banks’ reserve accounts. So again, rather than actually increasing the size of the Fed’s balance sheet, the composition of its liabilities is changed – currency outstanding is increased, and bank reserves are decreased. Of the $1.07 trillion decline in bank reserves, there was a corresponding increase in Federal Reserve liabilities to the Treasury and the increase in currency outstanding together accounted for $653 billion of the decline. The remainder is largely associated with the runoff and shrinkage of the Fed’s asset holdings.

It is important to note that when the Fed engages in what it calls reverse repo transactions, the securities sold remain on the Fed’s balance sheet. Bank reserves are temporarily reduced, but corresponding liabilities to banks under the account “reverse repurchase agreements” are increased. The composition of Fed liabilities changes but the volume does not. When the repo transaction is reversed, bank reserves go up and “reverse repurchase agreements” are reduced.

The bottom line is that the apparent decline in bank reserves, far in excess of the change in the decline of the Federal Reserve’s balance sheet, is offset by changes in the other factors absorbing reserve funds, which simply represent a reallocation of the ownership of Federal Reserve liabilities. In the case of the Treasury, it accumulates funds to spend on entitlements, purchases, salaries, etc., which when paid reduce Treasury balances but reappear as an offsetting increase in bank reserves when the funds are deposited with the banking system.

As for the notion that the Fed’s reducing its balance sheet holdings of Treasuries contributes to a so-called liquidity problem, again the mechanics are not clear, especially when we consider what has happened to Treasury debt issuance. To be sure, the Fed’s portfolio of Treasuries fell by $213 billion since the decision to let maturing issues run off, while MBS holdings declined by $132 billion. Treasury debt held by the public increased by $956 billion through the end of the third quarter of 2018 as the Fed’s portfolio began to run off. But the actual net issuance of Treasury debt is even greater than that because the Fed’s portfolio is treated from an accounting perspective as part of the public’s ownership of the debt. Since the Fed’s ownership declined by $213 billion, the Treasury securities owned by the public, not including the Fed, increased by $1.169 trillion. This issuance dwarfs the rundown in the Fed’s portfolio and its potential impacts on securities markets. The decrease in the Fed’s marginal demand for Treasuries is far offset by the increase in supply. That supply, depending upon the maturity structure of the Treasury’s refunding, puts downward pressure on rates across the Treasury curve relative to the impact that the FOMC’s rate increases have had on short-term rates. This issuance pattern probably is the major explanation for the overall upward shift in the yield curve that we have experienced since the Fed began letting its portfolio run off.

In the meanwhile, more liquid assets are now in the marketplace as a result of the increase in currency outstanding and the increased supply of outstanding Treasuries, and banks still have a huge volume of liquid reserves. Note that, like cash and bank reserves, Treasuries satisfy the banking regulatory agencies’ liquidity requirements, so it isn’t clear what the nature of the claimed liquidity problem is or who is experiencing problems.

Liquid assets are supposedly those that can be sold with little or no impact on their price. But we must be mindful that in order for an asset other than cash or deposits at the Fed to be liquid, there must be a buyer on the other side. If there is no buyer, then assets that were thought to be liquid suddenly are not. Indeed, the Fed in essence became the buyer-of-last-resort during the financial crisis. If Yogi Berra were asked to define liquidity, he might have said the following: “Liquidity is what you have when you don’t need it; but when you need it, you don’t have it.”

(1) The following discussion of asset purchases and sales omits much of the institutional detail and mechanics behind the transactions and focuses instead on the key results.

(2) We have noted before that the Treasury pays the Fed interest on its Treasury holdings, and the Fed pays interest on reserves out of those proceeds (as well as covering its other operating costs) and remits the remainder back to the Treasury. The effect is that the Treasury’s financing cost on the Fed’s Treasury portfolio is the cost of interest on reserves and not the interest payments on the Treasuries themselves.

(3) Foreigners and foreign institutions own about 50% of the outstanding debt held by the public.

(4) Author’s estimates

(5) Source: FRED FRB St Louis

(6) See http://www.nfib.com/Portals/0/PDF/sbet/sbet201403.pdf

(7) It is important to note that when the Fed engages in what it calls its reverse repo transactions, the securities sold remain on the Fed’s balance sheet, and bank reserves are temporarily reduced, but liabilities to banks under reverse repos are increased. The composition of Fed liabilities changes, but the volume does not. When the repo transaction is reversed, bank reserves go up.




Report from Leen’s Lodge

We start September with a cash reserve in our US equity ETF portfolios. Some details of our thinking follow.

We wish our readers a Happy Post-Labor Day return to confront the 9-week run-up to the midterms. Other risk items include a possible government shutdown (not likely, in our view) and the effects of the continuing trade war.

The US-EU truce persists. We expect a deal to get done with Canada. The interests of all sides are served if there is not further ratcheting up. Mexico is done but, Trump tweets notwithstanding, it is questionable whether much has been accomplished.

Nothing has been accomplished with China, either. The response in Asia to US moves on trade seems to be entirely opposite to that predicted by Trump trade advisor Peter Navarro. In our view, risk is rising for US interests in Asia.

Opinions on US-China outcomes varied at our 27-person Labor Day gathering at Leen’s Lodge. Forecasts were as varied as the political views of the participants, who ranged from hard-core Trump supporters to Sanders socialists. All discussions were civil.

Some bond folks await the mid-September change in the taxation of corporate payments to defined-benefit pension plans that are underfunded. Most folks at Leen’s believed the Treasury yield curve will steepen after this one-time flattening pressure subsides. We will learn more from the results of the October Treasury auctions.

We benefited from three days of extensive and detailed conversation about central banking, with two former practitioners present. The investment bankers and commercial bankers and deal-analysis folks chimed in. Add a few economists and some money managers, and things got lively.

The headcount of 27 was our largest Labor Day ever at Leen’s Lodge. The weather cooperated; the fish did, too. Leen’s new owners are upgrading the facility and have excellent hospitality skills.

On Monday our friend Chris Whalen of The Institutional Risk Analyst published his usual insightful piece on the economy and markets, but with a difference: This one originated at Leen’s Lodge and grew out of our intensive discussion of the Fed’s manipulation of the yield curve, which led us to the question, Is the United States really an AAA credit? We think you’ll appreciate Chris’s analysis, and we thank him for it. Here’s the link to his commentary: https://www.theinstitutionalriskanalyst.com/single-post/2018/09/03/View-from-the-Lake-Is-the-United-States-a-“AAA”-Credit

We will close with a link to a Bloomberg editorial about the Trump trade war. We remind readers that trade war effects are sequential shocks. They are nonlinear. There are no Z-scores.

Here is the link: https://www.bloomberg.com/view/articles/2018-06-19/trump-s-self-defeating-trade-war-with-china

David R. Kotok
Chairman and Chief Investment Officer
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