The IRA: Powell Fed Embraces Monetary Relativity

Chris Whalen quotes Bob Eisenbeis and others for his publication, The Institutional Risk Analyst, on financial and banking issues. Read this excerpt from a September 2020 edition or the full post linked below.

Cumberland Advisors Robert "Bob" Eisenbeis Ph.D. In The NewsCumberland-Advisors-Robert "Bob" Eisenbeis Ph.D. In-The-News

The idea of the FOMC deciding when average inflation targeting (AIT) has made up for periods of price deflation seems to stretch to the breaking point the elastic “necessary and proper” clause of the Constitution, which allows agencies of the federal government to take those actions required to implement the will of Congress. But the law still says “price stability.” Is it necessary for the FOMC to have AIT or merely convenient?

“The telling part of the problem with the new strategy came during the press conference,” notes Robert Eisenbeis of Cumberland Advisors, “when Chairman Powell struggled to answer several pointed questions about how long inflation would remain above 2%, how is “moderately above 2%” for inflation defined; how maximum employment is defined, why inflation above 2% didn’t show up in the SEP, and how and under what circumstances the asset purchases program might be stopped. All in all, few if any actual specifics were provided, which leaves us to wonder whether, at this time, the Committee simply hopes it can get inflation up, hopes it can achieve a 2% average rate, and hopes it can get back to full employment sometime in the future.”

Of note, the FOMC announced that it will continue its monthly asset purchases under this latest version of quantitative easing or QE. Chairman Powell, during the press conference, indicated that $80 billion would be in Treasuries across the curve and $40 billion in agency MBS, so as to support “the flow of funds to households and businesses.”


Read the full original post at the Institutional Risk Analyst site:  https://www.theinstitutionalriskanalyst.com/post/powell-fed-embraces-monetary-relativity


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Cumberland Advisors Market Commentary – 2019: Bonds Roar Back

2019 saw bond yields turn around from their climb in 2018 and move lower. Since the Federal Reserve changed their language last December to being accommodative and data-driven, we have seen yields across the board come down a lot.

2019 Bonds Roar Back

There is no question that this drop in yields was driven, in large part, by what were low or negative yields in Europe and Japan. The 10-year Treasury started the year at 2.70% and ended the year at 1.90% after making a low in early September at 1.45%.

The drop in Treasuries in the latter part of the summer was dramatic. We saw the 10-year Treasury move from a 2% yield to 1.50% in the space of two weeks as US yields moved to catch up on the downside with European and Japanese yields.

Muni yields also saw a significant drop in the year, with 10-year AAA muni yields moving from 2.28% to 1.44% and 30-year AAA munis moving from 3.02% to 2.09%. The drop in muni/Treasury yield ratios was impressive, with the 10-year yield ratio moving from 84% to 76%; but just as impressive was the 30-year muni ratio/Treasury’s moving from 100% to 88%.

What are some of the takeaways?

* The flattening Treasury yield curve – which was such a source of concern in the summer – unflattened. As we have written, we never saw the flattening curve as much of a concern, because it was accompanied by long yields falling as opposed to short-term yields being jacked up by the Fed. Indeed, the Treasury yield spread between the 2-years and 10-year has risen from a minus 5 basis points in late summer to 26 basis points currently.

* Inflation has remained steady. Core inflation began the year at 2.2%. The trailing twelve-month is 2.3% as of November. This means that the 10-year bond REAL yield went from +50 basis points to -40 basis points currently. We know that negative REAL yields generally don’t last. They didn’t last in 2016, and we don’t think they’ll last now. Election years tend to be volatile in that regard.

10yr US Treasury Yield vs Core CPI

* The muni story was impressive. Not only did ratios drop, but muni supply ended up an impressive $424 billion after 2018’s $338 billion. The increase really came from two sources. Issuers took advantage of low rates just to sell new money, locking in almost historically low long rates. But we also saw a phenomenon that wasn’t being considered in the higher interest-rate environment of 2018. That is, issuers used the taxable bond market to advance refund older higher-coupon debt, to the tune of $70 billion taxable issuance in 2019. The 2017 tax bill took away tax-exempt advance refundings. However, with the drop in rates, many issuers could issue taxable paper and refund bonds that might have had 4.5%+ original yields and 2–3 years left to call dates. The cost savings on out years more than make up for the negative interest-rate differential between taxable muni rates and Treasury rates.

* Demand continued to be voracious for munis in high-tax states such as California, New York, and New Jersey. The 2017 tax bill eliminated deductions for state income taxes and local property taxes, so there are few places other than munis from which to get a tax-free income flow. Also, bond fund inflows were dramatically higher than in 2018. We expect this demand to continue, although shorter-term tax-free yields are very expensive – look at the end of the year shorter-maturity ratios in the mid-60 percentiles!

* The terrific stock market of 2019 (S&P up 31%) bolstered municipal pensions. But the lower interest rates will hurt discounted liabilities as well as assumed returns going forward.

As we move into 2020, the negative real yields in Treasuries are causing us to play defense in bonds. That means a continuation of a barbell strategy, with some longer paper offset by shorter defensive structures. Given that the Federal Reserve cut the fed funds target three times in 2019 (the rate now sits at a target range of 1.50–1.75), we feel the Fed will play a pat hand for the most part in 2020, in part because they want to see what the effects of their rate cuts are and also because, in an ideal world, they would like to stay out of the political fracas.

Presidential election years are always interesting and usually volatile. We will keep everyone informed.

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


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Shocking surge: Municipal bonds strength based on several fluid factors

Cumberland Advisors John Mousseau

Excerpt from “The Bond Buyer”…

Shocking surge: Municipal bonds strength based on several fluid factors

By Chip Barnett
July 01 2019

With under a $1 billion of bonds and notes selling this week, municipal bond investors were looking beyond the week’s offerings — to fundamentals and performance.

So far this year, muni yields have declined to an almost shocking extent, according to George Friedlander, Managing Partner at Court Street Group.

He cites a recent report by John Mousseau, CEO of Cumberland Advisors that shows the magnitude of the decline in absolute and relative yields since the beginning of the year.

Mousseau noted that muni yields have dropped sharply when measured either using MMD or MMA benchmarks. Since the beginning of the year 10-year muni yields are down 63 basis points; 30-year muni yields are down by as much as 67 basis points; 10-year muni yields as a percentage of Treasury yields have dropped from 84% to 79% using MMD; and 93% to 90% using MMA; and 30-year yields have dropped from 100% to 90% using MMD and from 105% to 96% using MMA.

Continue reading with subscription at the Bond Buyer website: www.bondbuyer.com


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The Interview: David Kotok on GSIBs, Markets & Central Banks with Chris Whalen

My friend Chris Whalen was kind enough to use an interview he did with me in his weekly publication on financial and banking issues, The Institutional Risk Analyst. Chris has had a distinguished career, and it was a pleasure to interact with him again.

Market Commentary - Cumberland Advisors - The Interview David Kotok on GSIBs, Markets and Central Banks

This summer Chris and I are cohosting the June gathering at Leen’s Lodge in Maine. We’ve decided to invite some new participants and, for my part, to include readers who follow these conversations. If you are interested in joining us for the weekend after Father’s Day, email me your full contact information and we can see if a space is open. Spaces and guides are limited, so there are no guarantees.

I will insert the interview text below but want add a detail first. As I mention in the interview, we used SOFR to estimate a financial distortion that, we believe, exacerbated the December market selloff. We cited a 60-basis-point anomaly in pricing and a spike in certain interest rates that coincided with the stock market selloff and the widening of bond market spreads.

The direction of causality is never perfect. Coincidence isn’t proof of causation. But last December there were no other new elements that coincided. Also note how certain riskless rates were stable while others spiked. That oddity gives us high conviction in the view we articulated in our writings and in our interview with Chris.

We’re happy to discuss more in Maine and elsewhere. Here’s the full interview text with some minor edits for compliance purposes.

-David R. KotokSan Francisco | In this issue of The Institutional Risk Analyst, we feature a conversation with David Kotok, Chairman and Chief Investment Officer of Cumberland Advisors in Sarasota, Fl. David is an investment advisor, an observer of the evolving American political economy and an experienced fly fisherman. He and his colleagues at Cumberland publish commentaries on the markets and the world which may be found at www.cumber.com.


The IRA: David in your commentary last week (“Jay Powell, GSIBs, Christmas Eve Massacre”) you refer to December as a “massacre.” We concur. In fact, we are gathering more and more data that suggests our friends on the Federal Open Market Committee almost ran the proverbial ship aground in December. New issuance in the bond market went close to zero for several weeks and the flow of new home mortgages also cratered and has not yet recovered. There seems to be a lot of collateral damage here. Tell us what you see.

Kotok: I am in agreement. What I did in the commentary last week was to go through the estimates of the “global systemically important banks” or “GSIBs,” some 29 banks, and looked at the capital cost of a rule which came together in a perfect storm in December. Under the radar, except for those who looked for it, was a multi-hundreds of billions or even trillions of dollars in liquidity contraction. Why? Because the big banks pulled back from the markets at year end in compliance with the GSIB rule. A mispricing of whole segments of the so-called riskless market was triggered and resulted in a massive cost to the markets that we can estimate. Trillions of dollars in meltdown of market value were triggered because of billions in reallocations. This occurred because of the cost of a rule regarding the 29 designated large banks or GSIBs. Note that this is a rule which is totally unnecessary. Fed Chairman Jay Powell has said that he is satisfied with the capital structure of the big banks. I agree with him.

The IRA: The tightening of the REPO markets was very visible in December, long before the end of the month. Customers with collateral were shunned by the big banks, benefiting the smaller desks.

Kotok: The GSIB rule caused the big banks to step back from the market. On December 31st, the SOFR rate which is supposed to reflect a risk free overnight rate for funds was 60bp over referenced Treasury yields. The cost came because the big banks were incented to shrink, to convert assets into cash and other risk-free exposures. You can see the spike in REPO rates and the change in holdings. Any Bloomberg terminal demonstrates the visual spike. People who have expertise in the money markets saw it. You saw it. We saw it. But 99% of investors had no idea why the money markets were seizing up. They didn’t see that this is a temporary liquidity crunch that has nothing to do with default risk or credit risk. The risk is derived from the imposition of a rule, a regulatory provision called GSIB. But investors did not see that. They saw markets shifting violently and volatility spiking. They saw the spread on the credit default swaps of the United States rise by 50%. They didn’t understand that the Credit Default Swap is a hedging device used when such spikes happen.

The IRA: To add another datapoint to your analysis, in Q4 2018 the securities holdings of all US banks fell modestly, but there was a huge surge in Treasury holdings roughly equal to the runoff of the Fed’s portfolio. And there was continued erosion in certain types of deposits. This may be why Chairman Powell had to back off on further shrinkage of the Fed’s balance sheet.

Kotok: Individual banks around the world were acting rationally to protect their institutions. Can’t blame them for that. Collectively the 29 GSIBs imposed a temporary liquidity crunch on the entire system. And the result was that at one point the Treasury REPO rate shifted to a five hundred basis point spike. If riskless paper spikes in one day by hundreds of basis points, what is the cost? I computed what one basis point costs per trillion of market move in SOFR. The 29 GSIB banks represent hundreds of trillions of dollars in balance sheet and derivatives. And they wonder why the equity markets almost melted down? By the way, that may explain the bizarre December phone call that Treasury Secretary Mnuchin made to the biggest US banks. He was just “checking in to see if they were okay” According to press reports. Since the reason for his call was never fully explained, the reports of the call only worsened the market sentiment which was already based on faulty understandings.

The IRA: Agreed David. We think that the accumulation of evidence suggests that the Fed and other prudential regulators came dangerously close to running the global economy aground. This is a terrible refutation of the whole idea of “macro-prudential regulation.” Monetary policy goes one way, prudential rules go another and none of the agencies involved have any idea as to the net effect on the markets.

Kotok: Well, they sure were focused on a lighthouse or what they thought was a lighthouse but it turned out to be a pile of rocks.

The IRA: We have this strange confluence of monetary policy, where the FOMC is reversing past policy, and prudential rules. The Treasury is issuing and the Fed is now buying short-term paper again, essentially unwinding “Operation Twist.” And then, on the other hand, we see prudential policies that restrict liquidity. And nobody seems to understand what it all means for the markets or the economy. When they close the door of the Fed’s boardroom, are they focused on the markets or on the DSGE models? If we cannot rely on the numbers we see on the screens every morning to govern market risk allocations, isn’t the FOMC doing more harm than good?

Kotok: Yes. Those who are looking at DSGE models and those who are in the throes of the debate over whether the Philips curve is reliable need to answer a question. If we know that these tools are unreliable, then why are the dot plots used by the FOMC still measuring two of the main Philips Curve components? This reminds me of the General Eisenhower story about D-Day. In January 1944, Eisenhower was planning the invasion of Europe. And he asked his staff advisors for the long range weather forecast of weather for June, 1944. The experts replied that long range weather forecasts were notoriously inaccurate. But General Eisenhower’s staff insisted on a forecast because they needed it for planning purposes. We can put the Fed’s “dot plots” and long range Fed forecast models in the same category. The only thing we know about them is that they are wrong at the time they are created.

The IRA: Since we are talking about WWII history and General Eisenhower, our next book is tentatively titled “False Mandate” and goes back to the origins of the Humphrey-Hawkins law. Do you remember Rep Augustus Hawkins? He was the first African American from California in the United States Congress and co-authored the 1978 Humphrey-Hawkins Full Employment Act. Hawkins never lost an election in 58 years of public service. Rep. Maxine Waters (D-CA) inherited his seat in Congress. Speaking of long-term economic forecasts, can you tell us when the FOMC decided that zero and two are the same number when it comes to inflation? The Humphrey-Hawkins statute of 40 years ago says zero is the definition of price stability.

Kotok: Ha! May I invite a corollary? Two percent inflation means that the real value of your wealth will be cut in half in forty years. A person born today under the current Fed 2% policy who inherits $1 million at birth will have a quarter million worth of buying power remaining when they die, if they fulfill their current life expectancy. If the Fed is successful with their current policy objective, they will destroy three quarters of the real wealth of the average young person living today. Sounds rather harsh doesn’t it?

The IRA: No, you are quite right. The Humphrey-Hawkins statute says pursue full employment, then seek price stability which is defined as zero. Because of what has changed over the past forty years, the Fed staff in Washington has come up with this convoluted construction whereby zero = two. Two is really “price stability” because the system cannot tolerate deflation, which means that savers will never get a chance to buy a stock or distressed property and create future wealth. All of the bias of US monetary policy is on the side of the debtor (by using inflation as a hidden tax) and on transferring wealth from savers to debtors. Don’t we make a mockery of Thomas Piketty’s assertion that the return on wealth is greater than nominal growth?

Kotok: Precisely. Now if the Fed were to say listen, we are incapable of handling monetary policy affairs at zero. Let’s admit our frailty. And, by the way, I think this would be a fair statement. One needs only to look at the Bank of Japan and ECB to see the mess that can be created if you stay at zero long enough. And we are witnessing both the BOJ and the ECB at the point where there is zero probability of a policy change that leads to extraction. The BOJ balance sheet size is about equal to that nation’s GDP. And the assets are yielding near zero percent. Imagine a Fed balance sheet of $20 trillion size. That would be a similar metaphor. The ECB will soon roll €700 billion in TLTRO. What they must wrestle with is that if, they do not increase the amount to €900 billion or €1 trillion, then they will have done zero stimulus.

The IRA: Well, that is because they call QE stimulus. There are many people who see QE as an engine of market distortion and eventually deflation – unless it is made permanent and indefinite.

Kotok: Of course, but whatever the impact, it will be nothing if the amount is not increased. We will have neutralized an already neutered neutrality.

The IRA: Agreed. But what the FOMC has learned over the past few months is that you cannot withdraw the liquidity provided by QE without destroying the system. You can maintain neutral and have economic stagnation. But you cannot withdraw the liquidity once it is put into the system. In Europe, even the cessation of new asset purchases has put the EU economy into a tailspin. Without the constant heroin drip of QE, the enfeebled European economy has started to contract. And the US is not much better.

Kotok: Yes. But we are not as bad off as the ECB or BOJ. There is still a chance in the US to get this right. The current FOMC, in my view, has ignored Chairman Ben Bernanke’s warning, which he repeated several times, that if we shrink the balance sheet we will only be taking it back up in due time. He very politely said “why shrink it?” And no one can answer that question. There is at least discussion now of a $3.5 trillion baseline for the Fed balance sheet as a target. We both have friends in the Fed System who believe that the balance sheet should be reduced back to the pre-crisis level, but that it not going to happen. In my view that would be a horrible mistake. I would size the balance sheet at close to $4trillion target to meet all upper thresholds for required reserves, survey-based (ask the banks what they want and need) desired excess reserves , Treasury operating balances, special items and currency. That mix today requires a balance sheet size of about $3.5 to $4 trillion and will require balance sheet growth of between $100 and $200 billion a year.

The IRA: Our friends represent a more tradition view of the world, a more prudent view. But when the Treasury, which is the dog in this story, is borrowing $100 billion per month, traditional views about taking the balance sheet down to required reserves and whatever is required to accommodate Treasury issuance misses the point. Once the FOMC under Bernanke made the decision to pursue QE, there was no way to take it back. The Fed cannot ignore the reaction of the markets that we saw in December. The markets have subsumed everything. So the FOMC must obviously allow the balance sheet to grow to keep pace with Treasury debt issuance. The alternative is political suicide. The Fed’s first priority is whether the Treasury issues debt tomorrow, correct?

Kotok: Yes. We cannot afford anything that introduces a risk perception about the US Treasury’s ability to finance itself. May I add a second priority? Can the Fed grow its balance sheet so that the Treasury may enjoy $100 billion addition each and every year in seigniorage? This keeps the US banking system stable and the lender of last resort status of the Fed intact. Can we maintain the status as the least worst major reserve currency in the world and thereby finance $1 trillion in deficits every year? That is the unspoken truth. My stump speech now has four charts that focus on what a $1 trillion deficit and a four percent unemployment rate means year after year. We are less than a decade away from a $1 trillion interest bill for the United States.

The IRA: Thank you David.


The original commentary that launched this conversation can be seen here: https://www.cumber.com/cumberland-advisors-market-commentary-jay-powell-gsibs-christmas-eve-massacre/

Cumberland Advisors, USF Sarasota-Manatee and the Global Interdependence Center are pleased to invite you to our third annual Financial Literacy Day, Financial Markets and the Economy event. The date this year is Thursday, April 11, 2019 and it runs from 8:00 A.M. – 5:00 P.M. It’s only 50 bucks and includes a full interactive day of talks, panels and Q&A, plus a catered lunch.

Panel discussions will include:
* Outlook for the US Stock Market & Global Economic Outlook
* Special Session: Health, Hunger and Philanthropy
* How the World Looks in Economics and Geopolitics
* Keynote Speaker: Gretchen Morgenson, The Wall Street Journal: Senior Special Writer, Investigations Unit
* A Conversation with Susan Harper, Canada’s Consul General in Miami

Full information and cost available at: http://USFSM.edu/FinancialLiteracy

Please join us.

-David


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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The Cumberland World Series Theory of the Bond

Most investors have heard of the “Super Bowl Theory of the Dow.” This theory, first proposed by sportswriter Leonard Koppett in the 1970s (source: Wikipedia), posited that when a team from the “old” NFL (the current NFC plus the Colts, Browns, and Steelers, who joined the AFC in 1970) won the Super Bowl, the Dow Jones Industrial Average would advance in the year following the Super Bowl.

 

If a team from the AFC won the Super Bowl, the Dow would decline. Amazingly, this theory has worked out almost 80% of the time, though the February 2017 Super Bowl, won by the Patriots (AFC), did NOT accurately predict the stock market (up in 2017). The correlation, of course, is just a coincidence: There is no connection between a conference winning the Super Bowl and subsequent returns in the stock market, and thus there is no reason to think that the Super Bowl can be used to predict markets.

But we decided to have a little fun; and since it’s World Series time, we wanted to see whether there was any tie-in to how the BOND MARKET did in the calendar year following a World Series win by either the American League or National League. The easiest data to use was the 10-year US Treasury bond and its return in a calendar year. We measured TOTAL return (coupon and price) and then took away headline inflation (CPI). (By the way, we have this data in our bond models, so it was easy to deploy for a “fun” topic.) We went back to 1966 to have a similar time period to the Super Bowl.

Our results are below:

How the BOND MARKET did in the calendar year following a World Series win by either the American League or National League

What do the results tell us?Frankly, not as much as we hoped.

Some notes: We used the full calendar year AFTER the World Series. And we ignored 1995, which followed a year when there was not a World Series due to the players’ strike. In the bond market, 1995 was a big year because the market rebounded after the carnage of 1994.

In the 51 years that we measured, the American League won the World Series 27 times and the National League triumphed 23 times. The bond years following an American League winner had a positive return 15 years and a negative return 12 years. The AVERAGE bond market return following an American League winner was 2.39%. The average UP year for an American League winner was 9.12%, and the average DOWN year following an American League winner was -6.03%.

The National League numbers look a bit more promising. In the 23 years that the senior circuit won the World Series, the AVERAGE return was 3.06%, 67 basis points higher than the average American League return (remember, these are total returns, inflation-adjusted). The average POSITIVE return for the National League was 9.18%, fairly comparable to the American League’s 9.12%. But the average DOWN year for the National League was -4.88%, considerable less than the American League’s -6.03%.

At some point we may go back another fifty years to add to the study, since we have a much longer record for the World Series than we do for the Super Bowl (which started after the 1966 season).

But the results would suggest that the bond market on average does better after a National League win in the Series, with a slightly better upside number and a considerably better downside number. What does 2018 hold? Well the American League Houston Astros won the World Series last year over the Los Angeles Dodgers. But wait – the Astros were a National League team until 2013! So with this mixed history, the 10-year Treasury to date has a total return of approximately -3% through the end of the third quarter, with inflation of approximately 1.4% through the first nine months. That’s a total return through nine months (after inflation) of roughly -4.4%. If we have a flat quarter, that should suggest that a down year this year would be more like a National League return (and Houston was an National League team for all but six years of its 56-year existence). Of course the returns will change between now and the end of the year. The volatility in the equity markets, slowing housing markets in a number areas of the country, and possible worries about SALT provisions in the tax bill may start to push more assets into a bond market that has been oversold in general – particularly given that trailing headline inflation has dropped from 2.9% to 2.3% in the past three months.

As for next year, we know we fare somewhat better with the National League, but GO RED SOX!

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

Gabriel Hament
Foundations and Charitable Accounts
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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The Tale of Two Ratios: Shorter and Longer

In a year when we have seen commentators talking about the relative flatness of yield curves, we have a conundrum when we look at the US Treasury yield curve and the US muni yield curve (shown here as the Bloomberg AA general obligation yield curve).

Market Commentary - John Mousseau

Curve 1 below is from the beginning of 2017. Curve 2 is from September 2017. Curve 3 is from September of this year.

Curve 1
Source: Bloomberg

Curve 1, at the beginning of 2017, shows a very cheap muni yield curve across the board. Muni yields were at or above Treasury levels at EVERY POINT ON THE YIELD CURVE. This reflected the entire uncertainty surrounding the presidential election. There were questions as to whether we would see a tax bill and how munis would be treated, fear of a big infrastructure bill (and uncertainty over how that would affect munis), what the president would do regarding a new Fed chair, and whether Fed policy would change. All in all, it was an extraordinarily cheap moment for muni bonds. The long end was particularly cheap, as the market had undergone a selloff in the wake of the Trump election, with extreme bond-fund selling.

Curve 2
Source: Bloomberg

Curve 2 is from September of 2017. What happened? Short-term muni yields dropped. The trend really started in the first quarter when then-Chair Janet Yellen made it clear that the Fed would continue on its path of raising short-term interest rates gradually (read: not at every meeting) but would need to keep raising rates to reflect an improving economy. Thus the shorter end of the market essentially began to go lower in yield to reflect the tax structure, and the ratio moves were dramatic for paper inside of five years. Longer munis continued to exhibit cheapness of yield relative to Treasuries. We believe this was related to market knowledge that there would be a change in the tax code coming with the tax bill and to the uncertainty as to how municipal bonds would be treated under that bill. The expectation was that municipal advance refundings (which allowed municipalities to defease older, higher-coupon bonds in advance of their call dates) would be eliminated. Bond markets also expected that private-activity bonds – issued by charter schools, private universities, state housing agencies, and airports among others – would be prohibited. In the end the tax bill eliminated advance refundings but allowed private-activity bonds. The cheapness in the long end of the muni market was due to the expectation that SUPPLY would bulge at year end to beat the tax code changes, and indeed that is what happened.

Curve 3
Source: Bloomberg

Curve 3 is from this September. Two observations jump out. The long end remains absurdly cheap. One factor is some erosion of the buying base. Banks have been smaller buyers of munis because of the lower corporate rate; and individual demand for long munis has been good, but bond funds have not recouped the outflow of funds that they saw in the wake of the 2016 election. The more dramatic move has been the continued drop in ratios inside of 10 years – in some cases to lower than the break-even rate if we assume an average marginal tax rate of 25%.

One of our thoughts is that investors are expecting a possible change in the makeup of Congress this fall and possibly a change in the White House in 2020 and a potential revision of the tax code again. The current individual rates expire in 2025. Therefore, investors are turning over muni portfolios faster and paying more for short-dated securities. They would therefore have money back faster if there if a tax law change in the wake of a switched Congressional majority.

However, we believe the longer end of the bond market remains an extremely good value. A 4% tax-free yield is the taxable equivalent of 6.35% if an investor is in the 37% top tax rate bracket. For states with high income taxes that are no longer deductible, a 4% in-state bond yield is worth even more. At the top state tax rate, a 4% New Jersey tax-free bond is worth 8.97% taxable equivalent; a 4% New York bond is worth 8.82% taxable equivalent; and a California 4% tax-free yield is worth 8.04% taxable equivalent. This is for AA or higher-rated securities. To position the 4% in-state bond correctly credit-wise, it compares to high-grade corporate and long, taxable municipal bonds at the 4.0–4.5% level or a BB junk bond long yield index of 6.5% (source: Bloomberg).  In general, the muni yield curve drifted up 20 basis points during the quarter, across from 2 years out to 30. This is in sympathy with the treasury yield curve, which also experienced slightly higher yield movements across the board.

Curve 3 also is a way to understand Cumberland’s current barbell approach to tax-free bond portfolio management. We want shorter-term securities turning over faster as the Fed raises short-term rates, but we want the longer end locked in because we believe the current cheap yield ratios will eventually go to 100% or below. This happened during the Fed’s hike cycle of 2004–2006, when long muni/Treasury yield ratios fell from 103% to 85%. Our approach should give long munis a great deal of defensive value if overall interest rates rise. It is this defensive quality that causes us to include some longer tax-free bonds in the management of taxable bond portfolios of clients such as pensions, foundations, and charitable trusts. The total-return characteristics of owning a tax-free bond at these levels is very compelling when the expectation is for lower yield ratios over time. Certainly it will take some time for the strategy to work out, as longer Treasury yields are somewhat anchored to the general low level of longer bond yields in the Eurozone countries.

As the Federal Reserve continues to raise short-term interest rates (and we believe they will continue to do so to get the fed funds rate decently above the level of core CPI [currently 2.2%]), we will eventually move some of the shorter end of the barbell out somewhat longer, some of the longer end (where most bonds are callable) to more noncallable structures, and some bonds to the “belly” of the yield curve (where we don’t want to be now but will certainly want to be if we get to a point where the economy slows).

John R. Mousseau, CFA
President and Chief Executive Officer, Director of Fixed Income
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What’s a flattening yield curve and why it may be scary

What’s a flattening yield curve and why it may be scary
by Matt Egan – March 28, 2018

Excerpt below:

An obscure measure known as the yield curve is flattening. That means the gap between short and long-term Treasury rates has narrowed.

The flattening yield curve signals concern that the Federal Reserve could be hitting the brakes on the economy so hard that it inadvertently puts the United States into another recession.

The yield curve is nowhere near inverting right now, and few economists expect a recession on the horizon. Growth is expected to be strong this year, thanks in part to Washington stimulating the already-healthy economy with tax cuts and extra spending.

Just last month Wall Street was concerned the economy could overheat, creating a burst of inflation the Fed would have to cool off by raising rates aggressively. The 10-year Treasury yield spiked above 2.9%, sending the stock market into turmoil. Investors feared a move above 3% would spark more turmoil.

Now, the shrinking 10-year yield is spooking Wall Street.

“It shows that markets can be fickle,” said David Kotok, chairman and chief investment officer of Cumberland Advisors.

Kotok is watching the yield curve “like a hawk,” but he’s not worried about a downturn yet. He argued that the double whammy of tax cuts and government spending will be powerful enough to offset the Fed tapping the brakes on growth.

“I’m not ready to take this as a recession message,” he said.

What’s a flattening yield curve and why it may be scary

An obscure measure known as the yield curve is flattening. That means the gap between short and long-term Treasury rates has narrowed. The flattening yield curve signals concern that the Federal Reserve could be hitting the brakes on the economy so hard that it inadvertently puts the United States into another recession.

Read the full article at money.cnn.com




What Higher Yields Mean for Stock and Bond Portfolios

Excerpt below:

“Generally, when central banks pull back on stimulus that ultimately is the catalyst that brings growth to an end,” says Jeff Klingelhofer, a portfolio manager at Thornburg Investment Management. “The major story the next couple of years will be watching central banks.”

Also adding upward pressure on Treasury yields is an increase in supply. The Treasury announced last week that it would be adding $42 billion of new issuance over the coming quarter, including $1 billion each in upcoming 5-, 7-, 10- and 30-year bond auctions, and that can continue to grow as the deficit grows.

On the plus side, higher yields make bonds more competitive with stocks. One way to view the comparative value of bonds vs. stocks is to compare the earnings yield of the S&P 500, currently about 4.3%, against the 10-year Treasury yield. The difference currently is roughly 1.5 percentage point — the smallest spread in eight years — and traditionally the minimum to give stock investors comfort.

“When yields rise, that can take money out of the stock market,” says Leo Chen, a portfolio manager at Cumberland Advisors.

Read the full article at ThinkAdvisor.com