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Commentary
“Language is froth on the surface of thought.” – John
McCarthy
The Tell-Tale Two-Year?
It’s interesting to look at the two-year
Treasury as a barometer of the market’s views on the potential
for continued Fed tightening. The short end of the yield curve was last
inverted in 1999 and 2000. For much of this period, for example, yields
on one-month LIBOR were higher than the two-year constant maturity Treasury
(CMT) index. One year ago, coinciding with the Fed’s initial tapping
of the brakes, this spread was roughly 2.5 times as wide as today’s
levels. In the first three months of 2000, the twilight of the Fed’s
last complete tightening campaign, yields on the shorter maturity instrument
became significantly higher than yields on the two-year CMT.
As speculation increasingly turns to the question of when the current
tightening campaign will end, we’ll be watching how yields on the
two-year sector compare to those on shorter terms.
Also, appreciate the basis risk that may be present at this point in
the monetary cycle: if history repeats itself, yields on securities
that re-set monthly based on a longer-term CMT index could be superseded
by yields based on shorter indices.
Figure 1. Yields of 1-Month LIBOR and 2-Year Constant Maturity Treasury
12/99 to 4/05
Source: Bloomberg
Figure 2. Spread of 1-Month LIBOR and 2-Year Constant Maturity Treasury
12/99 to 4/05
Source: Bloomberg
Decelerating Growth: Sooner Rather Than Later?
The yield curve, in its
continued recumbent state, appears to suggest that several fundamental
developments may restrain economic growth and perhaps temper inflationary
expectations.
Last month, Warren Buffett addressed the widely watched Berkshire Hathaway
annual meeting. His top two concerns: (1) frothy housing prices and
(2) potential hedge fund failures during volatile markets.
Housing Prices
On the topic of housing finance, the picture
for the second half of 2004, as described by the Mortgage Bankers Association,
tells the story: non-interest-only, adjustable-rate mortgages accounted
for 46% of originations, with an additional 17% derived from interest-only
loans. Notwithstanding the fact that consumers are clearly choosing mortgage
types based on the size of a monthly payment, think of how high these
percentages might be in a yield curve environment that is steeper than
today’s!
Also last month, Fed Governor Donald Kohn stated, “A couple of
years ago I was fairly confident that the rise in real estate prices
primarily reflected low interest rates, good growth in disposable income,
and favorable demographics… Prices have gone up far enough since
then relative to interest rates, rents, and incomes to raise questions;
recent reports from professionals in the housing market suggest an increasing
volume of transactions by investors (rather than owner/occupants), who
may be expecting the recent trend of price increases to continue.”
Several days later, Chairman Greenspan added, “There are a few
things that suggest, at a minimum, there’s a little froth in this
market… while we don’t perceive that there is a national
bubble, it’s not hard to see that there are a lot of local bubbles.”
With the Fed firing a verbal shot across the bow at financial institutions
with lax documentation and valuation controls over home equity lines
of credit, it’s not hard to wonder if the muted consumer use of
the HELOC might impede the upside to economic growth. Let’s not
forget that, during 2004, consumers withdrew approximately $700 billion
in mortgage equity. In any event, the Fed is clearly facing its own conundrum:
in spite of raising short-term rates eight times over the past 12 months,
long-term mortgage rates have declined over the same period.
Figure 3. Growth in Unutilized Home Equity Line of Credit Commitments
Source: FDIC
Figure 4. Estimated Changes in Bank Industry
Loan Production by Category – Home
Equity Category Growth Exceeds Other Types
Source: America’s
Community Bankers 2004 Real Estate Lending Survey
Hedge Funds
Hedge funds, those private partnerships that employ
complex trading strategies, were last given top billing in 1998 with
the collapse of Long-Term Capital Management (LTCM), the now infamous
hedge fund established by former Salomon Brothers bond trader, John Meriwether.
At its height, LTCM supported equity of $5 billion on $125 billion of leverage.
The fund specialized in “convergence
trading,” a strategy involving monitoring the covariance of return
among different securities, buying the cheap security and shorting the
expensive security. Each convergence trade was modeled with the assumption
that securities would have a tolerable range of correlation.
One such major position was an accumulation of Russian sovereign debt
with the concomitant shorting of sovereign debt of other countries with
more established credit. Once Russian sovereign debt defaulted, investors
demanded liquidity and the fund’s correlation assumptions went
dramatically askew. A financial temblor was averted by the Federal Reserve’s
encouragement of a $3.5-billion, long-term financing and equity exchange.
The situation exposed many risks inherent in the hedge fund sphere: liquidity
risk, basis risk, credit risk, and leverage risk. Knowing the inherent
risks in the current environment, it wouldn’t be surprising to
see the Fed exercise a modicum of caution against sudden, un-telegraphed
policy moves.
Q2 Performance-to-Date: Don’t Rattle the
China!
Heading into
the final month of the second quarter, aided by the tailwinds of currency
appreciation and a quarter-to-date 7.3% rate-of-return, the 10-year Treasury
appears poised to outperform all major global government debt indices.
This exemplary performance seems to be based on the assumptions that:
(1) international investors will continue to add positions given the
relative yield advantages of the U.S. debt markets; (2) the Fed is nearing
the completion of its tightening campaign; (3) inflationary threats remain
stable; and (4) economic growth is slowing.
Let’s examine each assumption:
1. |
With the exception of those issued in Australia and
the United Kingdom, most bonds of major sovereign issuers have lower
yields than those from U.S. issuers. Think of the morose world of
the Japanese or German pension fund manager. Not only is he or she
saddled by fulfilling the actuarial requirements of an aging workforce,
but also is struggling to find yield. As a result, the U.S. markets,
especially with a recently appreciating dollar, represent the prospect
of a more encouraging rate of return. However, even with the potential
re-valuation of the dollar versus the Yuan, global payment balances
will not disappear overnight. As exemplified by Germany’s unemployment
rate, which is approaching 12%, it will be tough for the U.S. to
boost exports in the face of weakening global demand. |
Figure 5. Comparative Global Yields on 10-Year Sovereign Maturities
Source: Bloomberg
2. |
While the market is discounting two additional rate
hikes, including an additional 25 basis points at the June 30 meeting,
recent “Fed-speak” deserves some attention. During a
CNBC interview, recently appointed President of the Federal Reserve
Bank of Dallas, Richard Fisher, stated his belief that “we’re
clearly in the eighth inning of a tightening cycle… We have
a ninth inning coming up at the end of June.” Seems discussion
of the possibility of going into extra innings was omitted! |
3. |
Inflation indicators continue to raise a question
mark. As we pointed out last month, productivity is on the decline,
while unit labor costs are on the rise. In fact, unit labor costs
increased by 2.5% on an annual basis during the first quarter—the
steepest rate of increase in over four years. Thus far in 2005, core
producer prices have increased at an annual rate of 3.3%. That’s
compared with a year-over-year rate of 2.2% at this time in 2004. |
4. |
Recent evidence suggests a reduction in economic
growth prospects. Last Friday’s payroll report showed growth
of 78,000 jobs in May, well below half of market forecast. With
a May reading of 51.4, The Institute for Supply Management’s
index of manufacturing purchasing managers continues to decline.
The statistic has dropped consistently over the past 12 months
from its high of 61.6 and is now only slightly above the benchmark
reading of 50, below which purchasing activity would be forecast
to decline.
One can’t help but compare the Fed’s current position
to the little man on the Ed Sullivan show who so deftly twirled the
wobbly plates on top of long poles. In the wake of Mr. Greenspan’s
coming departure, it’ll be a tough act to follow. |
John Biestman is assistant vice president, IMS consultative
sales advisor at the Federal Home Loan Bank of Seattle.
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