The Great Unwinding of 2017
Good afternoon. I'd like to welcome everyone who has joined us for today's call and discussion about the great unwind of the Fed's balance sheet and what it may mean to your portfolio and the bond market as a whole. Today's presenters will be Dan Tirgovich. He's an assistant vise president and securities analyst in our research and strategy department. Dan will be presenting on behalf of Eric Kelly who ran into a scheduling conflict. Dan will be sharing Eric's views on the fixed-income markets. Jay Boster is a senior vise president in UMB's investment banking division, responsible for management of the investment portfolio for our correspondent bank customers in a number of states. Mark Bailey is also of UMB's investment banking division and is a senior vise president responsible for management of the investment portfolio for our correspondent banks in many states. And lastly, John McQueen is vise president within the UMB financial services group, where he's responsible for assisting clients with ALM strategies, interest rate risk measurement issues, and fixed-income portfolio strategies. Now I'll turn the call over to UMB IBD Investment Officer Mark Bailey, who will share an assessment of the Fed's announced plan of balance sheet reductions. Mark. Thank you, Phil. Good afternoon, everyone, and welcome. Thanks for listening in today. I thought I'd lead off by outlining a little background and history on quantitative easing. It's been almost nine years since the Fed implemented the first quantitative easing in November of 2008. In December of 2008, the Fed dropped the Fed funds target rate to 0% to 0.25%, essentially running out of tools to spark the economy. Hence, the previously unprecedented quantitative easing began. Three rounds of quantitative easing ensued, as shown, ballooning the Fed's balance sheet to nearly $4.4 trillion dollars from its pre-recession balance of about $800 billion. Fast forward to announced a tapering of some of the Fed's quantitative easing policies, contingent upon continued, positive economic data. The overnight rate was finally raised to 0.5 to 0.75 in December of 2015, almost two years ago. The overnight rate now stands at 1% to 1.25%. And recently, Janet Yellen, the current Fed chairman, announced that the Fed would begin a gradual sell off of the balance sheet assets, which Jay will outline the details of for you. Thanks, Mark. On the current screen, you're seeing the security holdings as of September 20. This can be found at on the New York Fed's website. Basically, it's split into two categories, about 2.2 in treasuries, $2.2 trillion, and then the remaining 1.8 in mortgage back securities. If you look at the detail, most of the mortgage backed securities are comprised of 30-year collateral with some 15-year mixed in. So on September outlined their plan to start reducing this bulging balance sheet. Now, the headlines that you saw initially made it sound like they're going to sell bonds. That's not going to be the case. They're going to slow the reinvestment of the proceeds that are maturing each month. Mark and I can't figure out what they're going to do with about the $100 billion in income that they're making, because they haven't addressed that. So there's some funny money involved somewhere. We're not going to address that. We're just going to talk about principal rule off of this particular chart. So this starts with they're going to reduce the amount of treasuries they roll off by $6 billion a month and $4 billion a month in mortgage backs. Now, per quarter, they've got $90 billion rolling off in treasuries and $45 billion in mortgage backed. So for the first quarter, they're going to reduce that amount by ten, 10 billion total, so reinvest 105. The next quarter, the first of 18, they're going to reduce that amount by 20 a month, whereas their reinvestment quarterly totals will be $75 billion and so on. So you can see on the left-hand side of this chart, they're looking at the treasury portfolio. On the right-hand side is the mortgage backed holdings. One thing I think that you should take note of, it takes them about 18 months to reduce this $4.2 trillion current portfolio about a half a billion at this pace. So if it takes 18 months to reduce by a half a billion, it's going to take four or five years plus-- and that's if everything goes right. This is kind of the best case scenario. This is assuming we get 2.5% or better GDP. Inflation is [? wanted. ?] The Fed continue their activities. And I think we've seen over the last seven, eight years a lot of projections only lead to disappointment, and they've backed off. So I'm a little skeptical as to the schedule. But this is what they gave us, outlined on the February 20th meeting. And so we'll go with it at this point. Now, where are they going to? They didn't give us an end point. Mark had said it started QE with about $800 billion in balance sheet. Historically, I looked pre-2008, the balance sheet had been about 6% of GDP. Currently we're at 23% of GDP. And I'm assuming they want to get back to historical norms. That would be about $1.1 trillion. So they've got a ways to go at half a trillion a year in reduction. But if they get started now, it's certainly going to take a while and not going to be anything that they do very, very quickly, which is why I think maybe the impact will be muted in rates. So that's kind of the mechanics of it. Dan is going to give you a little bit of color as to the [? statue ?] in [? DCs ?] and the economy and in general. Thanks. Thanks, Mark and Jay. In terms of the market impact, we see modest spread widening across the MBS sector. The reason for that is simple. The Fed has been the largest buyer of MBS for nearly a decade. They own about 25% of all outstanding MBS. And in many months, they were kind of the buyer of all the issuance coming to market. So when you remove the largest MBS buyer, I think it's natural to expect the spread to widen a little bit. Our research points to about 20 to 40 basis points of spread widening over the next 18 to 24 months. But it's important to keep in mind that we see this spread widening within an environment where treasury yields are already rising based on the fundamentals, economic and market. Two of the factors that are contributing to this rise are steady economic growth-- we're calling for about 2% to 2.5% GDP over the next two years. And it's probably going to be at the higher end of that range given probably some fiscal stimulus. And also, the global economy is improving. And then the second factor is we see inflation moving towards the Fed target of 2% due to a very robust labor market. We think we're pretty close to full employment. And then you're also starting to see wages firm. With the last September employment report, you saw 4.2% unemployment rate and then the highest in over 10 years. So we think inflation is coming, and that will put some upward pressure on the 10-year yield. In terms of UMB's forecasts, we expect three moves from the Fed by the end of 2018. We expect another 25 basis points in December and then two additional moves in 2018. In terms of our 10-year treasury yield forecast, we expect at the end of 2017 to be at 2.5% and then at the end of 2018 to be at 3%. And that is based on our economic growth forecasts and our inflation forecast. In terms of portfolio management considerations, we recommend keeping duration neutral or short relative to the benchmark and also limiting extension risk. Now, we'll be turning the call over to John of the financial services group. Thank you, Dan. By this point, many of you might be asking, what effect is all this going to have on my portfolio? There are some clients out there who have holdings in mortgage backed securities. Obviously, those shift in spreads could have an impact on market value going forward. Well, we can actually simulate that for you in the financial services group. And essentially it's a three-step process. First, we have to establish a baseline market valuation for the mortgage backed portfolio. And for purposes of this presentation, I use September month end data. We then rerun the baseline simulation, using different spread widening scenarios just to see how base valuation will change everything else held steady steady. Basically, no change in rates, just move the widened spreads out and see what happens to valuation. The last step in the process is then incorporating different mortgage interest rate scenarios to see when we add on that change in the Fed funds rate, what does that do in addition to the change in the spread. So on this, on the next page, you can see this is a portfolio. This was a well-diversified mortgage backed portfolio that I pulled at the end of September. It's about 15.2 million in total value. It's pretty short. It only is about with effective duration of 1.9. So many of you may have portfolios that are a little bit longer than that. I point that out just to keep that in mind as we look through this. So, again, that was the baseline valuation. Then reran that base scenario with no change in interest rates, just widening it out 10, 25, and then And you can see what happened. When we widened my 10 basis points with no interest rate changes, there was a minimal change to market value, only about 2/10 of a percent. When we went up to 25 basis points, it was about 1/2%. And when we up to 50 basis point, it was about a 1% drop. Again, those are instantaneous changes. So keep that in mind. And again, this is a pretty short effective duration. So if your effective duration is longer than that, it's going to be amplified. Lastly, we did in a couple of different markets interest rate scenarios. There are here. There's a bear flattening and a bear steepening. The bear flattening basically simulates a 50 basis point increase in the Fed funds rate over the next 12 months with the yield curve flattening, that is the spread between the 2-year note and the 10-year treasury note shrinking by The bear steepening scenario was, again, a 50 basis point increase in the Fed funds rate over the next 12 months. But in this case, the yield curve was actually steepening. The spread between the 2-year note and the 10-year note was actually increasing by 25 basis points. This 50 basis point increase in line with what Dan talked about, because we are projecting this out to September of 2018. And it is also in line with the current Fed FO1C dot plot. You can see by the inclusion of these rate scenarios, that 10 basis point spread, when we factor than in with the market interest rate changes really amplifies that change in market value. And what's interesting here is that the higher basis point widening has less of an effect than the 10 basis point here. And what's going on here really relies on what's happening with the average life of the portfolio. You can see that the base average life was 2.12. And in the bear flattening, under 10 basis point widening would go up to 2.3%. But then in the 25 basis point, it would go up to 2.36. And then in the 50 basis point widening it goes up to 2.47. So basically, it's kind of tapering off. If we just to a we get that big burst in average life. Then it starts to taper off as the spread starts to widen. So what the effect of that is is essentially you're extending your cash flows. And that's why we're seeing less a decline in the 25 to 50 basis points, because with that extended cash flow, your reinvestment is higher. You've got more time to capture that 50 basis point increase in the FO1C target rate. That in turn mitigates the impact on the market value of your portfolio. But you can see steepening scenario had the greatest impact. There was less of an impact of the spread change there. We're looking at least a 1% change over 12 months in the market value of this portfolio if market rates go in that direction. And then lastly on the next slide, you can see this is the actual simulation we used. This is a snapshot of what the yield curves look like 12 months from the end of September in our simulation. And with that, I'll turn back over to Jay. Thanks, John. So this good looking screen comes from Bloomberg. It gives us a 15-year historical on spreads. Dan had mentioned little mean reversion on spreads. We've been very, very tight, lack of supply, low interest rates on a relative basis. And historically, over the five-year treasury, around 100 basis points. We're currently in the mid 60s. So you can see there's that 42 at the upper right-hand corner. or the mean would make sense. And I think Mark and I are in agreement that we will see, hopefully, some relaxation in spreads. There are a couple of factors working against this. Since rates have begun begin to come up the last couple of years, there has been obviously rate refi activity is down. I looked it up, and refi volume year-over-year is down 20%. First lien production of new mortgage is down 9% year over year. I think tighter standards since '08, plus a little bit of drift in interest rates has caused us to drive things up a little bit. And housing starts, while they have doubled off the bottom, we're still about half of what we were at the peak of the bubble, which nobody says we want to go back to bubble stage. But we are still at a point where I don't think the supply, even though a big buyer may be slowly moving away from the table, it wouldn't surprise me if there are other buyers that came in to take up some of that slack. So while I'm hopeful that this unwind will help rates, I think the flat curve we're seeing right now, the 3% target, the 10-year Dan talked about with a 75 basis point move in Fed funds, it's still a relatively low rate environment from a historical perspective. And that flattening tells me that we tend to be closer to the end of a cycle than the beginning when rates get that flat. So, Mark, what are your thoughts? Yeah, I agree, Jay. My opinion is neither rates nor spreads are likely to increase significantly. Global demand for US bonds remains high. Bond rates globally are still negative amongst five of our major trading partners, which makes our bonds the best deal on the planet really from a yield and quality standpoint. Strategically, my recommendation is to continue to average into the market, take advantage of rates that are currently near seven year highs, believe it or not. While rates may still seem historically low versus past cycles, the five-year treasury hit a seven year high in March at 2.12%. And today it yields just under 20 basis points lower than that. So we're within 20 basis points of a seven year high in rates as measured by the five-year. Lastly, consider the US recovery has gone on now for eight years, making it one of the longest recoveries in US history. And although there's no current economic evidence to support it, it seems likely that economy is do at some point for a setback. Thanks all for those assessments and insights on the upcoming unwinding of the Fed's balance sheet. At this point in time would like to answer any questions that the audience may have. We have one question-- no, we do not have a question in the chat. So operator, if you can remind us how to ask questions on the phone, we'll take any of those. What are your thoughts of what will happen if other economies start reducing their balance sheet? Yeah, this is Dan Tirgovich. And you've seen the ECB is the big one. And like Mark talked about, you have really global forces that are at play that are keeping our interest rates low. If you do see the ECB taper, if they start reducing their balance sheet, if Japan starts reducing theirs, I would expect you would see more upward pressure on yields kind of across the globe. You saw this back in 2013 when the Fed first announced that they were going to taper. Our 10-year went from to 3% in a period of about six months. So I think if you saw that globally, which at this point, I don't expect in a big way, I do think the ECB will probably start to taper, but in a very manageable way. But if he did see this, you could expect some further upward pressure on rates. It would appear that we have no more questions at this time. So I'll wrap up by saying that we'd like to thank everyone for attending today. Thank you for your time.