William Dudley (a voting member of the FOMC), President of the Federal Reserve Bank of NY, made some "dovish" comments today in a speech.
He talked a bit about the "tapering timeline". Here are a few quotes:
The labor market, which the Fed is targeting with QE3, "still cannot be regarded as healthy," Dudley said, adding "there remains a great deal of slack in the economy."
He expects GDP growth of about 2.1 percent this year, about the same as it has been since the recession ended in 2009. But Dudley expects that to pick up next year.
Even under the timeline for reducing QE3, "a rise in short-term rates is very likely to be a long way off," Dudley said.
"Not only will it likely take considerable time to reach the FOMC's 6.5 percent unemployment rate threshold, but also the FOMC could wait considerably longer before raising short-term rates," he said.
"Market adjustments since May have been larger than would be justified by any reasonable reassessment of the path of policy," he said Thursday in a speech at the Bipartisan Policy Center, a Washington think-tank.
"To the extent the market is pricing in an increase in the federal funds rate in 2014, that implies a stronger economic performance than is forecast either by most FOMC participants or by private forecasters," he said in prepared remarks, referring to the policy-setting Federal Open Market Committee.
My take --> Short rates (out to 1 year and including 3 month Libor that Leverage Loans are based off of) are definitely not going up for likely 2-3 years. As per my post yesterday on Leverage Loans...they are based off of 3 month Libor and it sits right now at .27%...that ain't much. (NB. Air Canada was marketing a U$ 1bln Term Loan B over the past week at L+425 and even widened it to L+500 but still came up with only U$500mm out of U$1bln required for the refi and decided to pull the deal).
Longer term rates are likely not going to rise much from here either. They clearly moved extremely quickly and were largely led by negative convexity selling pressure from mortgage hedgers. That selling pressure seems to have calmed down the last 3 sessions.
Heck, I wouldn't at all be surprised to see a Flight to Liquidity bid develop in 10yr treasuries given what is going on around the world (China, Japan, EM). Don't forget, at this stage, the Fed is still buying $85bln of treasuries and agencies per month. Nice backstop.
U$ retail money has flowed into Leverage Loan Funds over the past 4.5 years, but never more than the past few months.
What is a Leverage Loan? A loan issued by a high yield issuer. Loans are usually secured against assets of the company. Many leveraged loans are classified as "Term Loan B's" which is to say that they are loans with a maturity date of about 5 years and are secured against some assets of the company but are sometimes considered "second lien" security...ie...they are second in line if there is a default. Loans also are "floating rate" debt. That is to say, they price at Libor plus a spread for the life of the loan. A typical Leverage Loan might price at L+400.
So why would investors want Leverage Loans? Well, first of all they are secured. Second of all, they are floating rate debt, so if one is afraid that short term interest rates are going to move sharply higher, you would be somewhat "protected" because your coupon would float with Libor (a 3 month interbank lending rate). And because of their floating rate nature, Loans have much lower duration than fixed rate bonds.
As we said above, money has flowed into Leverage Loan funds at quite a pace. This has been going on since 2009 when most people thought interest rates had no where to go but up. Well, interest rates fell and hard. So if you invested in loans at say L+400 for the past 4 years - and keep in mind that Libor is only .27%! - you would have been clipping out a return of about 4.25% pa over the past 4 years.
Here are a couple of reasons to reconsider this strategy(mania) of investing in Loans and re-think HY bonds:
1. HY bonds, in many cases are also secured. Take AHY.un for example. This is a HY Bond Fund, yet almost 40% of the bonds in the portfolio are secured against assets. Some are 1st lien and some are 2nd lien.
2. The Fed has said explicitly that short term rates (o/n fed funds and the discount rate) will not be going up for quite a while. So let's assume Libor will be stuck in this ~.25% area for another couple of years (pretty disappointing GDP and PCE data this morning for 1Q13). So in a Loan you are stuck with receiving L+400 (4.25%) for the next couple of years. Hardly stout. HY bonds, on the other hand, are fixed rate. So, yes you are taking some duration risk in HY bonds (the portfolio duration of AHY.un is only 3.3 years!) but after such a dramatic move higher in the longer part of the yield curve, maybe assuming some duration risk is not a brutal idea...especially after the weak 1Q13 GDP and PCE just mentioned.
Just like when we talk about various types of risk and how important it is to distinguish between credit risk, interest rate risk, portfolio risk and foreign exchange risk, it is also important to distinguish between interest rates and the yield curve which goes from o/n all the way out to 30yrs. Libor, which loans are based off of, is a 3 month rate. Again, if you think the economy is going to take off like a rocket and the Fed is going to jam fed funds back up towards 3-5% in the next Q, then by all means, knock yourself out and buy some floating rate debt through the Loan market. My bet is Libor will stay locked in this ~.25% area for another 2+yrs...and I am very happy to collect fixed rate debt in the ~8.00% range vs Loans in the ~4.00% range.
The move in global stock markets after the FOMC announcement, and Chairman Bernanke's speech to reporters, has been brutal. The Dow is off almost 4% since he spoke and answered questions. For those who thought that the stock market was at all-time highs due to an improving economy and strong fundamentals, may need to think again.
Probably fair to say at this stage that stocks, like most bonds, were fueled by monetary stimulus.
What will play out now, I am not sure, but I do know that the demographic story will be a large part of it as it drives investor preferences to various asset classes. (For a hint on what asset classes I think investors will desire, see my blog comment below on 06/13/2013).
This study is from the Federal Reserve Bank of San Francisco:
Chart 1 - The middle-age cohort (aged 40-49) divided by the old-age cohort (60-69) in Blue. The S&P 500 P/E Ratio in Red. As the Blue line drops, the old-age cohort(divisor) is getting larger. We know this old-age cohort gets larger for the next 30+ years. That won't change. And as they get older, they will continue to need "true yield" as offered by Fixed Income investments that are backed by an indenture (a legal obligation to provide, among other protections for investors, a steady coupon every 6 months). This demand for Fixed Income will come at the expense of equities.
Chart 2 - The Blue line if the Actual S&P 500 P/E multiple. The Red line is the Model generated S&P 500 P/E multiple. Note that it shows the P/E declining persistently from about 15.8x today to about 8.4x in 2025 before recovering all the way up to 9.14x in 2031!
So watch out when talking heads tell you that the only reason "bonds" have as low a yield as they do is because the FOMC has artificially kept them this low. True, that is part of the reason, but also true is that the weak economy (still only 2.5% growth after 4 years of massive monetary and fiscal stimulus) requires it. Also true, is that inflation is at a 50yr low. And finally true, is that the aging demographic requires "true yield". I think 10yr treasuries at 2.25% will draw in demand.
I am not so sure stocks have a ton of value at new all-time highs with GDP at barely 2.5%. One would think the GDP growth rate would be at 4% today and on it's way to 5-6% in 1yrs time. So I am not so sure the P/E multiple at 15x makes a lot of sense right now given the current and future demographic.