Rates declined in the third quarter, with the ten year treasury yield dropping over 36 basis points to 1.66%. The municipal yield curve inverted on the short end, joining the inverted treasury curve for the first time in 2019. Domestic yields look attractive vs. large swaths of the global market where ultra low and negative interest rates continue to dominate.
Review
The table below summarizes the returns of some major BofA/Merrill Lynch fixed income indices.
Fed Policy Reverses From Tightening To Easing
Last November the fed funds rate was at 2.25%, the 5YR UST yielded 3.09%, the 10YR UST was at 3.24%, and the 30YR UST yielded 3.44%. The Fed was raising short term rates and engaging in Quantitative Tightening (QT) by allowing their balance sheet to run off. The Fed was “normalizing” rates and their objective was to get rates to a level where they were neither stimulative nor restrictive on economic activity. The prevalent belief was that interest rates would continue to rise. Things changed when the Fed raised rates to 2.50% in December 2018. The bond market began to be convinced the Fed had become too restrictive, and the economy was going to go into a recession. The bond market began to rally in anticipation of future Fed easings. The Fed kept the Funds rate steady at 2.50% for another 8 months until they realized the bond market was correct. By this time the yield on the 10YR UST had dropped to a low of 1.46%. Since then the Fed has engaged in three rate cuts to reduce the Fed Funds rate from 2.50% in July to 1.75% in October.
The Fed clearly erred in raising the Funds rate too quickly up to 2.50%, and engaging in QT by letting their balance sheet decline rapidly by $600 billion. The decline in the balance sheet created a shortage of reserves which wrecked havoc in the repo market causing short term rates to rise. The events in the repo market led the Fed to start purchasing $60 billion a month in T-Bills. These purchases increased reserves in the banking system and have restored stability to the repo market. The chart below shows the dramatic changes in the Fed’s balance sheet since February 2018. It is important to remember there may be significant time lags before these changes in policy have an impact on the economy. These lags are normally about 1-2 years. We believe this change in policy will tend to boost the economy in upcoming months.
Foreign Sovereign Rates: Example Of Bond Market Mania
Approximately $17 trillion of bond debt is currently trading at negative interest rates globally. This has led to abnormalities in the bond markets. One such example is the Austrian sovereign bond. The bond has a coupon of 2.10% and matures on 9/20/2117. This is a maturity of about 100 years. The bonds are currently trading at a price of $168 and they yield less than 1.0%. This means if an investor buys these bonds today, he/she will get an annual yield of less than 1.0% and will receive $100 for every $168 invested when the bonds mature in 100 years. This seems to be a very risky investment. In order for this bond to perform well, we must assume that rates will not only be low for the next 100 years, but inflation will be negative. These bonds appear to be priced for a 100 year recession, a scenario we find very unlikely.
Climate Change: A Growing Problem
Several years ago it became clear to us we needed to be concerned with unfunded pension and OPEB liabilities. We began factoring these obligations into our credit process before municipalities were required to report them in their financial reports. We avoid credits that have large unfunded liabilities and/or retirement obligations that have become a large percentage of their budget. We tend to avoid large cities for this reason.
We are also incorporating into our credit analysis factors relating to climate risk. These weather related risks may include flooding, wildfires, winter storms, drought, freeze, or severe storms. These natural events may have a significant impact on property values, and the desirability of an area in which to live. Hurricane Katrina (2005) in New Orleans, Hurricane Harvey (2017) in Texas, and Hurricane Maria (2017) in Puerto Rico and the Virgin Islands were all powerful storms that were very destructive. Wildfires in California caused by severe drought conditions such as the Camp Fire (2018) have also done considerable damage to certain municipalities in California. In addition to these events, there is increasing risk of flooding to coastal areas due to a rise in sea levels. Sea levels have risen 3 inches since 1993. Projections are for levels to rise anywhere from 1.5 feet to 8.0 feet by the year 2100. Increases near the lower level of 1.5 feet will still increase the likelihood of flooding in coastal areas. As potential risks increase, we will be looking at several factors in our analysis. For example, what is a municipality doing to help mitigate damage from potential weather events? What is the likelihood of an event occurring? How would a weather event affect the financial status of the area? Would it cause population migration out of the impacted area?