Monetary Policy Response to COVID-19: Necessary & Insufficient

Trading in government securities (such as US Treasury bonds and Agency Mortgage-Backed Securities) has become much more illiquid in the past several weeks. The reason this matters is that much of our financial world relies on these assets and markets, from our banking system to insurance companies, pensions, mortgages,  money market funds, and so on. These markets are an important part of the “plumbing” of the US and global economy.

To address liquidity issues, the Federal Reserve announced last week that it would dramatically expand repurchases (repos), which allow financial institutions to borrow dollars if they post government securities as collateral. It is essentially swapping one government security (such a Treasury bond) for another (US dollars). The best analogy I have heard is that repos are like the change machines at an arcade; it does not matter how many $20 bills you have if the machines only accept quarters. Similarly, it doesn’t matter how good a balance sheet is if some of the assets are not dollars. Expanding repos is the Fed’s attempt to provide cash to financial institutions that own (less liquid than cash) government-backed bonds. Understanding the size of the program is best illustrated by a quote we read last week: “The Fed just brought an aircraft carrier to a knife fight.”

The Fed was scheduled to meet (on Tuesday and Wednesday of) this week, but held the meeting (secretly via teleconference) on Sunday and concluded with a surprise announcement and press conference. The major announcements were:

  • A 100 basis point (1%) cut to the target federal funds rate
  • A new round of Quantitative Easing (QE 4), of up to $500B in Treasury bonds and $200B of Agency MBS
  • Swap lines to ensure US dollars would be available to major trading partners
  • Elimination of reserve requirements for banks and an encouragement that the banks use the discount window

While the rate cut marginally decreases borrowing costs for businesses and consumers, the other announcements are likely much more consequential. While it remains to be seen if liquidity in Treasury trading improves, the QE announcement immediately bolstered MBS prices (and brought their concerning spreads down). Additionally, the swap lines and and banking news were meant to bolster the banking system and signal that although we may have health and economic problems, we will not have banking problems to worry about too.

These monetary policy actions are necessary, but not sufficient. The Fed saw some anomalies in the economy’s plumbing system and decided to act. If your house is on fire, a functioning plumbing system will not save your house. However, a dysfunctional plumbing system or fire hydrant could doom it.

The health and economic challenges that we face can only be solved with fiscal policy. As spending grinds to halt, businesses will find it difficult (or impossible) to pay their employees, vendors, rents, and then those businesses will not be able to pay their people and expenses, and so on. It does not matter if rates are higher or lower because nobody will be borrowing in the first place. The Fed has done what it can, but the economy really needs the federal government to step in and spend whatever is needed to get us through this health crisis. Hopefully, the fiscal authorities (The White House and Congress) can pass something soon.

A Wild Week For Fixed-Income

As the financial markets react to the covid-19 crisis, many investors are focused on the wild price action in equity markets. However, much more interesting and consequential things are happening in fixed-income markets. We saw crazy price action in Treasuries, MBS, and fixed-income ETFs, which I’ve outlined below.

Treasuries

This past Monday, Treasuries opened at levels never seen before. Below is a YTD chart of the 10-year Treasury yield, which touched .33% on Monday morning before rebounding the rest of the week. Moves of this magnitude are unprecedented and highlight a few issues:

  • There was a massive flight to safety. The steep drop in rates may have been reinforced by convexity hedging (as mortgage holders may have been forced to buy more Treasuries as prices rose, thereby driving rates down even more).
  • There were many reports this week about Treasuries being as illiquid as they’ve ever been. This likely exacerbated price volatility.
  • Even if yields are expected to fall to (or below) 0%, I personally do not see a lot reasons for individual investors to own medium- or long-term Treasuries at these levels. The yields are unattractive and the interest rate risk is high (even if the probability of a sharp rise in yields may be low). Why not just hold cash?

Mortgage-Backed Securities

Agency mortgage-backed securities (MBS) are generally viewed as safe assets due to their government guarantee. However, the aforementioned illiquidity hit MBS a lot harder than Treasuries. The top panel of the below chart shows that MBS yields often trade at a premium to Treasury yields, but that spread blew out to crisis levels this past week (see the bottom panel). To my knowledge, there is still no question about the credit quality of Agency MBS, so the spike in spreads is a liquidity issue rather than a credit issue (and which many expect that the Federal Reserve will resolve).

Fixed-Income ETFs

Fixed-income ETFs had a very weird week as well, as many fixed-income ETFs traded well below their Net Asset Values (NAV). While this happens from time to time in less liquid sectors (such as high yield), we saw this phenomenon for the first time in many investment grade funds. The $50B Vanguard Total Bond Market ETF traded at a deep discount to its NAV on Thursday. Interestingly, since Vanguards ETFs are simply a share class of their existing mutual funds, an investor could have redeemed their mutual fund investment at NAV and bought the same portfolio back (through the ETF) at a 6%+ discount! If you do not understand fixed-income fund NAVs or ETF redemption mechanics, Dave Nadig wrote a good explainer on it or check out Rick Ferri’s analogy.

Although unprecedented, it is quite conceivable how a discount could appear for a fund holding at least some credit. However, we saw similar action in ETFs that only hold Treasuries. Even the $20B iShares 20+ Year Treasury Bond ETF traded at a ~5% discount to the underlying value of its holdings. Treasuries are the most liquid asset in the world, so it is indicative of just how much volatility and illiquidity exists in the Treasury market.

Looking Ahead

The above examples indicate an extreme level of illiquidity in the financial markets. We are witnessing things that we have not seen since 2008 or ever before. Who knew that Treasuries could swing so wildly? Who thought that Agency MBS would trade so wide of Treasuries? And who could imagine a Treasury ETF trading at a deep discount to its NAV. NAVs are certainly moving around more than usual (and probably more than expected for most), but this illiquidity also brings unprecedented opportunity as some safe* assets are clearly mispriced.

*Safe meaning backed by the US federal government. There is a lot of credit (non-government) fixed-income trading at very distressed levels right now, but the above post is not focused on credit assets.

Why Aren’t Mortgage Rates Lower?

Even though mortgage rates are near all-time lows, many are looking at the benchmark 10-year Treasury yield and asking why mortgage rates are not even lower. Even though the 10 year Treasury yield (dark blue line) has fallen off a cliff, the average 30 year mortgage rate (light blue line) has remained stubbornly high. The difference between the two rates can be visualized in the lower panel. What gives?

Source: Bloomberg, 3.6.2020

There are several reasons for the difference in rates, which are illustrated in the chart below:

  1. Mortgage-backed securities (MBS) are not Treasury bonds. Yes, many MBS are backed by the federal government or by federally-backed Government-Sponsored Enterprises (GSEs, like Fannie Mae and Freddie Mac), but MBS are structured differently. One important distinction is that MBS can be “called” by the borrower and repaid early at par, which is typically done by refinancing the existing mortgage with a new mortgage at a lower rate. Thus, MBS yields (green line) are typically higher than Treasury yields (pink line) and they have not kept pace with the decline in Treasury yields in 2020 (MBS yields down about 1% YTD vs a roughly 1.5% decline in the 10 year Treasury yield YTD).
  2. The GSEs charge fees for securitizing and providing a federal backstop to MBS investors (these costs are why the white line is at a premium to the green line).
  3. Lenders need to generate a profit, so they add a spread on top of the rate that they commit to the GSEs. As of March 2020, lenders are reportedly at capacity for new loans, so there is no incentive for lenders to lower the rates offered to borrowers (even if the wholesale rates have declined). The red line represents the average 30-year mortgage rate.
Source: Bloomberg, 3.9.2020

The above only applies to government- and GSE-backed loans, known as “conforming” or “agency” mortgages. Non-agency mortgage rates are driven much more by investor risk appetite than the above factors.

S&P 500 vs Russell 1000

When comparing the S&P 500 and the Russell 1000, I found a story of two distinct eras. From 1994 until today, the returns are practically identical with only a .01% annualized difference!

Source: Bloomberg

However, the S&P 500 beat the Russell 1000 by a wide margin from the common datas’ inception of 1978 to 1994.

Source: Bloomberg

Selecting a benchmark includes many factors, but I found the above interesting.

Finding Bottoms

Predicting how equities will move is usually a waste of time. However, every few years we see extreme price declines that are often followed by massive rallies (much like bungee jumping), which are sometimes short-lived bounces (like 2015) and sometimes the beginning of multi-year rallies (like 2011). For investors who have cash to allocate or want to lever up when the odds are favorable, identifying these turning points may be worthwhile. When market declines get going, I monitor to the following categories of indicators to find tradable bottoms.

Implied Volatility

Implied volatility is a rough measure of how much investors are paying for protection. The headline benchmark is the VIX (first chart below), which measures the 30 day implied volatility of the S&P 500 index. We can look at the implied volatility of different time horizons, different indices (or ETFs or individual stocks), and even the volatility of implied volatility (second chart below).

VIX as of 2/28/2020
VVIX as of 2.28.2020

Credit Spreads

Credit spreads are an indication of how much yield investors demand. When markets are calm and perceived risk is low, credit spreads are low. When there is turbulence in markets and perceived risk is high, credit spreads widen. Although most useful in fixed-income markets, credit spreads can used as a rough proxy to evaluate fear in many asset classes.

Corporate Spreads at of 2.28.2020

Oscillators

Many oscillating indicators are based on some combination of price, time, volume, number of securities, and so on. One of the most commonly used oscillators is the Relative Strength Index (RSI) (first chart below). Another popular one is the McClellan Oscillator (second chart below).

RSI (14D) for SPX as of 2.28.2020
McClellan Oscillator as of 2.28.2020

Practical Considerations

I don’t recommend market timing to most investors, but for those who have cash to invest or who don’t mind constantly monitoring the market and taking some risk, below are some practical considerations:

  • Price declines often reverse before some (or even any) indicators hit extreme levels and many indicators may not corroborate one another. Respect the weight of the evidence.
  • Investors may nail the exact bottom every now and then, but it is more common to be a little bit early or a little bit late. It’s okay.
  • Extreme readings do not have to mean revert. I personally like to see big reversals in implied vol, spreads, and prices (!) before buying in size. I may average into positions once extreme levels are reached, but will accelerate purchases after a reversal has gone on for 2-3 days (as I rarely trust a bounce before 1-2 days has gone by).
  • There may not be a V-shaped bounce or recovery. In 2011, the market declined and then bounced around for months before rallying (for years!). Investors should not fixate on a particular scenario, but be prepared for anything.
  • Investors should do their own homework, define their own risk tolerance, and use the tools that work best for them and the environment.

This post is not a commentary on the recent market volatility, but hopefully a reference for this and future selloffs.

The Mexican Fisherman

The famous “Mexican Fisherman” story is at least fifty years old, but it is a timeless tale that is both revealing and enlightening. Below is one version of the story:

An American investment banker was taking a much-needed vacation in a small coastal Mexican village when a small boat with just one fisherman docked. The boat had several large, fresh fish in it.

The investment banker was impressed by the quality of the fish and asked the Mexican how long it took to catch them. The Mexican replied, “Only a little while.” The banker then asked why he didn’t stay out longer and catch more fish?

The Mexican fisherman replied he had enough to support his family’s immediate needs.

The American then asked “But what do you do with the rest of your time?”

The Mexican fisherman replied, “I sleep late, fish a little, play with my children, take siesta with my wife, stroll into the village each evening where I sip wine and play guitar with my amigos: I have a full and busy life, señor.”

The investment banker scoffed, “I am an Ivy League MBA, and I could help you. You could spend more time fishing and with the proceeds buy a bigger boat, and with the proceeds from the bigger boat you could buy several boats until eventually you would have a whole fleet of fishing boats. Instead of selling your catch to the middleman you could sell directly to the processor, eventually opening your own cannery. You could control the product, processing and distribution.”

Then he added, “Of course, you would need to leave this small coastal fishing village and move to Mexico City where you would run your growing enterprise.”

The Mexican fisherman asked, “But señor, how long will this all take?”

To which the American replied, “15–20 years.”

“But what then?” asked the Mexican.

The American laughed and said, “That’s the best part. When the time is right you would announce an IPO and sell your company stock to the public and become very rich. You could make millions.”

“Millions, señor? Then what?”

To which the investment banker replied, “Then you would retire. You could move to a small coastal fishing village where you would sleep late, fish a little, play with your kids, take siesta with your wife, stroll to the village in the evenings where you could sip wine and play your guitar with your amigos.”

(This story was originally written by Heinrich Böll, although Tim Ferriss published the above adapted version which can be found across the internet.)

Parenting 101

“Do you have any financial advice for new parents?”

A handful of friends have asked this question in the past week. The question often relates to childcare expenses or college savings plans, but I usually advise new parents to prioritize the below items before anything else:

  • Buy enough term life insurance to provide for your family if you and/or your spouse die prematurely. There’s no “right” amount, so ask yourself what you would want covered if you passed. Your salary of x years? Your spouse’s salary so he/she wouldn’t have to work for y years? Childcare expenses for z years? Payoff a mortgage? College tuition? Other expenses? Add those numbers up and go get some quotes.
  • Establish an estate plan, including a revocable living trust and will. The will should appoint a guardian for your children if you pass away while they’re still minors, although the courts do have the final say. The will also directs what to do with assets that were excluded from the trust (or forgotten to be put in the trust, which I see very often!). The trust should help avoid probate for assets placed within it and provide for supervision of the assets for the benefit of the children.

Buying insurance and establishing an estate plan are simple steps, but each does require some time and money. Fortunately, each item can be a one-time decision, which is a relief for many new parents who are completely overwhelmed with the chaos of parenthood!

The above is educational and is not legal or financial advice. Every situation is different and I’m not an insurance agent or an attorney. 

2s10s

One of the most-watched economic indicators is the 2s10s spread, which is simply the difference between the 10-year US Treasury yield and the 2-year US Treasury yield. Below is a chart of the 2s10s through time.

We can see how the 2s10s spread is calculated below, by simply subtracting the 2-year yield (red line) from the 10-year yield (blue line).

The 2s10s spread is often referenced because it provides a quick and simple indication of the slope of the yield curve. Historically, steep yield curves (indicated by a high 2s10s reading) are often followed by strong economic and financial market performance, while flat yield curves (indicated by low 2s10s readings) are followed by weaker performance.

Sometimes the yield curve flattens so much that it “inverts” and shorter-term rates are higher than longer-term rates (and the 2s10s reading goes negative). An “inverted yield curve” is typically seen as a warning sign as inverted yield curves are often followed by recessions (shown as vertical gray bars in both charts).

It is worth pointing out that the 2-year yield (red line) moves quite a bit more than the 10-year yield (blue line). In other words, the slope of the yield curve is often driven by the movements in shorter-term rates, which happen to be more closely linked with conventional monetary policy rates (such as the Fed Funds rate). Thus, rate hikes often flatten curve while rate cuts often steepen the curve, which makes sense when we think about the goals of monetary policy and economic performance following steep/flat yield curves.

The 2s10s is just one of many similar measures and curious minds can just as easily look up the 2s30s, 5s10s, 5s30s, and so on. Yet the 2s10s is one that many people watch and I believe it is worth watching as well.

Note: the above graphs are embedded directly from the Federal Reserve, so they should always show “live” data. However, you may have to hold your mobile device horizontally for them to render correctly.

MSCI World vs MSCI ACWI

Source: Bloomberg

When comparing the MSCI World Index vs the MSCI All-Country World Index (ACWI) the other day, I was surprised by how closely they’ve tracked each other over the past 30+ years. Since their inception in 1988, the annualized difference is just .05%!

The MSCI World Index only includes stocks of developed markets (think the US, Western Europe, Japan, Canada, Australia, etc), while MSCI ACWI includes stocks in both developed and emerging markets (think China, India, Brazil, etc). Since emerging markets have bounced around between 10-15% of global market cap in the past decade (and were much smaller prior to that), the risk and returns of the MSCI World and MSCI ACWI indices have been nearly identical.

What does this mean for investors? Since the risks and returns of the indices are nearly identical, selecting an investment vehicle and cost structure may matter more than selecting the index. A fund investor might select MSCI ACWI due to the greater geographic diversification (especially with a large index fund that invests in local exchanges), while an SMA investor might opt for MSCI World due to cost considerations. Of course, the next 30 years could be completely different than the past 30 years!