By: Russ Kamp, Managing Director, Ryan ALM, Inc.
The volatility witnessed in the capital markets during the last week or so has been incredible. As it relates to US fixed income, the interest rate moves have been nearly unprecedented. As you may recall, Fed Chairman Powell’s Congressional testimony sent US Treasury yields skyward on Monday and Tuesday, as it became more apparent that the Fed’s inflation fight would continue for longer. The trend to higher yields came to a screeching halt later in the week with the realization that Silicon Valley Bank (SVB) was quickly falling into insolvency only to be closed within about 24 hours of the first signs of weakness. This unanticipated situation was closely followed by the closure of Signature Bank on Sunday. What would come next?
Well, Monday did follow Sunday, as usual, but the interest rate environment and Treasury securities, particularly on the short end of the curve, produced a rally that has been eclipsed only a handful of times in our history. The yield on the 2-year Treasury note fell 61 bps on Monday (greatest move since 1982) eclipsing the move set following the stock market collapse of 1987 when yields fell 59 bps. The yield on this note peaked just last Wednesday at 5.07% and then plummeted to 3.985% by yesterday morning. Incredible!
Those moves of course coincided with the uncertainty surrounding our banking industry, particularly the regional banks. The action taken by the government to ensure that depositors would be taken care of has eased fears of a greater contagion, but what has really changed? The CPI data released this morning revealed a CPI for February that met consensus at 0.4% and 6% annually. However, core inflation came in above expectations at 0.5% and now sits at 5.5% for the last 12 months. Core inflation tends to be stickier, making the Fed’s job more challenging as we move forward.
There is a relief rally underway in the US equity markets today, with the major indices all up big (S&P 500 +2.02% at 11:50am), but is it warranted? The Fed is still focused on bringing inflation down to a 2% threshold. There seems to have been a significant shift in expectations from earlier last week when a majority of industry experts anticipated that the Fed would now elevate the Fed Funds Rate by 0.5% instead of a 0.25% increase which took place in early February. In a matter of days, and as a result of the banking “crisis”, expectations have shifted rather dramatically with most investors anticipating only a 25 bps increase and a number of market forecasters believing that no increase in the FFR is possible. I don’t see that happening given today’s economic news.
Well, I guess if you are a participant in our industry for less than 40 years, you’ve almost always seen the Federal Reserve step in at the first sign of trouble to ease concerns and stabilize the situation. Does that action help or hurt at this time? The dramatic fall in yields across the Treasury yield curve doesn’t help the Fed’s job. Yields are rising today, with the 2-year note currently trading with a yield of 4.36%, but that is still dramatically lower than where we were just 5 trading days ago. There once was a time when bond investors demanded a real return. Given the annual CPI at 6% and applying a normal 2-3% premium above inflation, it would seem to me that investors wouldn’t be accepting a 30-year YTM of 3.76%, but one more like 8%-9%.
A major reason given for SVB’s demise was disintermediation due to the rapid increase in US interest rates and the mismatch that existed between the bank’s holdings of longer-dated Treasuries and short-term rates. Well, if the Fed remains focused on price stability as its primary objective, rates need to continue to be elevated in order to tamp down economic activity and demand for goods and services. Won’t this scenario continue to put pressure on the US banking system? Pension plans should be concerned about this possible outcome as it will not be supportive of their asset bases. On the other hand, the present value of those benefits payments will look a lot more reasonable. Take advantage of higher US interest rates and reduce risk by defeasing your plan’s liabilities with bond cash flows of principal and interest. You’ll sleep a lot better than most industry participants did this past weekend!