By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Interesting data releases today. 

On the one hand, we have existing home sales data that came in light at 4.09 million (annual units) relative to forecasts of 4.17 million for the 10th monthly decline in a row. This got equity markets rallying as investors cheered the slowing housing market and the potential impact that has on interest rates (down). But we also had the monthly release of the Consumer Confidence Index that came in hot, blowing away expectations at 108.3 vs. 101.2! Since there is a positive correlation between sentiment and spending, bond markets have begun to sell off. Treasury yields which had fallen to start the day are basically flat at this point. 

What will the Fed do? Do we have an environment in which the consumer has shifted their spending away from housing to other goods and services, especially services, making the Fed’s job more difficult in fighting inflation, or is the dramatic fall in housing activity a prelude to collapsing spending? Equity investors would have you believe that the Fed will soon realize the error of their way and begin the great pivot, while bond investors remain far more cautious. Of course, only time will tell, but it is always interesting to see what drives markets and investors’ actions.

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Occasionally, we at Ryan ALM stumble over a fact or two that surprises us, and we like to bring it to the attention of our readers of this blog. Obviously, inflation and the impact of these inflationary pressures have been a dominant force within the US markets in 2022. Aggressive US Federal Reserve policy action (perhaps a bit late) has driven interest rates upward (FFR +4.25%) from historically low levels creating great uncertainty regarding the near-term implications for the US economic environment. Debate rages over the likely outcome with participants arguing about the potential for a hard or moderate recession or the Goldilocks soft landing.

Much debate has also focused on the primary source(s) of US inflation. Was it the stimulus provided to prop up our economy during the initial Covid-19 response or was it the disruptions to our ability to meet heightened demand as a result of global production disruptions, including the impact from both Covid-19 and the Russian invasion of Ukraine? There’s good reason to believe that both contributed to the four-decade-high inflation experienced in 2022, which makes the argument that inflation is transitory more difficult to accept.

Fact 1: In the nearly three-year period of 2020 to YTD 2022, the US has injected $6.8 trillion in net Treasury Bills, Notes, and Bonds into our economy. During the GFC (2008) and for 4 years subsequent, the US injected “only” $6.4 trillion in net Treasury debt to help the economy get back on solid ground from the most harmful recession that our nation had experienced since the Great Depression of the late ’20s to mid-’30s. That is a tremendous amount of stimulus that continues to work its way through the system. In addition, we have one of the strongest labor markets at this time with unemployment continuing to remain quite low at 3.7%, while annual wage growth hovers in excess of 6% as of November 2022. Yes, inflation has moderated during the last several months, but it continues to remain quite elevated relative to the Fed’s target level of 2%. Given the extraordinary stimulus and strong labor market, it is likely that a more aggressive stance by the Fed will be needed to finally eradicate inflation… not to mention the Fed’s intention to create real rates or an inflation premium which has averaged 3.04% since 1960.

One last observation (fact 2), in reviewing the history of Treasury issuance since 2000, it continues to surprise me that the US only issued $510 billion of gross Treasury Bonds during 2020 relative to the total gross issuance of nearly $21 trillion in Treasury debt (2.4% of total issuance) when the yield on the 30-year bond had fallen to 1.28% during the initial reaction to Covid-19. Why would you not extend maturity when rates were at historically low levels and not likely to fall any further? Instead, the US Treasury has had to refinance trillions in $s at ever-increasing interest rates? This scenario is likely to continue well into 2023 as the Fed appears committed. What a wasted opportunity.

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Happy Hannukah, Merry Christmas, and Happy Holidays! We wish you a wonderful holiday season.

We are pleased to provide you with the latest activity related to ARPA’s implementation. There were no new or supplemented applications filed with the PBGC during the most recent week. However, the PBGC was busy approving two supplemental applications for the Teamsters Local 617 Pension Plan and the Graphic Arts Industry Joint Pension Plan, which will receive additional SFA funding amounting to $31.0 mil and $82.2 mil, respectively. This additional funding will further secure the promises for 10,745 plan participants.

There are currently 30 applications that have been submitted to the PBGC that have yet to be approved with 12 of those being initial applications and two more that were revised and resubmitted. As a reminder, the window is currently open for Priority Group 5 plans (projected to become insolvent before 3/11/2026) with Priority Group 6 plans slated to become eligible to file an initial application beginning February 11, 2023.

The data above reflects the activity of multiemployer plans submitting an initial or revised application through December 16, 2022. Despite the good work to date from the PBGC, there is plenty left to accomplish. Next year should prove to be quite active as the bulk of potential ARPA/SFA recipients has yet to file.

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

There appears in today’s WSJ an article by James Mackintosh titled, “The Markets Don’t Believe the Fed”. It is incomprehensible to me that this continues to be the mindset of the average investor given the fact that the Fed controls short-term US interest rates. Whether you believe that the economic fundamentals exist to support aggressive interest rate policy, the Fed is in control. I began posting blogs about “believing” the Fed in March 2022. My first post, “You Should Believe The Fed” stated that “we (Ryan ALM) are NOT in the habit of forecasting rates, but after a 39-year bull market for bonds that produced historically low absolute and real interest rates, we felt pretty comfortable in our expectation” that US interest rates would rise.

I further wrote, “if you don’t believe us, I highly recommend that you listen to the US Federal Reserve, as they came out very aggressively yesterday (March 16th) and indicated that the 25 basis point move in the Fed Funds rate (first increase since 2018) would be followed by 25 bps increases at each of the remaining six meeting in 2022. Incredibly, those 25 bps increases didn’t occur, because they were superseded by a 50 bps increase, four 75 bps increases, and finally earlier this week another 50 bps elevation in the Fed Funds Rate (FFR)!

I went on to ask “is your portfolio structured to withstand this aggressive move upward in rates? What have you done to secure the promised benefits? If nothing has been done, are you prepared for deterioration in the plan’s funded status and increased contribution expenses? This is the reality that our pension industry is facing.” Regrettably, most sponsors and their consultants have done little to nothing to protect and secure the promised benefits. Expectations now exist that the Fed will raise the FFR to a level that exceeds 5% given the stickiness of “core, core” inflation and concerns that an easing in its restrictive policy might just result in a similar and painful outcome to what was experienced during the late ’70s and early ’80s.

Given the reluctance on the part of market participants to believe the Fed, long-term interest rates have fallen significantly during the last couple of months creating an environment of easier money conditions similar to what we witnessed earlier this year. 30-year mortgage rates are once again below 6.5% having peaked at 7.1% during this rate cycle. With long rates in the mid-3% range, just how much economic activity will be thwarted? The US labor market remains strong and wage growth remains well above the level desired by the Fed. Initial jobless claims, which had recently been elevating, came in 20,000 below forecast to a low level of 211,000.

I believe that it is fair to ask, “what has the Fed accomplished to date”? Their policy actions certainly haven’t driven inflation anywhere close to the desired 2% target. It appears to me that the Fed has much more work to do. Will market participants finally believe them? As we witnessed in 2022, you ignore the Fed at your own peril.

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

While the investing community holds their collective breath in anticipation of the latest US Federal Reserve Fed Fund’s Rate announcement, those plan sponsors using cash flow matching (CFM) can sit back knowing that interest rate movements provide little impact on their bond allocation that is used to defease their plan’s liabilities. How comforting! Despite the significant interest rate gyrations in 2022 that saw US rates rise rapidly through October (US 30-year Treasury Bond yield peaked at 4.34%) only to pull back as long-bonds recently rallied (US 30-year Treasury Bond yield is at 3.54% today), CFM is doing exactly what it proclaims to do. Importantly, the CFM portfolio is providing the necessary liquidity to meet monthly benefits and expenses, while the bond’s assets and the pension’s liabilities track very closely minimizing the impact on a plan’s funded status and contribution volatility.

We are quite fortunate to work with an array of clients who have asked us to cash flow match pension liabilities covering various lengths of time from 3 years to 30+ years. Since every client’s liabilities are different, there is no “standard” portfolio that is built by Ryan ALM, as we need to carefully match each client’s unique liability cash flow needs with bond cash flows of interest and principal (and reinvested interest income). For the first 9 months, bond asset values fell as rates rose, but so did the present value of pension liabilities that are bond-like in nature. For the two months since the current peak in rates, both assets and liabilities have seen their values rise. On a year-to-date basis through November 30, 2022, both assets and liabilities are down modestly, with a representative Ryan ALM CFM bond portfolio showing “alpha” of about 80 bps, as our yield advantage (skewed to A/BBB corporate bond exposure) buffers the portfolio versus the plan’s liabilities valued using a AA custom liability index (ASC discount rates).

As we’ve reported on numerous occasions in our blog, total return core or core plus bond programs managed against the Bloomberg Barclays Aggregate Index (-12.62% through 11/30/22) have suffered significant asset underperformance in 2022 as US interest rates rose significantly. Furthermore, these portfolios are not designed to provide the liquidity necessary to meet monthly benefits and expenses so bonds and other assets must be sold in order to meet those cash needs. Many pensions do a cash sweep of all assets including performance assets (i.e. dividends from stocks). This is troubling in down markets such as those that we’ve experienced this year when losses are realized.  Wouldn’t you like knowing that come 2:30 pm you can sit back and not worry what the Fed is going to say or do? It is comforting knowing that your pension liabilities have been secured through a CFM mandate, which mitigates interest rate risk since benefits are a future value and future values are not interest rate sensitive. We’d be happy to model your plan’s liabilities to see how CFM can help you.

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

We’ve mentioned “inflation” in 50 blog posts just since July 1, 2022. It is clearly on our minds and the minds of 99% of the investment community. What is our position? We are certainly not in the camp that inflation has been tamed and that the Fed’s 2% target is right around the corner. Our argument is quite basic. Given the strong labor market and rising wages, demand for goods and services will remain strong. Does this mean no moderation in our inflationary environment? No, it doesn’t mean that, but we don’t expect a dramatic reduction in inflation anytime soon, as many on Wall Street are predicting.

As the graph above highlights, wage growth continues to trend upwards. When people are working and earning greater wages, they demand more goods and services. The impact on inflation from Covid-19 production shortfalls and stimulus may be working through the system, but the Ukraine/Russia conflict is far from over and the outcome is certainly not known at this time. These impediments have certainly created supply and demand imbalances, but they are dwarfed in importance by 3.7% unemployment and 6% wage growth. Little evidence exists at this time that would lead one to believe that we are going to see a dramatic collapse in our current labor force. In my post from last week, I highlighted the fact that the Federal Reserve didn’t get its arms around inflation which started to spike in 1978 until 1981 when long rates were near 10% and unemployment was at 8.5%. Our current environment doesn’t come close to reaching those levels.

Lastly, rates have risen from historically low levels, but do you really believe that a 30-year Treasury bond yield of 3.57% (2 pm on the 12th) is going to curtail economic activity? My first house was purchased with a mortgage rate of >11% because I needed a place to live. What we wouldn’t have given to be able to finance that home at 6+%, which is today’s level.

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

The PBGC certainly didn’t let the upcoming holiday season get in the way of some important business. As we mentioned in last week’s update, there was a potential “tidal wave” of activity facing the PBGC team, as one revised application and 11 supplemental submissions were reaching the 120-day threshold for action. The one revised application was the mammoth Central States plan that received approval for nearly $36 billion in Special Financial Assistance (SFA). The SFA payout is slightly more than $100,000 per plan participant (357,056) and it goes a long way to establishing a firmer financial footing.

The 11 supplemental plans each received approval for their applications. In total, these plans will receive an additional $704 million covering 101,860 plan participants. To date, $45.4 billion has been allocated to 37 pension plans, with Central States representing roughly 80% of the SFA payout to date. Estimates vary as to the ultimate SFA payout, but a safe guess would be that at least 50% of the ARPA proceeds have been allocated and disbursed.

In addition to the activity mentioned above, the New York State Teamsters Conference Pension and Retirement Fund submitted a supplemental application seeking an additional $421.3 million for their 33,643 plan participants. This fund had previously received $963 million as a Priority Group 2 plan. Also, there are two more funds, Teamsters Local 617 Pension Plan and the Graphic Arts Industry Joint Pension Plan, whose supplemental applications are hitting the 120-day window for PBGC action during the next week.

Finally, congratulations to all of those individuals and organizations that worked tirelessly during the last decade-plus to secure the funds necessary to secure the Central States pension system. It would have been so easy to throw in the towel by using MPRA to slash the promised benefits. As a result of this effort, many Americans will once again receive the promised benefits allowing them to begin a more dignified retirement. Great job!

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Maybe things have changed during the last 40 years (my hair color certainly has), but there seems to be a major disconnect between the market’s (Fed’s) reaction to the early 1980s inflationary environment compared to the one that we are currently experiencing. Perhaps it is 40 years of falling rates and accommodative Fed policy that have created an expectation that rates will remain low forever, and that the Fed’s only responsibility is to prop up markets at the first sign of trouble. It may be challenging for those engaged in the investment community today that weren’t working in the industry 40 years ago to truly appreciate the actions taken by Paul Volcker and his team to combat historic inflation.

As the data above suggests, inflation today is not too dissimilar to that which we were experiencing in 1981. Sure, inflation has begun to fall from higher levels this past Summer, but it was substantially higher in 1980, too. GDP growth in 1981 compared to today was quite similar. The biggest difference has to do with the current labor market versus 1981, and this is what today’s Fed is focused on. We are near full employment and wages are growing at around 5% annually. The Fed doesn’t believe that inflation can be tamed to any great extent unless we begin to see weakness within the US labor force. Despite aggressive (?) Fed action throughout 2022, unemployment remains stubbornly low. What gives?

The graph above highlights the US Treasury yield curve for 1981 and 2022. Given similar inflation and GDP data, one would think that US interest rates would be occupying similar levels. But that is far from the case. Market participants today feel that rates have peaked given that inflation appears to be moderating. However, that doesn’t mean that the Fed won’t continue to raise rates in order to achieve a level of “real” rates, which is exactly what Volcker did in the early ’80s. It wasn’t until US interest rates were elevated to a level substantially above the prevailing inflation rate that inflation was finally tamed. Given today’s CPI of 7.7% applying a historic inflation premium (real rate) of 3.1% would push rates above 10% and place them very close to where they were at the end of 1981. Even if inflation fell to 3%, real rates should be at 5% to 6% with an inflation premium of 2% to 3%.

I don’t understand why investors today feel that rates are high. On a relative basis, US Treasuries are well below the long-term average and substantially below inflation. If fighting inflation is the Fed’s primary focus, then they have much work ahead of them. Increasing the Fed Fund’s rate by 50 bps instead of 75 bps is still an increase. Do that another 5-6 times and you’ll finally get rates to a level commensurate with today’s inflation. The Fed pivot doesn’t seem to reflect reality. We can all hope, but hope has never been a successful investment strategy.

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

Currently, the US 2-year Treasury Note is trading at an 85 bps premium yield to that of the 30-year US Treasury Bond. This inversion doesn’t happen often and has on many occasions predicted a near-term recession. Is 85 bps significant? Well, yes. According to the Ryan ALM Treasury Yield Curve Indexes, -85 bps is the greatest negative yield spread or slope between 2-year and 30-year Treasuries since April 15, 1982, when the spread was -110 bps. The all-time inversion between 2- and 30-year Treasuries occurred on March 20, 1980, when the inversion reached -281 bps.

What I find fascinating is that -85 bps wasn’t breached in 2000-02, 2007-09, or during the initial Covid-19 crisis. Given that the US Federal Reserve continues to suggest that rates will continue to rise in order to thwart inflation, will the -85 bps differential be maintained, expanded, or contracted? Have market participants discounted the strength of the US labor market which currently has an unemployment rate of 3.7%? As a reminder, the US experienced an unemployment rate of 10.8% in 1982 which was more than 3 times as great as that which we are experiencing today. With full employment and wage growth running at roughly 5%, how likely is it that demand for goods and services will be constricted?

We believe that the Fed will not stop increasing the Fed Funds rate until they actually achieve “real” interest rates. According to Yardeni Research, the average inflation premium (real rates) is 3.06% since 1960. What do you think?

By: Russ Kamp, Managing Director, Ryan ALM, Inc.

We at Ryan ALM, Inc. truly appreciate every opportunity that we get to speak with plan sponsors, consultants, and actuaries. We find the give and take during those conversations to be incredibly educational. During one such recent meeting, we received a question from a plan sponsor that had to do with the trading activity of a Cash Flow Matching (CFM) process relative to a Key Rate Duration (KRD) strategy. This individual assumed that there was far greater activity in a CFM mandate than in a KRD process since we were using cash bonds. That assumption/conclusion is not correct. Yes, a CFM program is going to be dynamic in its responsiveness to actuarial changes, but those usually only happen once per year. KRD products must respond to changes in the level of interest rates and the shape of the yield curve. These adjustments could occur daily.

Furthermore, the beauty of CFM is in the certainty of the outcome. When asked to defease a Retired Lives Liability, the bond portfolio that we construct to match assets to pension liabilities locks in the difference between the present value of the assets and the future value cost of the liabilities at the time that the portfolio is built. Whether rates rise or fall, that relationship and “savings” is secured. Furthermore, the liquidity necessary to make those monthly payments will be available as needed. Unfortunately, there is no such guarantee that the liquidity that is needed to meet payments will be available through a KRD strategy.

Lastly, because CFM is providing the monthly liquidity needed to make each benefit/expense payment, we are providing monthly duration matching. A 30-year CFM program would have 360 unique durations, unlike KRD which picks a modest # of spots along the yield curve. Intrigued? Call us. We wrote the book on CFM.