Get Real!

By: Ron Ryan, CEO, Ryan ALM, Inc. and Russ Kamp, Managing Director, Ryan ALM, Inc.

America’s investment community has enjoyed a history of real interest rates or an inflation premium on the 10-year Treasury nominal rates. As the chart below indicates, whenever real rates went negative (1975 and 1981, primarily), it proved temporary as it was followed by an increase in nominal yields until a real yield was achieved. The US Federal Reserve has indicated that they want a return to positive real rates with an inflation premium. We are shocked that “investors” aren’t demanding a real yield advantage in this environment given all of the uncertainty related to the significantly elevated inflation rate which has been brought about by a number of factors, including government stimulus, enhanced wages, full employment, war, Covid-19, production, and shipping delays, etc. Why?

Demand a real yield!

At the current level of inflation (July’s CPI-U # was 8.5%), one would expect the 10-year Treasury yield to be roughly 9.5%-10.5% given its long history of providing a real yield of 1-2%. However, the 10-year Treasury note currently has a yield of ONLY 2.78%! This yield provides the investors with a negative real yield of nearly 6%!

As everyone knows, the Fed has begun raising the Fed Funds Rate, which currently sits at 2.25%. They’ve indicated that further rate increases are necessary to help tame inflation. That said, even if these recent increases in the Fed Funds Rate somehow tamp down economic growth to the point that inflation falls to 3%, history suggests that the 10-year Treasury yield should be somewhere around 4% to 5%, which is a far cry from where we are today. Again, we ask, why are investors so complacent? Are they anchored in the idea of low-interest rates forever and always? Don’t they understand what transpired in the 1970s into the early 1980s?

For anyone who needs a history lesson, here is a conversation between Paul Volcker and Ray Dalio that was posted by Ray on his page. It is a wonderful reminder that true leadership is needed during periods of great uncertainty, even if it results in personal harm to one’s reputation. Increasing the Fed Funds Rate to only 2.25% is likely to do very little to reduce inflation, especially as we are at full employment with rising wages. The Fed is going to have to GET REAL if we as investors are to enjoy real yields.

Premature Reaction?

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

Given our current economic environment, are investors acting prematurely that the US Federal Reserve has actually accomplished its objective of thwarting inflation? We believe so. As the graph below depicts, market participants have been driving longer-dated Treasury yields lower with each subsequent move up in the Fed Funds Rate anticipating that our economy will slow, and rates will need to fall as a result. In fact, this belief is so strong as to have longer-maturity 10- and 30-year Treasuries trading at yields lower than they were on May 1st.

The Fed has more to do!

As we wrote in Tuesday’s post, Can Inflation Be Contained at an FFR of 2.25%?, in February 1982 when we last had an annual inflation rate in excess of 8%, the Fed Funds Rate was at 14.8% and the 10-year Treasury was yielding 14.0%. Given that it took the Fed elevating the FFR to 6.8% above the prevailing inflation rate during that month, why would anyone believe that our current FFR of ONLY 2.25%, a full 6% below the CPI-U, would constrain inflation? Yet, every time the Fed raises the discount rate, long bond yields fall. Does this action seem premature to you?

It will be interesting to witness the reaction in September to the Fed’s next move. Will we see a similar pattern to recent activity in which an increase in the FFR immediately drives longer-dated bond yields lower or will investors realize that the Fed is going to have to do much more to finally tamp down economic activity and inflation? I certainly don’t want to see the FFR at >10%, but unless inflation comes down quickly, and today’s retail sales # (0.7% X gas and autos) certainly doesn’t support the premise that our economy is slipping into recession, we will likely see the Fed remain aggressive in pursuit of their primary objective… an inflation rate approaching 2% and positive real rates. We are far from those metrics today!

Are Bonds RSA or Not?

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

There seems to be major confusion with regard to the investment of the APRA legislation’s Special Financial Assistance (SFA). When the PBGC released the Interim Final Rules in July 2021, potential investments of SFA grant proceeds were limited to investment-grade (IG) bonds with a maximum of 5% in “Fallen Angel” bonds that were now considered High Yield. There was no mention of the phrase return-seeking assets (RSA). However, in the PBGC’s Final Final Rules (might we still get a new category of Absolute Final Final Rules?), the phrase return-seeking asset was injected into the conversation. Return-seeking asset (RSA) investments were now going to be permitted, but only to a level equal to 33% of the total SFA segregated pool.

However, investment grade bonds are return-seeking investments unless they are specifically used to defease liabilities. One only needs to look at the YTD return for the Bloomberg Barclays Aggregate Index through 8/15/22 (-8.68%) to realize that there is downside risk, and potentially substantial risk if inflation isn’t tamed and interest rates rise substantially as a means to contain inflation. So, unless the PBGC states specifically that IG bonds are to be used to defease the plan’s liabilities , they are return-seeking…plain and simple! Thus, 100% of the SFA may in fact be RSA, which violates the PBGC’s guidance as to no more than 33% in RSA.

Why is it not understood that bonds are performance instruments when not used to secure liabilities? Is it the fact that in only 4 of the last 40 years have we witnessed a negative return for the Aggregate Index with -2.92% in 1994 being the worst performer? We have been in a falling rate environment for most of those four decades leading to this historic period for bonds. However, the 30 years prior to 1982 was a lengthy bear market. Might we be headed for a similar fate today?

If the PBGC truly intends to keep the RSA exposure to no more than 33% in any 12-month period, it MUST mandate that the IG exposure be used to defease pension liabilities chronologically from the first payment as far out as the SFA allocation will go. The remaining 33% may now be invested in RSA as approved in the Final Final Rules. Please remember that the legislation was passed with the expectation that promised benefits would be secured through 2051. By allowing a portion of the SFA assets to be invested in RSA, the securing of benefits becomes much more uncertain. It is truly an unfortunate development. The lack of understanding that bonds are also RSA is shocking!

Can Inflation Be Contained at an FFR of 2.25%?

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

Ryan ALM’s Head Trader, Steve Devito, shared some extraordinary figures with the team last week. Thanks, Steve! We’ve been saying all along that the US Federal Reserve needs to tighten interest rates to a significantly greater extent in order to finally control inflation. We’ve produced blog post after blog post highlighting what we believe to be the reality of our current situation despite market action during the last month or so that would counter our observations. Let’s take a look at some of the numbers from the last period in which we observed inflation in excess of 8% (the latest CPI # posted was 8.5%). In February 1982 the CPI for the month was 0.3% and the annualized inflation # stood at 8.3%.

However, unlike today’s environment in which the Fed Funds Rate (FFR) stands at 2.25%-2.50%, the FFR during that month was a robust 14.8% representing a 6.5% premium to inflation. Not the -6% “premium” that exists in today’s environment. Furthermore, the 2-year Treasury Note was trading at a yield of 14.45% far outpacing today’s 3.17% yield. It seems extraordinary that today’s “investors” would actually believe that a 2.25% FFR would tamp down our significant inflation. Furthermore, why are they willing to hold bonds at such negative real rates? Skeptical that I may have cherry-picked a bond that was an outlier? For further proof of just how unbelievable today’s environment is, the 10-year US Treasury Note was yielding 14.03% in February 1982, which was -0.77% relative to the FFR, but a whopping +5.7% real rate when compared to inflation.

The 30-year Treasury Bond also showed similar results, as its yield was 13.8% for a real yield of 5.5%. Again, we ask, do you really believe that the Fed has accomplished its objective? How much economic activity do you really believe will be constrained by these incredibly modest levels of interest rates? Could it be that we have 2 generations of investors who have not experienced excessive inflation leading to significantly rising rates? Despite the double-digit FFR in 1982 (14.8%), inflation didn’t fall below 3% until July 1983 and it never touched 2% – the current Fed target – before rising again to 3.4% by year-end 1983.

With today’s robust employment and wage growth, is the average consumer more concerned about inflation or borrowing at slightly higher rates? My money is on inflation, as is the Feds. How many more times do we need to hear from a Fed Governor that inflation needs to be contained until rates can be stabilized? They’ve stated that they haven’t been dissuaded from raising the FFR based on newly released information. Not only are equity and bond investors giddy about inflation’s path, but they actually believe that the Fed may ease in the near term. However, Thomas Barkin, Fed Governor from the Richmond Fed, said on TV last weekend that the Fed needs to see real positive rates. Why the disconnect?

We aren’t suggesting that the Fed will raise the FFR to 14.8% in this environment, but 2.25%-2.5% seems like a small down payment on where rates will eventually need to go in order for this august governing body to have achieved its ultimate objective. Hoping that rates have peaked likely sets our markets up for massive disappointment leading to further declines. The greater the current euphoria the likely the bigger disappointment. Pension America has seen some nice recovery in markets. Let’s hope that they take some steps to reduce risk before everyone realizes that the Fed has much more to do. Securing benefits through enhanced liquidity and the buying of time – Ryan ALM specialties – may just be the necessary prescription for what lies ahead.

ARPA Update Through August 12, 2022

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

The flood gates have been opened! From May 3rd to August 5th there had been 10 applications filed for Special Financial Assistance (SFA). During the week ending 8/12, 12 applications were submitted. The activity has been almost exclusively driven by the PBGC’s issuance of the legislation’s Final, Final Rules, as 11 applications were classified as supplemental. The only non-supplemental filing was the Central States, Southeast & Southwest Areas Pension Plan (a.k.a. 800-pound gorilla). The Central States plan withdrew the initial application that had been filed on April 28th and resubmitted an updated application on August 12th. As a reminder, this plan is seeking nearly $35 billion in SFA support for the 364,908 plan participants. To put that sum into perspective, the Central States’ request is nearly 5 times greater than the $7.5 billion that has been paid out to date to the 29 applications that have been approved.

Only the Central States plan withdrew an application last week. In addition, there were no applications that were either denied or approved. The PBGC has 120 days to act on the supplemental applications but given the fact that these entities have already received SFA from the previous submissions, it doesn’t seem likely that 120 days will be necessary for an adjustment to the original SFA to be approved and paid.

No new applications have been filed since June 30, 2022, despite the fact that Priority Group 4 plans (those projected to become insolvent before 3/11/2023) have been able to file since July 1st. To date, 41 plans have submitted applications to receive SFA. When Ron and I were involved in the Butch Lewis Act effort, Cheiron had produced an excellent analysis of 114 plans. I’ve read on numerous occasions that perhaps as many as 200 pension plans might be eligible to participate in the ARPA legislation. If that is the case, we’ve only seen about 20% of the applications filed or <50% if the number of eligible plans is closer to Cheiron’s initial study. Obviously, there is more to come. Stay tuned!

One Month Doesn’t Make A Trend!

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

As a child playing football, I was told to look at my opponent’s belt buckle when going to make a tackle, so as to avoid head fakes. Well, market participants cheering yesterday’s inflation news might do well to heed this advice, as head fakes occur in the capital markets all the time. What would be the equivalent of focusing on the opponent’s belt buckle? In the inflation case, perhaps we should avoid the headline # of 8.5% and focus more attention on those components that continue to highlight significant inflationary pressures such as food and housing. Also, the 8.5% CPI number is still significant, as wages continue to fall substantially below that level at 5.2% YOY growth.

The graph below highlights the path that inflation took during the 1970s into the early ’80s. In August 1972, before Tug McGraw would famously chant “You Gotta Believe” in reference to the NY Mets going from bottom dwellers to the World Series, annual inflation would bottom at 2.95%. It would continue an unabated rise “peaking” 23 months later at 11.54%. Following that month (July 1974), the annual CPI would fall to 10.89% or -0.65% in one month – sound familiar? Did that occurrence represent the beginning of the end for inflation – NO! As August’s CPI quickly rebounded producing a 1.06% increase to an annual rate of 11.95%. Inflation wouldn’t peak until November of 1974 at an annual rate of 12.2%.

US Federal Reserve eased too quickly

In an attempt to thwart these inflationary pressures, the US Federal Reserve would raise the Fed Funds Rate (FFR) to 16% by March of 1975. However, they would dramatically reduce the Fed Funds Rate in April down to 5.25%, as inflationary pressures were subsiding – was that action premature? Inflation would fall precipitously from that November peak in 1974 to a bottom in that cycle in December 1976. However, the low annual inflation # was still at 5.04%, or 2.5 times where the Fed would like to see inflation today. Regrettably, inflation once again took off eventually peaking at 14.6% in April 1980. However, despite increasing the FFR to a whopping 20% in the month prior to the peak, it would have to revisit that extraordinary level on several occasions during the next couple of years.

Where did inflation go following these unprecedented moves? Well, it didn’t plunge. In fact, it took 3 years and two months to finally have inflation post a number that began with a 2! Inflation would eventually bottom out at an annual rate of 2.36% in July 1983 before once again ascending. Market participants that believe a Fed Funds Rate of 2.25% will quickly extinguish our current inflation have not studied past cycles. One should realize that unemployment touched 10.8% in 1982! With current unemployment at 3.5% and annual wage growth of 5.2%, just how much economic activity will be tamped down by our current levels of interest rates? I suspect very little. Don’t let one month of “falling” annual CPI rates cloud your judgment. History suggests that we are in for quite the rollercoaster ride.

ARPA Update Through August 5, 2022

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

I look forward to these Monday updates but would prefer a bit more activity to get everyone excited by the progress being realized in the quest to secure the pension promises that are so important for our American workers. However, I can only report on what is actually happening at this time. That said, we had Local 966 Pension Plan file a revised application seeking Special Financial Assistance of $51.3 million for its 2,356 plan participants. The initial application was filed on March 31, 2022 and withdrawn for unknown reasons on July 15th. The PBGC now has 120 days to act on this revised application.

In other news, the PBGC announced last Monday, August 1st, that the Pension Plan of the Printers League – Graphic Communications International Union Local 119B, New York Pension Fund had its application approved for $90.6 million in SFA proceeds that will go a long way in securing the promised benefits for 1,213 plan participants.

We, at Ryan ALM, are working with a few pension plans that have or will receive SFA proceeds. We are still waiting to see how these plans and their consultants will react to the PBGC’s Final, Final Rules that permit the expansion of permissible investments. We still favor only using SFA proceeds to invest in bonds that would be used to defease the promised benefits (and expenses) chronologically from the next month’s benefits as far out as possible. I’ve modeled many scenarios using historic data and possible future returns with the newly expanded investments. I will be reporting in a separate post on those results, but I haven’t been motivated to change my opinion on how the SFA should be invested. More to come!

Recession Fears Overblown!

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

Yesterday, I produced the chart below with the intent to write a piece regarding premature recessionary fears. My premise was based on the fact that since 1970, recessions only occurred as unemployment rose/peaked. With today’s jobs report, I am more convinced that we will be saddled with inflationary pressures for longer without a corresponding recessionary environment. The calendar year 2000 is interesting as unemployment began to rise but given the low level of unemployment at that time, the economy never went into recession. Could our current landscape be foretelling a similar outcome?

Produced by Russ Kamp, Ryan ALM, Inc.

As for today’s news, it’s been reported that US employers added a robust 528,000 workers in the last month which far exceeds prognostications by a factor of 2Xs. Furthermore, these new jobs spanned many industries/sectors. As a result, the unemployment rate now stands at 3.5%, which is the lowest level of unemployment in the last 50 years. As has been reported numerous times, individual balance sheets have been improved since the flood of government stimulus beginning in 2020. Their spending may be shifting from goods to services, but they are spending nonetheless!

Bond investors that were anticipating a dramatic reversal in both inflation and interest rates may want to rethink that strategy given this news. As we’ve been reporting, US real rates are at historic lows providing “investors” with significant real losses after inflation. This news shouldn’t come as a shock. The US Federal Reserve has been showing its hand for quite some time that it would do what is necessary to tame the inflationary beast. We warned you on several occasions to not ignore the Fed. Caveat emptor!

What Do They Know That We Don’t?

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

It was announced earlier today that the Bank of England (BofE) has raised its key rate by 50 bps representing the largest increase since 1995. This marks the sixth consecutive meeting in which they’ve raised this rate, which now stands at 1.75%. This decision follows England’s June inflation reading of 9.4% (the US is at 9.1%). The aggressive pace of rate increases mirrors the U.S. Federal Reserve’s, but the magnitude has been slightly less intense, as the Fed Funds Rate currently sits at 2.25% to 2.50%.

In announcing this latest increase they also provided perspective on the future paths for both rates and inflation in stark contrast to the recent pronouncement by the U.S. Federal Reserve which stated that future “guidance” would be limited. BofE is anticipating inflation to eventually peak at 13.2% during Q4’22. They are also forecasting that Great Britain’s economy could suffer a recession for 5 consecutive quarters beginning later this year. However, that is not going to impact BofE’s decision to aggressively fight inflation, which mirrors the US Fed’s position that inflation poses a great threat and must be tamed even if economic growth is impacted in the short term.

It is fascinating to watch the market activity within the U.S. at this time, as investors seem sold on the idea that inflation has already been tamed and that rates will have to fall in the near term. The U.S. has not posted an inflation # yet that would indicate that inflation has peaked. Furthermore, the Fed Funds Rate is at 2.25%-2.50% which is at the low end of the normal range of 2% to 5%. In 1975, the Fed increased the FFR to 13% in July while inflation was still at 11.5%. The US economy would fall into recession later that year and the Fed aggressively reduced rates once again to 5.25% by April, but inflation remained elevated at >10%. This premature action would lead to the Fed eventually raising the FFR to 20% in March 1981. It wasn’t until 1982 that inflation eventually fell below 10%, but rates remained elevated with the FFR still at 20% in March 1982.

Given the history cited above, just how much economic activity will they have hampered with rates remaining this low? Remember, inflation peaked in early 1980, but interest rates didn’t begin to fall until 1982. If a similar pattern forms, bond “investors” will be sitting on huge negative real returns for quite some time. That is not a winning strategy!

Have We Seen Negative Real Rates of This Magnitude?

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

Following the publication of yesterday’s post, I received several good questions including the following: “Have real interest rates (nominal rate minus inflation) ever been below -5%, let alone the current -7%?” It is a terrific question and one that should be on the minds of all investors. The simple and not surprising answer is not since at least 1953. We came close during the turbulent ’70s, but nothing to this extreme. With the most recent rally in Treasuries, the real rate for the US 10-year Treasury Note is – 6.22% as of 8:20 am on August 3, 2022.

It makes no sense to me and many others why the investment community continues to accept such a ridiculously low return on US government bonds given the inflationary environment that won’t likely collapse as quickly as it rose. Again, my premise is that 4 decades of falling US interest rates that culminated in historically low rates associated with the Covid-19 crisis have clouded our judgment and anchored us to believe that interest rates will remain low forever and ever. All one needs to do is look at the yield on the US 10-year Treasury Note for the 30 years prior to 1982.

US interest rates historically provide a real return

One should also note that US rates kept rising into 1982 despite the fact that inflation peaked in 1980. Again, investors thinking that the US Fed has already accomplished its objective in curbing inflation by increasing the Fed Funds Rate to 2.25% – 2.5% are just kidding themselves. These rates remain near historic lows and likely remain stimulative to economic growth. Couple that fact with full employment and strong wage growth and it remains highly unlikely that the investment community will get their Christmas gift of a Fed providing easing early in 2023. As always, we encourage your questions and look forward to engaging with you in the near future.