Tag Archives: Interest Rates

04.29.24
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How “Real” Will the Fed Get?

By: Ronald J. Ryan, CEO, Ryan ALM, Inc.

Chairman Powell and the Fed have consistently said they want real rates. The Fed primarily focuses on the Personal Consumption Expenditures (PCE) as their gauge of inflation. Currently the PCE is at 2.7%. What the Fed has not said is the target level of real rates. Historically, real rates as measured by the St. Louis Fed have averaged about 3.0% although the trend line has decreased steadily since the 1980s (see graph below). With the PCE at 2.7% today a 2% to 3% real rate would suggest a 4.70% to 5.70% 10-year Treasury nominal rate. With the 10-year Treasury at 4.66% today, it would seem that there is no reason for any cut in rates by the Fed. In fact, there may be more reason to increase rates.

The question remains… where will inflation (as measured by the PCE) level off? Who knows since there are too many factors to consider. The major causes of inflation today seem to be:

  1. Excessive Government Spending

Biden 2025 budget of $7.3 trillion is 12.3% higher than the 2024 budget of $6.5 trillion. Jamie Dimon, CEO of JP Morgan Chase, warns that excessive deficit spending is inflationary and that interest rates could spike up to 8%. The Biden Administration Student Loan forgiveness package could increase the deficit by $430 billion if successful.

  • Oil Prices

       West Texas Intermediate (WTI) Crude oil prices are up over 19% in 2024.

  • Red Sea Attacks

About 12% of global trade goes through here to the Suez Canal. Ships now have to be rerouted around southern tip of Africa creating a delay of about two weeks at a cost of $3,786 per vessel or about $1 million per week. According to Drewry World Container Index costs are up over 90% YoY.

  • Francis Scott Key Bridge Collapse

One of the largest ports in America handling $80 billion in cargo annually. Estimated closure costs = $15 million per day with closure expected for two to three years.

As always, the motto “let the buyer beware” (Caveat Emptor) seems to apply here.

04.29.24
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ARPA Update as of April 26, 2024

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

Can you believe that a 1/3 of 2024 will soon be behind us? It is finally feeling like Spring in NJ today.

There is not much to discuss regarding the PBGC’s implementation of the ARPA pension legislation. According to the latest update, there were no new applications filed, approved, denied, or withdrawn. However, there was one fund that received the SFA. United Food and Commercial Workers Union Local 152 Retail Meat Pension Plan, a Mount Laurel, NJ, plan received SFA and interest in the amount of $279.3 million for the more than 10k plan participants.

There currently are 114 names on the waitlist. Of those, 27 have been invited to submit applications. As the data above reflects, 8 of those applications have been approved, 12 are currently under review, while another 7 have been withdrawn presumably to have the submission corrected and resubmitted. In addition to that activity, 112 of the 114 funds have locked-in a valuation date for SFA measurement (discount rate). Ninety-two percent of those chose 12/31/22, while 2 have no lock-up and the other 9 have chosen dates between December 31, 2022 and November 30, 2023. As a reminder, the SFA is based on a series of discount rates. The lower the rate, the greater the potential SFA. Using the 10-year Treasury yield as a proxy for the discount rate, those plans locking in an evaluation date as of year-end 2022 have done alright, as the yield at the end of 2022 was 3.88%, while it currently stands at 4.63% (4/29 at 3:39 pm).

We’ll have to see if the others have faired as well. In the meantime, the higher US interest rates have certainly helped from an investment standpoint, as the current environment is providing 5%+ YTM investment grade bond portfolios. The higher rates reduce the cost of those future promises while extending the coverage period to secure benefits through a cash flow matching investment strategy.

04.24.24
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Milliman Reports Improved Funding For Public Fund Pension Plans as of March 31, 2024

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

Milliman recently released results for its Public Pension Funding Index (PPFI), which covers the nation’s 100 largest public defined benefit plans.

Positive equity market performance in March increased the Milliman 100 PPFI funded ratio from 78.6% at the end of February to 79.7% as of March 31, representing the highest level since March 31, 2022, prior to the Fed’s aggressive rate increases. The previous high-water mark stood at 82.7%. The improved funding for Milliman’s PPFI plans was driven by an estimated 1.7% aggregate return for March 2024. Total fund performance for these 100 public plans ranged from an estimated 0.9% to 2.6% for the month. As a result of the relatively strong performance, PPFI plans gained approximately $85 billion in MV in March. The asset growth was offset by negative cash flow amounting to about $9 billion. It is estimated that the current asset shortfall relative to accrued liabilities is about $1.271 trillion as of March 31. 

In addition, it was reported that an additional 4 of the PPFI members had achieved a 90% or better funded status, while regrettably, 15 of the constituents remain at <60%. Given that changing US interest rates do not impact the calculation for pension liabilities under GASB accounting, the improvement in March’s collective funded status may be underreported, as US rates continued the upward trajectory begun as the calendar turned to 2024.

04.24.24
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Tricky? Not Sure Why!

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

The WSJ produced an article on April 22, 2024 titled, “Path for 10-Year U.S. Treasury Yield to 5% Is Possible but Tricky” At the time of publication, the 10-year Treasury note yield was just under 4.7%. It is currently at 4.66%. Those providing commentary talked about the need to further reduce expectations for potential rate cuts of another 25 to 40 basis points. As you may recall, there were significantly greater forecasts of rate cuts at the beginning of 2024, but those have been scaled back in dramatic fashion.

Given the current inflationary landscape in which the Consumer Price Index for All Urban Consumers (CPI-U) increased 0.4 percent in March and 3.5% annually, a move toward 5% for the US 10-year Treasury note’s yield shouldn’t be surprising or tricky. According to the graph below, the US 10-year yield has averaged a “real” yield of nearly 2% (1.934%) since 1984. A 2% inflation premium would place today’s 10-year Treasury note yield at roughly 5.6%.

Given the current economic conditions (2.9% GDP growth for Q1’24) and labor market strength (3.8% unemployment rate), it certainly doesn’t seem like the Fed’s “aggressive” action elevating the Fed Funds Rate from 0 to 5.5% today has had the impact that was anticipated. Inflation in 2024 has been sticky and may in fact be increasing. Should geopolitical issues grow in magnitude, inflation may get worse. These current conditions don’t say to me that a move to a 5% 10-year Treasury note yield should be tricky at all. As a reminder, the yield on this note hit 4.99% in late October 2023. Financial conditions have not gotten more restrictive since then.

Should the Treasury yield curve ratchet higher, with the 10-year eventually eclipsing 5%, plan sponsors would have a wonderful opportunity to secure the future promised benefits at significantly reduced cost in present value terms, especially if the cash flow matching portfolio used investment grade corporate bonds with premium yields. Although US corporate bond spreads are tight relative to average spreads, they still provide a healthy premium. Don’t let this rate environment pass without taking some risk from your plan’s asset allocation. We’ve seen that scenario unfold before and the outcome is scary.

04.03.24
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What Are the Stats Telling Us?

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

Mark Twain quoted Benjamin Disraeli in his 1907 autobiography, when he stated “Lies, damned lies, and statistics” as a phrase used to describe the persuasive power of statistics to support weak arguments. Folks who regularly read my posts know that I am a frequent user of statistics to support my arguments, whether they are strong or weak. As a young man, I would study the sports section box scores and the backs of my baseball cards for every possible stat. It is just who I am. I love #s!

The investment management industry is inundated with statistics. You can’t go a day without a meaningful insight being shared in reference to our industry, the economy, interest rates, politics, companies, commodities, etc. I try to absorb as many of these stats as possible. However, it is easy to fall prey to confirmation bias, which humans are prone. Putting a series of statistics together and building an investment case is never easy. That said, we at Ryan ALM, Inc. have been saying since the onset of higher rates that the US Federal Reserve would likely be forced to keep rates higher for longer, as inflation would remain stickier than originally forecast.

We also didn’t see a recession on the horizon due to an incredibly strong US labor market, which continues to witness near historic lows for unemployment. Despite the retiring of the Baby Boomer generation, the labor participation rate is up marginally during this period of higher rates, indicating that more folks are looking for employment opportunities at this time. They are being supported by the fact that job openings remain quite elevated relative to pre-Covid-19 levels at roughly 880k. When people work, they spend! Wage growth recently surprised to the upside. Will demand for goods and services follow? It usually does.

Furthermore, as we’ve disclosed on many occasions, financial conditions are NOT tight despite the rapid rise in US interest rates from the depths induced by the pandemic. Long-term US rates remain below the 50-year average, and in the case of the US 10-year Treasury note, the yield difference is roughly -2.1%. Does that give the Fed some room to possibly increase rates should inflation remain elusive?

In just the past week, we’ve had oil touch $85/barrel, the Atlanta Fed’s GDPNow model increase its forecast for Q1’24 growth from 2.3% to 2.8%, a Baltimore bridge collapse that will impact shipping and create additional expense and delays, housing that once again exceeded expectations, Fed (Powell) announcements that a recession wasn’t on the horizon, job growth (ADP) that was the highest in 8 months, manufacturing that stopped contracting for the first time since 2022 (17 months), and on and on and… Am I kidding myself that our case for higher for longer is the right call? Am I only using certain stats to “confirm” the Ryan ALM argument?

We don’t know. But here is the good news. Our investment strategy doesn’t care. As cash flow matching experts, we are agnostic as to the direction of rates. Yes, higher rates mean lower costs to defease those future benefit promises, so higher rates are good. However, once we match asset cashflows of interest and principal to the liability cash flows (benefit payments and expenses), the direction of rates becomes irrelevant, as future values are not interest rate sensitive. Building an investment case for cash flow matching was challenging when rates were at historic lows. It is much easier today, as one can invest in high quality investment-grade corporate bonds and get yields in the range of 5%-5.5%, which is a significant percent of the average return on asset assumption (ROA) with much less risk and volatility of investing in equities and other alternatives.

I don’t personally see a case for the Fed to cut rates in the near future. I think that it would be a huge mistake to once again ease monetary policy before the Fed’s objective has been achieved. I lived through the ’70s and witnessed first-hand the impact on the economy when the Fed took its collective foot off the brake. As a result, I entered this industry in 1981 when the 10-year Treasury yield was at 14.9%. The Fed can’t afford to repeat the sins of the past. I believe that they know that and as a result, they won’t act impulsively this time.

03.22.24
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Are We Witnessing a Heavy Weight Fight?

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

Most everyone is aware that monetary policy has gotten much tighter than we’ve witnessed in multiple decades, especially on the heels of the Fed’s zero interest rate policy (ZIRP). As a reminder, the Federal Reserve began raising the Fed Funds Rate (FFR) on March 17, 2022. After 2 years of their tightening action designed to combat inflation, the Fed Funds Rate sits at 5.25%-5.5%, where it has been for the last 1/2 year. Has the Fed’s action achieved its primary objective of price stability? No, but they’ve certainly made strides toward that quest seeing inflation fall from a high of 8.4% in July 2022 to February’s 3.2% reading. Furthermore, neither the economy nor the labor force have collapsed.

I recall when the Fed first began raising the FFR, they anticipated that both the economy and labor force would be impacted. In fact, I remember seeing estimates that the unemployment rate would likely elevate to between 4.5% and 5% as a result of this action, and the economy would most likely fall into recession. Thankfully, neither event has occurred. Why? Despite the aggressive Fed action to raise interest rates, financial conditions are not that tight. In fact, as I wrote in yesterday’s post, by some measures, financial conditions are actually easier than they were before the first rate increase.

Could it be that the Federal government’s budget is the reason behind the economy and labor market’s strength despite “aggressive” monetary policy? The Office of Management and Budget (OMB) estimates that the Federal budget for fiscal year 2024 will ultimately produce a deficit of roughly $1.6 trillion. Furthermore, 2025’s budget is forecast to create a deficit of $1.8 trillion. This is incredible stimulus that is being provided to the US economy. It is in direct conflict to what the Fed is trying to accomplish. First, I don’t believe that the current level of interest rates is that high, especially by historical standards, but they definitely aren’t high enough to combat the government’s deficit spending at this time.

As a reminder, when the government deficit spends, those $s flow into the private sector in the form of income which leads to greater spending and corporate profits, which we are witnessing at this time. This conflict between monetary policy and fiscal policy is what I’m defining as the heavyweight battle. Which policy action will ultimately prevail? Back in the 1970’s monetary policy became quite aggressive leading to double digit interest rates that bled into the early 1980s. There were many factors that created the excessive inflation that ultimately had to be curtailed with unprecedented Fed action. What the Fed didn’t have to do was fight the Federal government budget.

During the 1970s, the average budget deficit was only $35 billion. Yes, that is correct. The peak deficit occurred in 1976 at $74.7 billion , while 1970’s deficit of $2.8 billion was the lowest. In case you are wondering, the $35 billion average deficit would equate to roughly $153 billion in today’s $s or <1/10th of 2024’s expected deficit. Clearly, there was little excess spending/stimulus created by the Federal government at that time for which monetary policy had to combat. So, again, the US doesn’t have a debt problem. It has an income problem! The excess stimulus is elevating economic activity, keeping workers employed and spending, while corporate America produces the goods and services that are being demanded, leading to excess profit growth that continue to fuel the stock market.

As you can see, this tug of war or heavy weight battle is far from decided. I don’t believe that US interest rates are high enough to truly impact economic activity and the labor force, which continues to enjoy sub 4% unemployment rates. We either need rates to rise more, government deficits to shrink, or a combination of both before we see the Fed achieve its goal of a 2% sustained inflation rate. Let’s pray that our very uncertain geopolitical environment doesn’t take a turn for the worse with further escalation of the Ukraine/Russia war or worse yet, conflict in Southeast Asia between China and Taiwan. Our inflation story could get much worse under those scenarios.

09.18.14
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Maintain Your Asset / Liability Mismatch At Your Own Peril!!

Recent news from around the world indicates that growth is slowing in nearly every region. Japan and China are pumping liquidity into their systems to encourage more growth. Europe, an unmitigated disaster, will need to continue to provide stimulus, and not austerity, in order to get their citizens working and consuming. The US continues to plod along, but given our trading partners’ struggles, it would be naive of us to think that our ability to export goods won’t be negatively impacted.

With that said, US interest rates remain significantly above those of our partners in Europe and elsewhere, particularly in the 5- and 10-year space. The US rates provide real value relative to these other countries, and so it is likely that the value will be captured as investors seek those higher yields.

In the US pension arena, most plans continue to be dramatically underweight fixed income, as they fear higher rates and yields that are well below the ROA. Stop! The ROA isn’t the objective, and rates aren’t necessarily going higher. The only asset that moves in lock step with a pension plan’s liabilities is fixed income. We have a major funding issue in the US that will be exacerbated should rates continue to fall.

A new direction is needed in the day-to-day management of DB plans. Call us if you want to receive our insights.

04.24.14
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When everyone expects one thing, you may want to prepare for a different outcome

On January 9th, and again on April 4th, we at KCS addressed the issue that US interest rates wouldn’t necessarily rise, and in fact, with everyone in the world seemingly believing that interest rates had only one way to move – UP – we thought that there was a good chance that rates might fall.  In fact, the interest rate on the 10 year US Treasury has fallen by more than 30 bps so far this year.  That is a fairly meaningful move.  With many plan sponsors and asset consultants trimming, eliminating, and restructuring their US fixed income exposure, a plan’s asset allocation is now more disconnected from the liabilities than before.  This disconnect exacerbates the volatility in funded ratios and contribution costs. 

Don’t believe us, then how about the following.  Here is a brief research piece that I found on Cullen Roche’s website today.

“Jim Bianco, of Bianco Research, points out in a market comment Tuesday that a survey of 67 economists this month shows every single one of them expects the 10-year Treasury  yield to rise in the next six months.

The survey, which is done each month by Bloomberg, has been notably bearish for some time now, with nearly everyone expecting rising rates. In March, 97% expected rising rates. In February, 95% expected yields to climb. And in January, 97% held that expectation. Since the beginning of 2009, there have only been a handful of instances where less than 50% expected rates to rise.”

Read more at http://pragcap.com/the-metamorphosis-of-the-bond-bears#6KE3VCCCBLDYV554.99

The US Retirement industry cannot afford to get the direction of rates wrong.  A continuation in the decline of rates will only further inflate the underfunding of US pension liabilities, and continue to put pressure on both private and public DB plan sponsors to do something else, such as close or freeze the DB plan and move more participants into DC.  At KCS, we’ve spoken and written about alternative strategies that go along way to improving funded ratios and stabilize contribution costs.  We are waiting to hear form you.

The beneficiaries of our collective effort cannot afford to have us screw up any more. DC plans are not the answer, but are quickly becoming the only game in town.

 

“Jim Bianco, of Bianco Research, points out in a market comment Tuesday that a survey of 67 economists this month shows every single one of them expects the 10-year Treasury  yield to rise in the next six months.

The survey, which is done each month by Bloomberg, has been notably bearish for some time now, with nearly everyone expecting rising rates. In March, 97% expected rising rates. In February, 95% expected yields to climb. And in January, 97% held that expectation. Since the beginning of 2009, there have only been a handful of instances where less than 50% expected rates to rise.”

Read more at http://pragcap.com/the-metamorphosis-of-the-bond-bears#6KE3VCCCBLDYV554.99

“Jim Bianco, of Bianco Research, points out in a market comment Tuesday that a survey of 67 economists this month shows every single one of them expects the 10-year Treasury  yield to rise in the next six months.

The survey, which is done each month by Bloomberg, has been notably bearish for some time now, with nearly everyone expecting rising rates. In March, 97% expected rising rates. In February, 95% expected yields to climb. And in January, 97% held that expectation. Since the beginning of 2009, there have only been a handful of instances where less than 50% expected rates to rise.”

Read more at http://pragcap.com/the-metamorphosis-of-the-bond-bears#6KE3VCCCBLDYV554.99