Category

Bond Market

Reversing The Risk Retention Rule For CMBS Could Improve Commercial Lending

By | Bond Market, Commercial mortgages, Financial Markets, Lenders, Regulation

There are several key bank regulations in the Dodd-Frank Act which if loosened could improve bank lending. One important one, is the risk retention rule for asset-backed securities including commercial mortgage-backed securities (CMBS). Reversing the risk retention rule, Section 941 of Dodd-Frank could help improve the CMBS market. The rule became effective December 24, 2015 and gave CMBS an additional year to comply which has caused lower CMBS loan origination volumes over the past year as CMBS lenders prepared to comply. It caused some smaller CMBS lenders to withdraw from CMBS lending altogether.

The risk retention rule problem

The main issue causing problems with the rule is that the CMBS issuers must have “skin in the game” by retaining 5% of the aggregate credit risk of the commercial mortgage loans that it adds to a securitization. Typically, a transaction goes like this. A lender originates a commercial mortgage and either holds on to it or sells it to a larger CMBS issuer. The CMBS issuer is an investment bank who pools other commercial mortgages from various lenders as collateral to support the CMBS. The CMBS issuer does its own homework on the loan before it purchases it.

So a lender will only sell loans that it feels would be accepted by the CMBS issuer. To do otherwise, risks the lender’s reputation with the CMBS issuer. There is already a lot of risk reduction going on before they get to the risk retention rule of holding 5%. That was not the case before the crisis for residential mortgages leading to the risk retention rule.

With the rule, the CMBS issuer, not originating lender has to hold a 5 percent interest in each mortgage they sell to a CMBS issuer. This causes issues both with the originating lender and with the CMBS issuer because the CMBS issuer must really know the lender’s origination and underwriting practices to have the assurance when purchasing loans from a lender. The bottom line is lower margins for all, higher interest rates and higher requirements for loans stemming from another rule that restricts lending. Loans that need to be refinanced and could be before the rule, now might struggle to get refinanced.

Additional issues occurring

A recent Wall Street Journal article expresses some of these issues.

“Pressures have been mounting on these firms for more than a year as volatility and risk have increased in the commercial mortgage-backed securities market.

Profit margins have narrowed in the past few months and are likely to be squeezed further as new rules take effect that require issuers of commercial mortgage-backed securities to keep at least 5% of the bonds they create.”

Some of the smaller lenders have left the business because of the new rules. Other lenders are having to increase their interest rates due to added cost of holding the 5 percent retention piece.

What to expect if you’re in the market for a commercial mortgage

CMBS lenders have, in the normal course of business, also been faced with increasing delinquency and default. As a result, according to another Wall Street Journal article more stress on CMBS lenders is causing additional requirements for commercial real estate borrowers. Some of the cautious steps lenders are taking to reduce their risk include the following. If you haven’t been in the market for a commercial mortgage recently, these are some things  you can expect.

  1. Lenders are keenly focused on their fundamentals of lending. Other than the top markets, commercial real estate geographic markets, lenders are really doing their homework and reviewing everything they can about the property in question. They are looking at the strength of the tenants, the lease terms, the net cash flow and looking closely at the sponsor’s liquidity globally not just on the subject property for example.
  2. The new risk retention rule has made borrowing more costly and complicated. Some property owners will not be able to refinance loans obtained prior to the financial crisis, or if they are able to it will be at a higher interest rate.
  3. Construction lending by banks (while not a CMBS product) has become more strict– with some of the big banks out of the business for certain property types. Part of this is the supply of new commercial properties, the other part is less permanent lending options available with CMBS. There are other non-bank lenders making construction loans, however. Some property types that remain strong candidates include industrial and multifamily.
  4. Increasing interest rates are causing lenders to underwrite commercial mortgages to higher interest rates than the current market rates -called a phantom rate. Note, a phantom rate is not the contractual rate– think of it as a stress test rate. By using a higher phantom rate, prospective borrowers will find that they are being approved, but at a loan amount lower than what they requested. So be ready to add additional cash to get a deal funded.

These and other lending rules have led to an increase in specialty finance sources to fill the gap that regulation has created with the big bank lenders. We are contacted almost daily by these lenders seeking deals to finance.

Reducing the regulatory burden

The Trump administration is working to reduce the regulatory burden that banks and financial markets are under. It could be a key step to improving the lending environment. Lenders were punished enough through their own mistaken lending practices to have the additional burden of more regulations imposed. Before any of the new regulations were written or became effective lenders had already learned their lessons. Lenders made the necessary changes to reduce their risk and make prudent loans. Banks don’t need post-crisis regulation to do it for them. Lenders are the practitioners, they know better than regulators what mistakes were made and how to correct them.

The regulatory backlash always happens after a crisis. A crisis happens, regulators point to the mistakes (that’s the easy part) and then write more rules to prevent the mistakes from occurring in the future (the hard part)– the problem is every crisis is different and rules don’t get repealed very often. Regulators have never predicted or stopped a financial crisis from occurring and it is not their mission. Even with prudent lending, lenders will have losses when the economy turns down and goes through a recession. If regulators wrote rules to prevent lenders from taking on risk and suffering losses, then there wouldn’t be any banks– because the rules would essentially prevent them from lending in the first place.

Finally, on a positive note, the economic outlook is strong and commercial real estate remains solid, and there are many lenders lending in a competitive environment so it’s still a great time for both lenders and commercial property owners.

 

 

What Commercial Real Estate Trends To Focus On For 2017

By | Bond Market, Commercial Real Estate, Economy, Federal Reserve, Interest rates, Regulation

2017 is almost here! We will be watching the following commercial real estate trends in 2017. These will be important especially if you need financing or are looking for a new property to develop or buy and need financing to do it.

Unemployment

One of the biggest trends to watch will be unemployment– particularly over the next two years. If you followed only unemployment you would have a good feel for where commercial real estate values are headed. Cap rates tend to follow the unemployment rate. So understanding the health of the labor market is an important indicator. It affects how much office space a company needs, the sales volume of a retailer, the industrial space needed for distributors and manufacturers, how many travelers are booking hotel rooms and household formation which drives occupancy and affordability of multifamily. All of this is dependent upon how many people are employed. Closely related unemployment is interest rates.

Interest Rates

What the Fed does will influence interest rates for sure. But unemployment is also what the Fed is watching that influences them to take action too. The Fed’s dual mandate to influence unemployment and control inflation is only done by changing interest rates. The Fed has the ability to change short-term rates by changing their federal funds rate. That’s on the short end of the yield curve. They can also influence the longer end of the market through their HUGE multi-trillion dollar bond portfolio.  It’s the long end that can impact borrowing rates. Raising short-term rates has a direct impact on long-term rates.

Inflation

Recently interest rates spiked up because of the Fed’s anticipated decision to increase the federal funds rate. But it was also because of market factors such as an increase in commodities and President-elect Trump’s election win and commitment to infrastructure spending.  The bond market has had a big reaction to those two events. It will take time for both increasing commodity prices and any infrastructure spending to impact an increase in prices generally that would lead to inflation. At this time, inflation is still not a concern. But with low unemployment, the largest drivers of inflation is wage growth and with low unemployment, employers have to pay more to get qualified workers. More people working with rising wages will eventually lead to inflation. So we are watching this closely too.

Tax Reform

With President-elect Trump, tax reform is a top priority. The benefit of this is he’s a commercial real estate developer and operator too! So we can expect that whatever actually happens to tax reform, there will be some beneficial change that is positive for commercial real estate. One of the likely benefits is the 1031 exchange will remain. That’s a close item of the tax reform that we will be following, in addition to lower tax rates– another plus for economic growth.

Financial reform

The Dodd-Frank Act, unfortunately, is not going away. But with President-elect Trump, some of its provisions hopefully will. By reducing the regulations that banks are under they will be more nimble to expand their commercial real estate lending in smart ways. Banks do not need regulations to force them to make better loans. Banks are very cognizant of making safe and sound loans. The fewer regulation banks are forced to comply with allows them to make loans that make sense for both them and their borrowers. Yes, there may have been some bad actors, but generally speaking, less banking regulation will allow our economy to function more efficiently, productively and grow at a healthier rate.

To much success in 2017!

Happy new year!

 

Fed Raised Its Rate And It Is Old News

By | Bond Market, Economy, Federal Reserve, Interest rates

This week the Fed raised their overnight lending rate 25 basis points to .75%. But this is old news. The market basically did it for them with the bond market’s overreaction to the election results with president-elect Trump. So what! The Fed raised their rate 25 basis points. The 10 year US treasury yield has already risen from a July 8th low of 1.38% to 2.6% as of today– that’s 122 basis points. As interests rates rise, bond prices decline and the bond market has been selling off since July– two sides of the same coin. So, did the bond market really see a Trump win back in July? The bond market is very conservative, so did they see a republican win? People have been saying the increase in interest rates generally is a reaction to the Trump win, but that’s not so, because the increase started in July. Or is there an underlying trend that the press hasn’t picked up on yet? Political events and politicians really don’t have a large impact longer term on economic trends unless the effect major policy errors or war. The longer term trends typically are due to larger underlying pressures.

Higher rates attract foreign investment which bids up an already strong dollar which is great for imports, terrible for U.S. exports and foreign investments if you have them. Stocks have moved higher but many anticipate the stable dividend stocks with bond-like qualities which have been so strong for so long will also go the way of other income producing assets– aka bonds. Precious metals have fallen as the dollar has increased– that’s a typical inverse relationship. Commodities have fallen too as they are priced in U.S. dollars and have an inverse pricing relationship– except for the price of oil which has rallied approaching $60. Say what? An oil rally? Some have suggested that oil is the reason why bonds have sold off since July, pushing interest rates higher. Trump’s campaign statements about infrastructure spending and lower taxes to generate growth in the economy has further spiked interest rates.

Back to oil for a minute. Why is oil rising? Is it because of increased world demand or even U.S. demand? Has OPEC changed their stance? Has Saudi Arabia? What is the reason for oil prices bidding up? I do know, just like my car’s engine needs oil to run smoothly, the world economy needs oil to operate as well, so is demand coming from somewhere? Or is oil supply the driving factor? Someone knows, I don’t.

These are the current economic conditions. They are also the market’s expectation of rising interest rates. We have all had 10 years to think about these relationships and the implications of increasing interest rates. We knew this would happen, right? So that is why the Fed’s rate increase is old news. Further and more important, Trump’s win is also probably an overreaction even if the price of oil is an overreaction. Nevertheless, some have discussed that a 10 year U.S. Treasury yield of 3% would be enough to slow down the U.S. economy, which is already having its own troubles trying to grow, let alone the world economy. Is 3% possible? Or is the there finally enough strength in the world economy that a rise in U.S. rates wouldn’t be harmful? I don’t know if 3% is the tipping point.

Interest rates are likely going to come back down a bit in the short term, but probably not to the prior July low. I think the bond market has overreacted to recent events. But I think longer term the trend in rates has begun. Having said that, I am not a forecaster of interest rates, nor do I even try. It’s better to follow the market, is my motto. If you can’t beat them, join them. The Fed’s 2017 forecast is for 3 more rate increases.

Anyway, here’s my reasoning for why I think the interest rate trend is moving higher– at a very slow pace. These trends take time to develop. Trump’s policies will have to make their way through Congress and that takes time as we all know. Commodity prices are low and therefore, finished goods prices are not going to be going higher until producers start paying more for raw commodities. A strong dollar helps import prices remain low, so no inflationary pressure there either. Global inflation isn’t a concern currently either. Inflation is typically a treat at the end of a strong period of growth– something we have not had.

U.S. wage growth while ticking up is also not terrible even with a low unemployment rate. But that never seems to stay low for long and with labor market participation rates at historic lows with baby boomers retiring, employers are left with younger new entrants who have less experience and are more willing to work (forced they may say) for a lower wage. So wage pressures will remain subdued for a while as well. So I think we have 1 or 2 years more before we really start to see rates return to more normal, historical levels with U.S. Treasurys eventually settling in the 4 to 6% range. Nevertheless, the chart below helps me, at least, keep a rising rate increase in perspective. Look how long it has taken rates to drop from the earily 1980s highs. I don’t see an overnight return to high interest rates, do you? I’m not worried.

fredgraph

Another trend that is being discussed is this one on unemployment. As mentioned above, unemployment never stays at low for very long. When it is at low under 5%, guess what happens? An economic recession occurs. This pattern has occurred almost every time since the 1950s and probably longer than that. Why we can’t remain at low unemployment for long is a mistery. I don’t think economists have fully figured it out, but you’ll earn a Nobel prize for sure if you did! If you have, please let me know! But then the optimist in me sees the opportunity when unemployment is high on the other side of the recession. High unemployment is a good sign that the economy is starting to recover. See the chart below. And remember, none of this should be considered investment advice. These are just my observations.

Unemployment chart.

Additional sources for analysis.

Here’s the Fed’s public announcement on their rate decision.

The Wall Street Journal had a good article on the news. (WSJ)

 

Fed Seeing More Cause for Pause on Rates

By | Bond Market, Economy, Federal Reserve

Minutes show officials grappling with growing threats from market volatility, China slowdown; inflation concerns

Federal Reserve officials appear increasingly reluctant to raise short-term interest rates at their March policy meeting, and possibly beyond, amid market turbulence, China’s dimmed outlook and indications that inflation could stay at low levels longer than expected.

Officials struggled with uncertainty about these developments at their January policy meeting, according to minutes of the gathering released by the central bank Wednesday. Since the meeting, some officials have started speaking out about their desire to wait to raise interest rates again until they’re sure the U.S. economic outlook isn’t deteriorating and inflation isn’t stuck below their 2% target.

At the January 26-27 gathering, officials “agreed that uncertainty had increased, and many saw these developments as increasing the downside risks to the outlook,” said the minutes, which were released with their regular three-week lag.

The Fed in January held its benchmark short-term interest rate steady at between 0.25% and 0.5%. The central bank increased that rate by a quarter percentage point in December and penciled in four more rate increases for 2016, driven by a view that inflation would start rising as hiring and the economy continued to expand.

The Fed’s next policy meeting is March 15-16. Traders in futures markets see a 94% chance it won’t raise rates then, an 83% chance it won’t move before midyear and about a 50% chance the Fed won’t move rates at all in 2016, according to the Chicago Mercantile Exchange.

“Inflation is not likely to pick up substantially until the second half of the year,” Patrick Harker, president of the Federal Reserve Bank of Philadelphia, said at the University of Delaware on Tuesday. “It might prove prudent to wait until the inflation data are stronger before we undertake a second rate hike.”

Fed Chairwoman Janet Yellen expressed uncertainty about the outlook in testimony to Congress last week without taking a March move off the table. She did emphasize that Fed policy is not on a set course and would be responsive to new developments.

“If inflation is slower to return to target, monetary policy normalization should be unhurried,” Eric Rosengren, president of the Federal Reserve Bank of Boston, said Tuesday. “A more gradual approach is an appropriate response to headwinds from abroad that slow exports, and financial volatility that raises the cost of funds to many firms.”

Of course nothing is yet set. Markets can quickly reverse and the Fed will have a chance to look at more data on inflation and jobs before making a call next month.

Stock markets have already shown some signs of stabilizing. Moreover, economic data haven’t been all bad. The Federal Reserve Bank of Atlanta estimates economic output is expanding at 2.6% annual rate in the first quarter, up notably from a 0.7% pace in the fourth. Moreover wage growth shows signs of accelerating as the jobless rate falls.

The Fed’s policy statement in January was striking because officials decided not to make a judgment about what they call the “balance of risks” to the economy—whether they believed the economy was likely to perform more poorly than their forecasts or exceed their expectations.

The balance of risks matters because it is an indication of whether they are inclined to raise rates again, hold steady or cut them. Some officials already concluded the economy risked underperforming, but other wanted to withhold judgment. Their unwillingness to make any declaration about the balance of risks underscored their hesitance about raising rates.

“Most [officials] were of the view that there was not yet enough evidence to indicate whether the balance of risks to the medium-term outlook had changed materially, but others judged that recent developments had increased the level of downside risks or that the risks were no longer balanced,” the minutes said.

Peter Hooper, chief economist at Deutsche Bank Securities, said he expected the Fed to lower its growth and inflation forecasts when officials next meet in March. That would be a precursor to moving interest-rate plans into neutral.

Mr. Hooper started the year projecting three Fed rate increases this year. He has now downshifted to one later in the year.

The minutes showed the Fed’s own staff economists saw a risk that economic growth and inflation would underperform expectations and unemployment could be higher than forecast, “mainly reflecting the greater uncertainty about global economic prospects and the financial market turbulence in the United States and abroad.”

Expected inflation is an important wild card. Bond-market measures and survey measures of expected future inflation are dropping. Fed officials don’t want to see inflation expectations drift lower. Inflation has already been running below the Fed’s 2% target for more than 3½ years.

Further declines in inflation expectations indicate investors and households might be losing confidence in the central bank’s ability to drive inflation up to target. Undershooting it is an indication of an economy’s lack of vitality, like low blood pressure in a hospital patient.

“A number of participants indicated that, in light of recent developments, they viewed the outlook for inflation as somewhat more uncertain or saw the risks as being to the downside,” the minutes said. “Several participants reiterated the importance of monitoring inflation developments closely to confirm that inflation was evolving along the path anticipated” by the Fed.

The Fed used the word “uncertain” or “uncertainty” 14 times in the January minutes, compared to seven times in December when the central bank raised rates, and six times in October when it telegraphed that a rate increase could be coming.

via (wsj)

Fed Nods to Negative Rates, Hurdles and All

By | Bond Market, Commercial mortgages, Federal Reserve, Financial Markets

Legal and practical obstacles make negative rates unlikely, but Janet Yellen suggests such a move is possible

Federal Reserve Chairwoman Janet Yellen waded into fraught territory before Congress, suggesting the central bank could turn to negative interest rates in an economic downturn despite legal and other uncertainties.

Her comments Wednesday came as concerns about unsettled markets and weak global growth pushed benchmark U.S. Treasury rates to a one-year low. The yield on the 10-year note fell to 1.706%, leaving it down more than half a percentage point so far this year.

Central banks in Europe and Japan have turned to the once-radical idea of negative interest rates to spur their moribund economies. The idea that their U.S. counterpart might follow suit is unlikely but not impossible. The Fed raised interest rates in December for the first time in a decade and is weighing whether to raise them further. Ms. Yellen in her testimony said it was unlikely the central bank would need to cut rates soon, much less go negative.

When questioned about the possibility, however, she said it could be done if necessary.

“I’m not aware of anything that would prevent us from doing it,” Ms. Yellen said.

That the question even comes up is a sign of the bind central banks find themselves in seven years after the financial crisis. Growth remains weak, and investors have retreated from risky assets this year, putting pressure on monetary-policy makers to find more aggressive ways to stimulate demand.

The  Janet Yellen adopted negative rates in January, following the example of the European Central Bank and policy makers elsewhere in Europe. Countries representing more than a fifth of global economic output now are experimenting with negative rates.

Fed officials are taking the idea seriously after watching the efforts overseas. Negative rates are “working more than I could say I expected” only a few years ago, Fed Vice Chairman Janet Yellen said this month. The Fed said in recent materials related to its annual bank “stress tests” that big financial institutions need to model how they would perform under negative borrowing costs.

The prospect would face a number of challenges. A central impediment is the law authorizing the Fed to pay interest to banks on reserves they deposit with the central bank. The Fed now is paying 0.5%, a rate it moved up from 0.25% in December in hopes the economy and job market would keep improving.

The 2006 law granting the Fed that authority says depository institutions “may receive earnings to be paid by the Federal Reserve.” That language—“to be paid”—might prevent the Fed from charging interest on deposits without new legislation from Congress. The Fed looked at the legality of negative interest rates in 2010 but didn’t reach firm conclusions, Ms. Yellen said Wednesday.

The Fed faces more practical barriers, too. Fed computer systems for calculating interest on reserves don’t allow for negative rates, though they could be modified, according to an internal Fed memo from 2010 that was authorized for public release late last month. Negative rates also could pinch bank profits and the $2.7 trillion money-market fund industry that households and corporations rely on as a place to keep money readily accessible.

“We would need to see recession-like conditions before the Fed seriously considered this option,” Michael Feroli, an economist with J.P. Morgan Chase, said in a recent note to clients.

Meanwhile, the yield on the 10-year U.S. government note fell after an auction of government debt Wednesday drew strong demand from investors at home and abroad. Investors accepted a 1.73% yield on new 10-year Treasury notes, the lowest auctioned yield on that maturity since 2012.

Those results reflect investors’ struggle to obtain assets that offer a good mix of safety and income. Thanks to negative rates elsewhere around the globe, U.S. Treasury bonds offer some of the highest yields in the developed world.

“U.S. yields are still much higher than many other peers, creating demand,” said Mary Ann Hurley, vice president of trading at D.A. Davidson & Co. “There is no inflation, and the global economy is struggling.”

Should the economy sink, some economists say the Fed will have no choice but to find a way around the impediments to engineering negative rates.

In almost any likely recession scenario, the Fed won’t have been able to raise rates high enough to then lower them enough to provide real economic lift, said Scott Sumner, an economics professor with George Mason University’s Mercatus research center. So to get there, the Fed will have to go under zero with its short-term rate target, he said. “When we next go into recession, we’ll go negative,” he said.

via (wsj)

Commercial Mortgage Interest Rates Likely to Remain Low For a Long Time

By | Bond Market, Economy, Federal Reserve, Interest rates

As the Federal Reserve seems set on raising overnight Fed funds rates this December, longer term US Treasury security yields will likely remain low for a longer time. Which means interest rates on commercial mortgages will remain attractive going into 2016. There are several reasons the bond market is reacting this way to movements in short-term interest rates. The bond market is more concerned about overseas economies being weak, the strong US dollar, wages rising ever so slowly, inflation unlikely to reach the Fed’s 2 percent target and commodity prices low especially energy prices.  With the Fed all but certain to raise rates, the yield on the 10-year Treasury note remains flat as it has all year. This is a key bond yield for commercial property owners to watch because residential and commercial mortgages are priced based upon the current yield on the 10-year US Treasury bond.

So regardless what the Fed does to effect short-term interest rates, don’t expect to see longer term rates increasing soon.  See the Wall Street Journal article on this topic.

Don’t Blame the Fed for Low Rates

By | Bond Market, Federal Reserve, Regulation

William Poole’s editorial published in the Wall Street Journal Opinion section today may provide some confirmation to what you might already be thinking about the slow growth the US economy has experienced for the past seven years. Here’s the editorial:

“The frequent claim that Federal Reserve Chair Janet Yellen and her colleagues are responsible for continuing low rates of interest may be correct in the small, but not in the large. The Fed does set the federal-funds rate—the overnight interest banks charge to lend to each other—and surely affects the timing of rate changes, but not the longer-run level. The real villain behind low interest rates is President Obama.

Long-term rates reflect weak job creation and credit demand. As the Fed correctly points out in its Statement on Longer-Run Goals and Monetary Policy Strategy: “The maximum level of employment is largely determined by non-monetary factors that affect the structure and dynamics of the labor market.” The same argument applies to all real variables, such as the rate of productivity growth.

The Fed has successfully kept inflation close to its 2% target. But the real rate of interest, currently negative for short-term interest rates and only slightly positive for long rates, is a consequence of non-monetary conditions that have held the economy back.

The recovery since the recession trough in June 2009 has been the weakest since World War II. Why? Disincentives to business investment deserve special notice. Despite the lowest interest rates for a sustained period since the 1930s, business investment has exhibited weak growth. Lagging business investment has meant smaller than usual demands in credit markets, and thus low interest rates.

The Obama administration has created one disincentive after another. One is the failure to pursue tax reform and the president’s insistence on higher tax rates. Another is the constraint on investment flowing from environmental activism. Cancellation of the Keystone XL pipeline is a metaphor for the entire range of environmental policies that inhibit growth. Businesses cannot expand if they cannot obtain the required permits.

The regulatory environment is a disaster, ranging from growth-killing overreach in the Affordable Care Act and Dodd-Frank to the Consumer Financial Protection Bureau, the Environmental Protection Agency and the Labor Department. The Federal Reserve is not responsible for this mess.

The Fed is responsible, however, for not defending itself by explaining to Congress and the public what is going on. The Fed is too afraid politically to mention any details of its general position that it cannot do the job on its own. Yes, there are “headwinds,” but they are largely the doing of the administration. I say largely because some of the problems have been inherited from prior administrations. The Obama administration didn’t create Fannie Mae and Freddie Mac, for instance, or the government’s affordable-housing goals—both of which fueled the 2008 financial crisis.

But the Obama administration has failed to correct the economic problems it inherited. It has simply piled on more and more disincentives to growth. These disincentives have kept long-term rates low.

Mr. Poole is a senior fellow at the Cato Institute and a distinguished scholar in residence at the University of Delaware. He retired as president and CEO of the Federal Reserve Bank of St. Louis in March 2008.”

via (wsj)

Fed Tipping Toward December Rate Hike, Minutes Show

By | Bond Market, Economy, Federal Reserve, Financial Markets, Interest rates

The official minutes of the Fed’s October 2015 meeting are available here. The key point making headlines in the press is the following section of the minutes:

“the Committee decided to indicate that, in determining whether it would be appropriate to raise the target range at its next meeting, it would assess both realized and expected progress toward its objectives of maximum employment and 2 percent inflation. Members emphasized that this change was intended to convey the sense that, while no decision had been made, it may well become appropriate to initiate the normalization process at the next meeting, provided that unanticipated shocks do not adversely affect the economic outlook and that incoming data support the expectation that labor market conditions will continue to improve and that inflation will return to the Committee’s 2 percent objective over the medium term. Members saw the updated language as leaving policy options open for the next meeting. However, a couple of members expressed concern that this wording change could be misinterpreted as signaling too strongly the expectation that the target range for the federal funds rate would be increased at the Committee’s next meeting.”

The Wall Street Journal reports that the Fed “minutes stated ‘some’ Fed officials felt in October it was already time to raise rates. ‘Some others’ believed the economy wasn’t ready. The wording meant that minorities on both sides of the Fed’s rate debate are pulling in different directions, with a large center inside the central bank inclined to move.”

But even if they do increase short term rates, a trend towards increasing rates will be slow, “At the same time, the Fed minutes included several new signals that after the Fed does move rates higher, the subsequent path of rate increases is likely to be exceptionally shallow and gradual.” Additionally the Wall Street Journal noted, “Looking ahead, Fed officials see new factors—most notably low productivity growth and an aging population—continuing to put downward pressure on growth. As a result, Fed staff argued the Fed’s target interest rate will rise only gradually as the economy strengthens. Many Fed officials have embraced that view and are trying to telegraph it to blunt the blow to markets of the first rate increase.”

Looking out longer-term,

“Beyond near-term planning on rates, discussions at the Fed turned at the October meeting to an ominous longer-run outlook.

With rates already low and not likely to move up much, the Fed’s target interest rate could return to near zero in the years ahead if the economy is hit by some new shock and the Fed decides to cut rates to cushion the blow.

One such shock might be if the Fed itself raises rates more quickly in the months ahead than the economy can bear.

“They could end up killing things pretty fast,” Mr. Blitz said. The other side of that risk, however, is that the Fed could cause a new bubble if it leaves rates too low. “They don’t have a lot of room here to get it wrong.”

Read the full Wall Street Journal article here.

Fed Keeps December Rate Hike in Play

By | Bond Market, Federal Reserve, Financial Markets, Interest rates

“Federal Reserve officials explicitly said they might raise short-term interest rates in December, pushing back against investors who have bet that the central bank wouldn’t move this year.

The message appeared to have the desired effect. Before the Fed released its policy statement Wednesday, traders in futures markets put about a 1-in-3 probability on a Fed rate increase this year; after the release, that probability rose to almost 1-in-2.

While the Fed kept rates steady after its two-day meeting this week, investors appeared to welcome a vote of confidence in the economy from the central bank. The Dow Jones Industrial Average rose 198.09 points, or 1.1%, to 17779.52.”

via (wsj)

The Fed’s October 2015 press release after the meeting can be read here.

Concern About China’s Sale of U.S. Debt Is Overdone

By | Bond Market, Financial Markets, Interest rates

China has and still does hold a significant share of U.S. sovereign debt. The main concern is that should China sell their US Treasury securities, it would cause U.S. interest rates to increase and be a shock on our domestic economy. These concerns were highlighted recently when China began selling their U.S. Treasury bonds and use the cash to keep their currency cheap against the U.S. dollar. By doing this, China would be able to sell more stuff at lower prices here in the US. As China’s economy has slowed down there has also been downward pressure on its currency.

But China’s sale of U.S. debt has not caused Treasury yields to increase–as so many were anxiously suggesting. Instead others have been buying those very U.S. debt securities that China has been selling. So as China has stepped out, other investors have come in buying U.S. Treasuries and maintaining the demand for U.S. Treasuries and keeping U.S  interest rates low. Another similar instance was when the Federal Reserve began to tapper their quantitative easing program and scaled back their bond buying.

What these two recent financial market events tell us is that the U.S. government bond market is much larger in depth and breath than previously thought. What this market action shows is that the world still finds U.S. debt a safe haven along with the strong U.S. reserve currency. When there is financial distress or world events that provoke fear in foreigner investors, they still come here to the U.S.A with their cash. And when they do, these investors take shelter from the storm by buying U.S. Treasuries. It is also why during the Great Recession, the U.S.A. was one of the few countries that had a strengthening currency or the least bad currency during that time. Thus, you can strike this from your list of things to keep you up at night.