In 2014 Janet Yellen became the new Federal Reserve Chairman and ended the quantitative easing programs. The economy had a slow start, resulting from an unseasonably cold winter, and gained momentum over the summer that continued through the fall. During the 4th quarter we saw renewed fears in Europe and an Ebola panic, which was followed by a 50% drop in oil prices.
Looking into 2015, one cannot ignore the impact of $50/barrel oil. The average hourly paycheck now buys nearly 8 gallons of gasoline, as compared to just over 4 gallons in 2008. Other energy sources have fallen as well. Heating oil and natural gas average costs are 30% lower versus last winter, helping consumers deal with another cold winter and maintaining the economy’s current growth trajectory. After all, consumer spending makes up 70% of the U.S. economy.
Risks to the US economy include contagion from emerging economies and lower inflation in developed nations. 80% of international trade is financed in US dollars, so strength in the dollar is a de-facto tightening in global financial conditions. Emerging markets are impacted the most by a rising dollar as funding sources dry up. Sovereigns will begin buying local currencies to prevent further slides, effectively tightening local financial conditions during a time of stagnant global growth. On the other hand, developed nations may experience lower inflation from falling energy prices – Europe most notably, as they are already in a disinflationary environment that may drift towards a deflationary one.
The FOMC has left the overnight rate in the 0-0.25% range for more than six years. Fragmented employment growth, European weakness, and emerging market instability have kept the Fed cautious on its timing for tightening liftoff.
After staying in a relatively stable range during the first quarter of 2014, yields on bonds exhibited increasingly larger swings during the fourth quarter. The Treasury curve flattened, with yield on the 2 Year Treasury rising from 0.38% to 0.66%, and the yield on the 10 Year Treasury falling from 2.98% to 2.17%. The spread between the 2yr and 10yr Treasury contracted over one hundred basis points, from 2.60% to 1.51%, as markets anticipate the Fed to increase its target rate in 2015, but reduced longer term expectations for the level of interest rate increases.
In 2015 we anticipate Treasury yields to remain in a range fairly consistent with 2014. Highs on the 2yr and 10yr yields near .90% and 2.75% respectively. Lows on 2yr and 10yr yields near .50% and 1.50% respectively.
Investing in 2015
Portfolio managers should consider potential bond price volatility when making investments in the currently low interest rate environment. Therefore, defensive assets should comprise a certain percentage of bank portfolios. A defensive asset could be described as an investment that has stable cash flow within a short period of time and/or exhibits low price volatility during a rate rise, but also provides a stable source of earnings.
There are a variety of economic and interest rate forecasts available in the marketplace. It is important not to fall into the pitfall of basing all major investment decisions on any particular forecast. Rather, investment decisions should be evaluated within the context of the entire balance sheet. For example, if the balance sheet is asset sensitive but needs to maintain its asset liquidity, then an intermediate duration pledgible agency-backed or government-backed amortizing security might be a good fit.
Relative Value and Diversification
MBS and CMO spreads have continued to compress vs bullet Treasuries. Agency MBS and CMO spreads averaged 120 bps in 2012. Today they average 60bps and are possibly going lower. Therefore, investors should favor shorter duration cash flows with limited extension risk. Diversifying among collateral types should also be considered. Fannie Mae and Freddie Mac CMBS bonds with locked out cash flows and short final maturities seem attractive because of their bullet like characteristics and spread pickup to bullets.
Investors could employ a barbell strategy investing in shorter-term sectors described in the previous section and also some longer maturity call-protected bonds. Shorter securities provide the ability to reposition/reinvest during a rate rise with significant pick up in yield versus the current Fed Funds rate of 0.25%. Longer municipal securities provide higher tax equivalent yields of 3% – 5% with high credit quality. High performing risk adjusted portfolios have an average allocation to municipals near 25%.
Banks are setting up wholly owned subsidiaries to invest in General Market municipals and take advantage of the relative value yield pick-up for like Bank Qualified municipal duration and credit quality. This relative value tax-equivalent yield pick-up can be as high as 1.75% in some cases. The subsidiary also gives the bank the ability to avoid the TEFRA disallowance all together. Municipal analysis and ongoing monitoring requirements have continued to stay in focus as regulatory agencies continue to release updates of their expectations. Non reliance on external credit ratings, and more emphasis on independent basic and expanded analysis will prevent some portfolio managers from taking advantage of the relative value pick up in municipal bonds. Other considerations when investing in 2015 include new Basel iii risk weightings for private label RMBS and compliance with new joint agency due diligence guidance on all investments (FIL-51-2013).
A community bank’s investment portfolio is not a standalone group of assets. Rather, it is an integral part of a bank’s balance sheet along with loans, deposits and capital. Moreover, more often than not, the role of the investment portfolio as an A/L management tool is simply overlooked. Before making investment decisions, it is critical to have a solid understanding of the institution’s A/L sensitivity, overall balance sheet composition, and short- and long-term goals.
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