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Spread Out

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    August 9, 2013

    For Three Stooges aficionados (this is where Gen X’ers and Gen Y’s can tune out if they so choose), you’ll remember that every time the Stooges physically bunched up a bit too much in one of their routines, Moe Howard would yell out, “spread out!” Right to the point, were the global fixed income markets telling us various historical fixed income vehicle spread compressions had “bunched up” a bit too much back in May and that finally it had come time to “spread out” for the current cycle? Why “soitenly”, at least from a very short term perspective. The important questions now remain, where are the Treasury curve and interest rate spreads in general headed from here?

    Although I could launch into an exhaustive review of intra and inter market yield spreads, maybe it makes the most sense to keep it simple for now and look at the historical rhythm of the Treasury curve. As go Treasury rates, so goes the broader fixed income market in spread fashion? Something like that. Moreover, the Fed now “owns” the curve, whether literally or perceptually. It’s the focal point de jour. And the maneuvering room for the Fed is getting tight. Of course we already know ours is unlike any cycle we’ve known in modern history.

    Below we are looking at the historical yield spread between the 10 year US Treasury and the Fed Funds rate.

    10 year ust 1960 to 2013

    In cycles past, the Treasury curve inverted (long dated yields fell below the Funds rate) prior to or coincident with official recessionary periods. This inversion was invariably caused by prior period Fed Funds increases often accompanied by the fixed income investment community pricing down longer dated yields in anticipation of the next recession. In the chart above I’ve marked the nominal Fed Funds rate at each yield spread cycle low since the early 1980’s. In the current cycle, Treasury yield curve inversion has been impossible due to Fed Funds being priced near zero. Up to the present, yield spread compression and across the Treasury curve rhythm has been 100% driven by the movement in longer dated yields, in this case the 10 year UST. Unless the Fed really gets with it and raises the Funds rate, we will not see a curve inversion prior to the next recession. It’s just math.

    In like manner throughout prior cycles, interest rate spread expansion was primarily driven by the Fed dropping the Funds rate in relatively accelerated fashion at the outset of each recession. Just like a curve inversion, spread expansion in the current cycle has not and will not be driven by the Fed dropping interest rates for very obvious reasons. It can only be accomplished by a widening in long dated yields relative to the Funds rate. So in one sense, should we be turning the lessons we learned from prior cycles regarding the Treasury curve and Treasury yield spreads on their proverbial heads? Hopefully a few comments help frame that question.

    As is clear in the chart above, the near 4% 10yr/Fed Funds spread level has been an upside barrier for well over a half century. That 4% level has also been a very important buy signal for equities in each major stock market up cycle. Question – if this spread widened out to near a 4% level in the current environment (implying a near 4% 10yr. UST yield), would you consider that a major buy signal for equities, or something different? In like manner if this spread collapsed from here, would it be a sign of a strengthening and perhaps overheating economy as it was historically? In a word, no, as the credit markets of the moment would be pricing in deflation.

    Could the 10yr/Fed Funds spread again widen out to near 4% any time soon? Anything can happen in this environment. In fact at current quotes we’re almost half way there post the May spread lows. What would clearly drive the spread toward this level is a Fed that digs in its heels and remains behind the curve in what more than a number of Street pundits believe will be a meaningfully growing US economy in the latter part of 2013 and into next year.

    But that’s not all. The Fed WILL make good on the tapering. It’s only a matter of time and a game of wordsmithery until the reality sets in. Clearly, the credit markets have already been pricing in the event. But like Fed rate increases in the days of yore, the markets always anticipate what lies ahead. After the first tapering event, the markets will not be sighing relief that the tapering is all over now. The markets will certainly be asking “what’s next”? You already know it will be very important to watch the reaction of credit markets when tapering becomes a reality. Maybe at worst, our near to intermediate term fate in credit markets is heightened volatility. Anything can happen while the Fed has its foot on the neck of the Fed Funds rate.

    Finally, and far from exhaustive in terms of possibilities, I remain concerned personally over the potential for a change in market sentiment regarding faith in the Fed and politicians in general. Sounds melodramatic, right? The “benefit of the doubt” is going on five years and 1000+ S&P points. Nothing lasts forever. After all, the financial markets are about nothing but the fact that change is the only guarantee. Is this what we are starting to see right now in the Treasury market with longer dated yields that refuse to back down for more than a few days? In my very humble opinion, a reduction in “faith” in the monetary authorities will first be seen in a repricing of the credit markets. Interesting to note that the day after the FOMC comments hit the tape last week, bonds had quite the ugly day while stocks dutifully went to new highs. And this was on no further comments of tapering.

    So let’s fast forward to the present cycle that we all know has been dominated by QE. Just what are we seeing? This is just an observation. As is more than clear in the chart below, at the outset of each QE exercise, the 10yr UST/Fed Funds yield spread widened out literally on command – at the exact outset of each QE excursion. But, not with QE III.

    There is no mystery as to why this happened in the first two iterations of QE. Rightly so, the markets were worried that the “printing of money” would spark inflation, which has never come to pass at the headline level. After the early 2009 QE announcement, this 10yr UST/Fed Funds yield spread widened for close to a year before peaking and retreating. With QE II, the widening lasted about four months. And with QE III, the widening was nonexistent as the markets had “learned” that QE I and II were theoretically non-inflationary so why expect it with III?

    And as is also clear, the curve steepening/ yield spread expansion is now coming nine months after QE III was initiated. The curve steepening of the moment is being driven by a different set of factors. It’s not the fear of Fed induced inflation, but rather the fear of the most significant Treasury and mortgage backed buyer slowly walking away from the markets they have been supporting for close to half a decade.

    Although I did not draw this into the chart above, in each instance of US Treasury interest rate spread contraction in all economic cycles of the last three decades, one could have drawn a declining tops trend line along the spread tightening path. At the breaking of each declining tops trend line to the upside, the 10yr/Fed Funds yield spread expansion took off almost vertically. And where are we now? We’ll just have to see if we break the line in the current cycle and whether the hold relationships still hold true. A break of 2.75% to the upside should be darn close to the moment of truth. We’re just not that far away. Will this be a breakout, if it’s to come, that will be meaningful to asset classes outside of the credit markets? Time will tell.

    10 year ust qe 2009 to 2013

    Before moving ahead, just a very quick review of the 2 and 5 year Treasury yields relative to Fed Funds. The historical patterns are very close to what you saw in the first chart. This is a “curve experience”.

    5 year ust spread 1977 to 2013

    2 year ust spread 1977 to 2013

    In my mind, the key near term watch points for all investors are the shape of the Treasury curve and nominal levels of yield. Yes, equities can take having interest rates move higher, but there is a tipping point. The tough part is that historically, equity market “tipping points” driven by the credit side of the house have been inconsistent in terms of rules applications. There simply are no magic nominal yield or spread levels. In some cycles it has taken very little upward rate movement to spark equity indigestion, and in some cycles a whole lot more. Each cycle has been different.

    Having said this, I have a thought with which I’d like to leave you that concerns the upward movement of interest rates as a longer term theme. I’ve seen a lot of folks simply dismiss the recent character change in the Treasury market. Not so fast. This may be 100% hot air for all I know, but I have thought for a while that previously non-existent inflationary pressures would become a concern for the markets once interest rates started to rise. We may not see it in the headline CPI numbers right away, but you’ll know it when you see and feel the pressure. Here’s the thinking.

    For a second, remember back to the 1970’s. The US economy was clearly more manufacturing oriented than is the case today. Certainly a key input cost to the more cyclically driven economy at the time was oil. As oil prices rose systemic inflationary pressures took hold as the variable cost that was oil prices reverberated in cost push fashion across the entire economic landscape.

    Fast forward to the present and we know that the US economy today has been heavily financialized. With 40% of corporate earnings in 2007 being driven by the financial sector, there is little mystery as to how the dynamics of the US economy have changed in three short decades. Moreover, with emerging market manufacturing centers having grown over the past few decades, the impact of commodity price changes on the US economy have become less direct.

    What I’m getting at is that in a financialized economy, is not a key “input cost” the cost of credit?  In an economy that still carries a meaningful level of leverage, isn’t the cost of credit a potential driver of broader prices and ultimately economic outcomes? Examples are many. If the cost of financing investment rises, IRR dynamics dictate nominal dollar end market prices rise to cover the increased cost of financing if margins are to be held stable. If the cost of carrying inventory rises, to maintain profit margins final goods pricing must rise. Something as simple as taxes are an issue. For every 1% increase in interest rates, US interest only costs on government debt rises approximately $175 billion. And just how is that ultimately funded? With increased taxes that now become a higher “cost burden” to taxpayers. I’m sure you get the concept. Key question being, in a financialized economy, will a rising cost of debt capital reverberate in cost push fashion as analogously did oil in the 1970’s? I know it sounds counter-intuitive. But for now the question stands, will domestic inflationary pressures rise as interest rates rise ahead?

    And this leads me to one final observation and hopefully key fundamental watch point tied directly to the cost of credit – bank lending. With US equities having vaulted to new heights as most all other global investment asset classes have fallen by the wayside one by one, an underlying belief of the moment is that US economic growth is on the cusp of accelerating meaningfully in the latter part of 2013 and into 2014. It’s belief in this outcome that allows equity investors to be unshaken with respect to the current rise in interest rates. If indeed this is the correct scenario that is to unfold before us, then return on investment in an accelerating economy should outpace what is now a bit of a higher cost of debt capital. If all of this is correct, we should see bank lending continue to expand.

    The chart below traces the character of bank C&I lending over the past two plus decades. First, what is noticeable is that in each economic cycle it has taken about 5 years for the level of nominal dollar bank lending (top clip of the chart) to achieve and exceed prior cycle highs. It just so happens that we are very near this point in the current cycle. Secondly, it’s not uncommon to see the year over year rate of change in bank lending spike up at the outset of each economic cycle and then settle into a “range” of growth for a number of years. After the outset of the early 1990’s recovery, the year over year change in bank lending rose between 5-10% for over half a decade. In the last cycle it rose between 12 and 20%, of course largely due to real estate lending.

    So here’s the point. I can tell you from first-hand knowledge that the bulk of bank C&I lending in the current cycle has been for refinancing purposes. Yes, there has been some organic lending, but many a bank has been running to stay in place in terms of loan volume – keep existing loans on the books via refinancing them. The annual rate of change in US bank C&I lending peaked well over a year ago. What we need to see now is a leveling off of the growth rate in bank lending as was the case in prior cycles. We need to see continued expansion in nominal dollar loans outstanding and the arresting of the decline in the year over year growth rate in loans out. My suggestion is that the character of bank lending ahead will be a key tell as to how a higher cost of capital will influence economic activity. Meaningful expansion in bank lending ahead will be a sign that the economy can whether a higher cost of credit, in good part justifying equities decoupling from the credit markets. Continued rate of change deterioration in bank C&I loans out would speak to perhaps a less robust economy than many now believe. This is where the rubber meets the road.

    banking system loans 1990 to 2013

    banking system year over year 1990 to 2013

    For now, the Fed has been able to jawbone equity markets to new heights. The glaring dichotomy of the moment is that credit markets have not followed and credit spread expansions have not retraced. The character of bank lending ahead will be a key tell as to whether equities are correct in anticipating accelerating economic momentum, or otherwise. Stay tuned.

    Images: via Flickr (licence attribution)

    About the Author

    Brian Petti – Contrary Investor

    Brian Pretti is the managing editor of Contrary Investor. Contrary Investor is written, edited and published by a very small group of “real world” institutional buy-side portfolio managers and analysts with, at minimum, 20 years of individual Street experience. Our credentials include CFA, CPA and CFP, as well as the obligatory MBA’s in Finance. We are all either partners or employees of institutions with at least $1 billion under management.