At The Margins

FOMC Considers Global Economic Outlook At January Meeting

Banks Add Municipal Bonds To Combat Low Rate Environment


Segal,Robert_2015

Federal Reserve officials left interest rates unchanged at the January meeting of the Federal Open Market Committee (FOMC) and said they still expect to raise borrowing costs at a “gradual” pace while watching to see how the global economy and markets impact the U.S. outlook. The FOMC is “closely monitoring global economic and financial developments and is assessing their implications for the labor market and inflation, and for the balance of risks to the outlook,” the central bank said in a statement.

Since the Fed raised rates last December, turmoil in financial markets and a dimming of the prospects for growth have caused investors to expect a slower rise in borrowing costs. The projection of policymakers’ forecasts in December called for four quarter-point rate increases this year; futures markets indicate that traders see just one or two hikes coming.

Minutes from the January meeting show that officials were worried about a series of disruptions that could hinder the recovery. Global financial market volatility is concerning central bankers. The economic impact of further persistent declines in stocks as well as widening credit spreads would be “roughly equivalent to those from further firming in monetary policy,” the minutes said.

Speaking in Washington recently, Fed Governor Lael Brainard said the U.S. economy isn’t immune to global risks and called for “careful adjustments” to the policy rate to preserve the expansion. Brainard noted that there are risks around the base case forecast, the most prominent of which lie to the downside. “Given weak and decelerating foreign demand, it is critical to carefully protect and preserve the progress we have made here at home through prudent adjustments to the policy path,” she said.

The market is pricing in no chance of a rate increase for the FOMC meetings in March and April. According to the CME Group, the probability rises to 50 percent by September and 66 percent for December. A Bloomberg survey of economists suggests the Fed will move once in the second quarter of 2016, and bring overnight borrowing costs to 0.88 percent by the end of 2016.

In financial markets, government bonds continue to rally.  The yield on the benchmark 10-year Treasury note traded recently at 1.80 percent, compared with 2.30 percent at year-end 2015. Based on futures markets, the yield will rise to only 2.00 percent by the end of 2016.

In this environment where long-term rates are expected to remain low, financial institutions have been scooping up municipal bonds in an attempt to improve current income. In fact, banks have surpassed both money market funds and insurance companies to become the third-largest holders of municipal securities, according to the Federal Reserve.

 

Slow And Steady Growth

The size of the municipal bond market has been relatively stable the past few years as municipalities have issued less “new-money” debt. The Fed, in its most recent Flow of Funds report, said the municipal market at the end of the third quarter of 2015 totaled $3.71 trillion, similar to the level in 2011. Banking institutions held $511 billion, up from $398 billion as recently as 2012. Banks have been boosting their holdings in municipal bonds steadily over the past decade, say the Federal Reserve numbers.

Industry reports generally show that institutions holding larger percentages of municipal bonds tend to be the high-performers. For example, banks holding at least 30 percent of their investment portfolios in munis are typically found in the first quartile for investment yield, which is often 3 percent or higher.

A primary benefit of municipal bonds is the long period of call protection. Bank investment officers may be relatively certain they’ll hold on to the initial yield for seven to 10 years, regardless of interest rate movements. This is as opposed to Callable Agency bonds or certain mortgage securities, which will inundate investors with cash to reinvest when interest rates are low. With considerable optionality on most bank balance sheets, municipals provide much-needed predictable cash flow. In addition, the municipal curve is steep, and this will provide some price protection for a rising rate environment.

Municipal bonds outperformed other asset classes in 2015, beating corporates, Treasuries and the major stock indexes. The S&P Municipal Bond Index posted a total return of almost 3.2 percent, compared to a 0.81 percent loss in the Merrill Investment Grade Corporate Bond Index and a 0.84 percent advance in the Barclays Treasury Index. For 2014, munis beat corporates by 2 percent and by more than 5 percent for Treasuries.

Most economists expect another year of slow but steady growth and muted inflation. Assuming the economy continues on this path, then municipal bonds should provide another year of positive returns. Financial institutions looking to boost income may wish to evaluate this sector more closely as a viable investment option.

Robert B. Segal is president of Atlantic Capital Strategies Inc., an investment advisor located in Bedford. He can be reached at bob@atlanticcapitalstrategies.com.




FOMC Considers Global Economic Outlook At January Meeting

by Robert Segal time to read: 3 min
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