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Robert Segal
Federal Reserve policymakers said they will consider tightening policy at their Dec. 16 meeting, without making a commitment to act this year, as they said the economy is expanding at a “moderate” pace. “Labor market indicators show that underutilization of labor resources has diminished since early this year,” the Federal Open Market Committee said in a statement following a two-day meeting.
The Fed removed a line from the September statement saying that global issues might impact the domestic economy, noting only that the central bank is monitoring the international situation. The committee added a reference to the possibility of increasing the rate at its next meeting based on “realized and expected” progress in reaching its objectives of maximum employment and 2 percent inflation.
The committee continues to see the risks to the outlook as “nearly balanced” and anticipates that inflation will be muted in the near term. The central bank also expects inflation to rise gradually toward the 2 percent goal as the labor market improves further and the short-term effects of energy price weakness subside.
The FOMC reiterated that any rate hike campaign will be moderate, consistent with a balanced approach to achieving long-range objectives. “The committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target Fed funds rate below levels the committee views as normal in the longer run,” the statement said.
The market’s expectations of a December rate hike increased after the release, according to the CME Group. As of this writing, the market was pricing in a 56 percent probability of a December rate hike, up from only 2 percent just last month. At the same time, a higher number of economists believe the first interest-rate hike will occur this year. According to a Wall Street Journal survey, about 64 percent of respondents say the Fed’s Dec. 15-16 meeting will result in a higher Fed funds rate. Half of this group (47 percent) say the second move will be in March 2016 while a third (31 percent) are calling for June.
The Market Reacts
Short-term Treasury yields spiked immediately after the announcement, posting their largest single-day jump since early February, rising nine basis points to 70 basis points. Changes in longer Treasury maturities were slightly less marked, as the 10-year Treasury gained seven basis points to 2.09 percent.
While interest rates along the yield curve edged up recently, investment yields are nevertheless unappealing, according to some market participants. Accordingly, many investment officers are reluctant to put on new investments at this time. The fear is these securities will quickly go under water if market rates unexpectedly rise. In addition, financial institutions could face the opportunity cost of realizing better returns should the environment pick up.
Financial institutions hoping for better investment yields may be waiting for a long time. However, there are opportunities to improve performance by proactively managing the investment portfolio. From time to time, relative valuations change among investment sectors, making certain groups of securities undervalued, and vice versa. And while the yield curve has flattened somewhat recently, it still retains some measure of steepness. Investment officers can take advantage of this situation to enhance current income without taking on significant risk.
Take the example of a non-callable Agency note that has “rolled down” the yield curve. Let’s assume a financial institution purchased a five-year Agency security two years ago at a one percent yield. The bond may now be sold at a half-point profit. At the same time, the institution is able to reinvest the proceeds into a similar five-year note yielding 1.75 percent. This transaction produces a gain on sale of $5,000 per million dollars of face amount while adding 75 basis points of incremental interest income.
Also consider that corporate bond spreads have widened in response to global jitters and falling energy prices. This has affected even industrial companies with strong credit quality and sound balance sheets. As a general rule, double-A nonfinancial firms have seen their yield spread-to-Treasuries expand by 30 to 40 basis points for intermediate-term notes. This means institutions may “swap out” of bullet Agency notes and into highly rated corporate bonds and add 60 basis points or more of incremental income, all else equal. Keep in mind that corporate bonds carry risk-weightings of 100 percent and have fewer pledging capabilities. In addition, the institution must be comfortable with the sector.
Lastly, mortgage-backed security spreads remain ultra-narrow, especially for bonds with less perceived extension risk. As an example, seasoned 10- and 15-year mortgage securities currently trade in a range of 35- to 40 basis points over comparable-maturity Treasuries. Similar to the “seasoned” Agency example, financial institutions should be able to take gains on mortgage securities that have been on the books for a few years, while reinvesting into higher yielding new-issue mortgage bonds or loans.
In the current environment, a “buy-and-hold” strategy may not produce the most optimal results for a financial institution’s investment portfolio. Rather, the investment officer may find that by working the portfolio a little harder, they can increase returns while improving its overall characteristics. This may also put the balance sheet in a better position heading into 2016.
