The past three months have been exciting and distressing, hopeful and dour, but most of all, they have been full of headlines. Headline risk in the markets has taken a front-and-centre role again. Investors are cautious, with the yield of the US 10-year Treasury staying within a fairly narrow 25bp range following a modest post-election increase (see Exhibit 1 below).
Exhibit 1: The yield of the 10-year US Treasury bond has remained within a fairly narrow 25bp range following a modest post-election increase (the graph shows the yield of the 10-year US Treasury bond for the period between January 2016 and 20 February 2017).
Source: Bloomberg, BNP Paribas Asset Management, as of 20 February 2017
Markets are telling us they do not expect any significant changes and that US interest rates are biased to remain fairly low. Expectations for President Trump to implement any change to fiscal policy are being pushed further and further out due to his caustic approach to leading.
Headlines and market volatility
The president has spent considerable political capital trying to get his cabinet through congress, battling the judicial branch on his travel ban and avoiding his myriad conflicts of interest. His perceived misunderstanding of the process has been evident in his actions. His staff appears disorganised and at times greatly confused about the law and the facts at hand. The learning curve is always steep for a new administration. The ability to surmount that may prove too difficult for an administration with no political experience. Brands may succeed in business without any substance, but this does not transfer very well to politics where the voters are in charge and they expect results. This will do little though to diminish the impact that headlines will have on markets and near-term volatility.
Speculation about the future shape of the Federal Reserve’s balance sheet has been a popular topic in the news, Wall street research and Fed speeches, specifically, what the path of balance sheet normalisation may look like. The views vary across market participants and risk around this subject is significant for interest rates and especially for the US mortgage-backed securities (MBS) market. We have seen a number of requests from clients for commentary on the subject. We expect that with more headlines we will see more questions due to investor unease.
Clarity on the Fed’s MBS portfolio or just confusion?
This comment, from St. Louis Federal Reserve President James Bullard, is indicative of the headline risks involved with normalisation. “If there were to be government-sponsored enterprise (GSE) reform on the horizon and some people on Capitol Hill are talking as if GSE reform would be imminent, then we might not want to be holding mortgage-backed securities (MBS) on the grounds that the successors to the GSE's are private-sector companies and we’d be helping private-sector companies.” Most investors have not been overly concerned about the impact of GSE reform on the Fed’s balance sheet. This adds a completely new angle to the discussion regarding the ownership structure and future guarantee of agency MBS.
Bullard appears to be arguing that any potential GSE reform might weaken the guarantee of Federal National Mortgage Association (FNMA) or the Federal Home Loan Mortgage Corporation (FHLMC) MBS. We believe this is not in the realm of possibility. The Federal Reserve Act could potentially limit their ability to buy new, non-guaranteed MBS. They would still have access to a large stock of grandfathered, guaranteed agency MBS and would not be compelled to sell any of those agency MBS under the Act either. A regional Federal Reserve president should know that prior to publicly making that statement and generating confusion.
MBS guarantee not in doubt
We believe that GSE reform is not in any way imminent. Any change to the current structure would need to come from Congress, not from executive order. Additionally, the GSEs have become a very profitable revenue generator for the US Treasury, so the incentive to make any material changes to the status quo is quite low.
The point here is that comments get picked up by news outlets and published with little context, producing uncertainty and anxiety among market participants, even as President Bullard ultimately preaches patience on any changes. Our expectation for GSE reform is for stronger guarantees and a more formalised guarantee from the government, not less, and certainly less skewed towards private-sector lending. The idea that there would be a need to sell assets due to GSE reform seems very far off the mark.
Look for facts rather than just at headlines
The ability to see through the headlines and focus on the facts is paramount. The Fed continues to take a patient, data-dependent approach and there is no sense of urgency to aggressively tighten monetary policy. Employment trends continue to be positive, but wage growth has been constrained and economic growth continues to be at the lower end of expectations. In the same speech, Bullard commented that, “you could allow some runoff in the balance sheet and it would probably go very smoothly so long as it was communicated appropriately.” Given the size of the balance sheet and the deep understanding of how decisions influence markets, we fully expect the Federal Reserve to be transparent in the communication of its plans.
Written on 13 February 2017 in New York