The Treasury market is still being led around by the ebb and flow of geopolitical concerns, and ever-present trade-related news. With some easing in Middle East tensions Treasury yields were initially ticking higher off some unwinding of safe haven trades put on last week when tensions were noticeably higher. That uptick, however, failed to seriously breach support levels that have been in place for the last ten weeks. In addition, while the signing of the Phase 1 trade deal today might have been another factor driving yields higher, the details being leaked are less profound than some of the early cheerleading would have suggested. And now the news that existing tariffs will remain through the election has dimmed animal spirits a bit more. Adding to this mix is chatter that the EU will be the next target for tariffs and the realization has settled on Treasury investors that trade-related angst will not go away in 2020. Thus, Treasuries are finding bids this morning and the docile CPI read from December has only helped in that regard. We discuss the latest inflation report below, as well as the trend in payrolls and wages, to build a case that while the Fed may be on the sidelines for the first half of 2020, the next move is more than likely a cut in rates and not a hike. To see why, read on below.
- December CPI disappointed with the headline change at +0.2% MoM (unrounded 0.219%) versus +0.3% anticipated and +0.3% (unrounded 0.258%) in November. Core-CPI also came in lower-than-expected at +0.1% MoM (unrounded 0.113%versus +0.2% forecast and +0.2% (unrounded 0.23%) prior. On a year-over-year basis, CPI was 2.3% for both headline and core. What’s more intriguing is the trend is softening. The three-month annualized core average is 2.0% versus 2.1% in November. By comparison that average was 2.8% in September and 3.4% in August.
- Also of importance within the details of the report was the fact that real average hourly earnings decelerated to +0.6% YoY vs. +1.1% prior. That pace is the slowest since August 2018. The combination of slowing wage gains (more on that below), and core inflation remaining at 2% or better is digging into the real earnings numbers. The concern here is that with the economy reliant on the consumer, anything that hints at diminishing purchasing power could lead to softer GDP growth in the second half of the year, and this is what we’re expecting. Bloomberg consensus expectation for 2020 GDP is 1.8%.
- In regards to the December jobs report, job growth for the full year was 2.09 million. While that was about 200,000 above what economists were expecting a year ago, it’s also the smallest gain since 2011 and down from 2018’s more-robust 2.68 million. For this year, economists expect monthly job gains to settle in the mid-100,000 level, or 1.8 million for the year. What’s more, while manufacturing has been in the doldrums over the past year and suffering net job losses, the services sector has been adding jobs in the 184,000-193,000 range over the three months prior to December. But in December service job growth dipped to 140,000. Is the softness in manufacturing finally impacting the services sector; or, could it just be a one-month blip? It’s too early to tell but something investors and the Fed will be keeping an eye on.
- Perhaps most importantly, YoY wage gains disappointed. dipping to 2.9% versus 3.1% expected. That’s the lowest YoY reading since a 2.8% print in July 2018. February 2019’s gain of 3.4% YoY remains the high for this cycle but still that pales in comparison to the 4.0+% gains in expansions past. Moderating wage gains could crimp consumer spending growth if the trend doesn’t reverse. We expect that will be the case which leads to our expectation that second-half growth will slow.
Time to Swap-Out Your Low-Yielders
The beginning of a new year is a good time to comb the portfolio looking for bonds that for whatever reason you no longer wish to retain. Whether it’s the yield, the credit or some other factor (like a declining MBS balance), the beginning of the year affords the luxury of recouping any loss on sale when getting rid of the undesirables. One trade that has drawn plenty of interest in the early days this year is to swap out of low-yielding bonds that mature over the next couple years and reinvest in new MBS pools. This swap is based on the notion that with the Fed on hold for the first half of 2020, coupled with expectations of moderating growth and inflation trends, longer-rates are likely to be rather range-bound as well. Add to this mix increasing prepays on many legacy MBS pools and portfolio managers are finding their portfolio durations declining in recent months.
The basic idea of the swap is to sell bullet and select callable bonds maturing in the next couple years that yield at or below the effective fed funds rate (currently 1.54%) and reinvest in longer-duration MBS pools that provide yields closer to 2.50%, or better. By keeping maturities on the sell-side inside two years, losses are more easily recouped given the 100bps, or more, pick-up in yield. We don’t mind adding duration in this swap because of our benign rate outlook for the year and because, as mentioned, most bank portfolios are seeing durations move lower given recent increases in prepayments on legacy MBS pools . An example of such a swap is shown below. Note the $5.5mm in bonds being sold yield 1.399% and the loss on sale is $25,413. That par amount is then reinvested in two MBS pools yielding on average 2.573%. The annual pre-tax income pick-up on the new bonds is a cool $63,902. By year-end, the loss on sale is recouped with a net after-tax income advantage from the swap at 28,471.
Most likely you have similar bonds and performance characteristics in your portfolio. If you would like to see if a similar swap makes sense for your bank, please contact your CenterState representative and we’ll be happy to prepare a customized swap analysis for you.
Agency Indications — FNMA / FHLMC Callable Rates
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