Investors will be focused on comments this morning from Fed Chair Powell at a live stream event with the Patterson Institute for International Economics. Possibly the most intriguing thing the market will be looking for is Powell’s resolve to resist negative interest rates. No current FOMC member has expressed a willingness to go there but when “all policy measures are on the table” the question has to be asked. We expect he’ll continue to resist, but the market will be looking for any slight nuance. Yesterday, the market focused more on Dr. Anthony Fauci’s testimony to the Senate Health Committee than a weak CPI report. The combination of an unmistakable disinflationary trend in CPI and the note of concern from Dr. Fauci about reopening the economy too fast was enough to send stock prices lower and bond prices higher as a risk-off tone took hold.
While the lowest core CPI print since 2011 came and went without much reaction from Treasuries it’s another sign that the economic damage inspired from the coronavirus will be long-lasting with repercussions across the country. The core rate dipped –0.4% which was worse than the –0.2% expected and the –0.1% print in March. In fact, it’s the largest single-month drop since the data series began in 1957. The year-over-year rate dipped to 1.4%, the lowest level since 2011. Meanwhile, overall CPI dropped –0.8% in April, the most since December 2008, with a year-over-year rate at 0.3%, the lowest since 2015.
A sustained trend of declining prices spur worries about deflation and contribute to already increasing concerns that a recovery from COVID-19 will be very slow. We think the quick action by the Fed on the monetary policy front and the trillions in fiscal stimulus will eventually provide a floor to the disinflationary trend but it’s something that will certainly merit continued vigilance by the monetary and fiscal officials. And while the Treasury market largely ignored the CPI numbers yesterday, they didn’t ignore Dr. Anthony Fauci’s testimony to the Senate Health Committee where he expressed concern over opening the economy too quickly and setting back the economic recovery. It’s not surprising that the market traded more off the Fauci testimony than the CPI numbers, but it’s all a part really in that a slow recovery likely keeps the disinflationary forces alive, and slow growth with little inflation seems will keep long-end yields in the range that we’ve become accustomed since the pandemic reached our shores.
Is Now the Time to Consider Callable Agency Securities?
It’s not often we promote callable agency securities for the simple reason you’re typically going to get your money back when you don’t want it, and not get it back when you do. Thus, it makes them a tricky investment to manage both from a liquidity and asset-liability standpoint. We hate to see this time is different, but we really do think this virus-driven downturn will be different in how interest rates, and the yield curve behave, and consequently how callable securities will perform.
Coming out of the last recession, we saw many portfolios load up on callable agency securities in a search for yield with little credit risk and without the complications of mortgage securities. The problem, as you can see in the graph below of the 10yr Treasury yield, is that following the drop in yields going into the recession (the red-banded area), yields bounced around without a well-defined trend but with a couple periods of rapid yield increases. This led to many callable agencies remaining outstanding longer than perhaps initially anticipated, and typically at market prices well below book, making it harder to work out of them.
This time, the rate outlook seems more amenable to callable agencies. First, given the deep and ongoing economic damage, the Fed is likely to be at the zero lower bound for the balance of this year and well into next year. Thus, rising short-term rates do not appear to pose a risk. Second, given the worldwide recession, docile inflation, and a future recovery that appears will be stuttering and slow, catalysts for higher long-term yields are few. That’s a recipe for a range-bound market, both on the short and long-end of the curve. Thus, we recommend investments with fairly short call dates (3mo-1yr) matched to a maturity that achieves your yield objective. Given our range-bound market call, the security has the possibility of being called, but also because of the range-bound market reinvestment at a similar yield is a realistic possibility. The matrix below provides some current yield indications.
Agency Indications — FNMA / FHLMC Callable Rates
|Maturity (yrs)||2 Year||3 Year||4 Year||5 Year||10 Year||15 Year|