Fake News. Alternative Facts. Rule by Tweet…

13 Feb 2017

Key takeaways

  • Smart investors need to look beyond the increasingly volatile headlines that have become a daily occurrence
  • Bond markets are pricing in limited success of fiscal policy changes
  • We expect the Federal Reserve will continue to take a patient, data dependent approach to monetary policy

 

Full commentary

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 center role again. Investors are cautious, with the 10-year Treasury staying within a fairly narrow 25 basis point range following a modest post-election increase. Markets are telling us they do not expect any significant changes, and that interest rates are biased to remain fairly low. Expectations for the president to implement any change to fiscal policy are being pushed further and further out due to his caustic approach to leading.

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 of conflicts of interest. His misunderstanding of the process has been evident in his action. His staff is disorganized and at times appears greatly confused about the law and facts at hand. The learning curve is always steep for a new administration. The ability to surmount that curve may prove too difficult for an administration with no political experience. Brands may succeed in business without any substance, but it does not transfer over 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 Federal Reserve’s (Fed) balance sheet has been a popular topic in the news, street research, and Federal Reserve speeches. Specifically, what the future path of balance sheet normalization may look like. The views across market participants vary, and risk around this subject is significant for interest rates, and especially for the US mortgage-backed securities 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.

The following comment, from St. Louis Federal Reserve President James Bullard, is indicative of the headline risks involved with normalization. “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 GSEs 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 Federal Reserve’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 those Federal National Mortgage Association (FNMA) or the Federal Home Loan Mortgage Corporation (FHLMC) MBS. We do not believe this is 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 Federal Reserve Act. A regional Federal Reserve President should know that prior to publicly making that statement and generating confusion.

We do not believe that GSE reform is in any way imminent. Any change to the current structure would need to come from Congress, not from executive order. Additionally, the GSE’s have become a very profitable revenue generator for the Treasury, so the incentive to make any material changes to the status quo is quite low.

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