Since the Dodd financial regulation bill (and specifically the Collins amendment) was signed into law questions arose about when and if banks would call in their trust preferreds. One camp believed that banks would call in all of their trust preferreds as soon as possible as that form of capital made little sense for banks now that they would lose their Tier-1 capital treatment beginning 2013. Another camp believed that banks would not begin to call in trust preferreds until they actually began to lose their Tier-1 eligibility.
Then there was my camp. I thought that banks would call in trust preferreds whenever it was most economically advantageous to do so. Besides the Tier-1 aspect of trust preferreds, there is the cost of finance aspect. I was of the opinion that banks would choose to call in their highest coupon issues first and that banks are free to determine when the capital event, which is required to trigger an early call occurred. I warned readers that a bank could decide to call in a high-coupon trust preferred, not only before 2013, but at anytime.
Today, Fifth Third back called in their 8.875% FTBprC. It will be called on 6/17/11 at a price of 25. This was bad news for investors who purchased shared recently (up to this morning) at over $26.00 per share. I will warn readers once again; don’t buy high-coupon, high-premium trust preferreds thinking that the will be around until their first call dates and don’t buy low-coupon preferreds at deep discounts thinking that they will be called in the near future at par. Neither scenario is economically advantageous for issuers. Calls are always executed when it is the best interest of the issuer, not investors.
Wednesday, May 18, 2011
Sunday, May 15, 2011
On the QT
Whatever happened to rising interest rates? The newswires were hot with stories of hyper inflation and soaring interest rates. The stories stoked fear from two angles. One school of thought said that if the Fed kept QE2 rolling it would foster inflation, and therefore, higher interest rates. The second school of thought believed that if the Fed ends QE2, there would be little support for treasury price and long-term interest rates would rise. In other words, no matter what actions the Fed took, long-term interest rates were heading higher. Not so fast Sparky. There appears to be much misunderstanding regarding how QE2 (and QE1 for that matter) affected the bond market.
When the Fed ended QE1 last year, long-term interest rates declined (helped by Euro troubles). When the Fed announced the possibility of QE2, long-term rates began to climb. Long-term rates hit their highest levels since early 2010 last December following the launch of QE2. Now, with the Fed’s announcement that QE2 will end on schedule in June, but that the Fed will reinvest maturing assets, long-term U.S. treasury yields have fallen. The yield of the benchmark 10-year not dropped to 3.16% the other day.
The recent fall of long-term interest rates is not as counterintuitive as it may appear at first glance. When the Fed halted QE1 it was considered to be disinflationary. Many market participants took off their risk trades and headed into U.S. treasuries. When the Fed moved toward QE2, risk trades went back on and really took off when QE2 was launched. Risk trades include speculating in equities, commodities and junk bonds. Now with QE2 likely coming to an end, but with the economy showing a bit more life than last year, long-term rates have fallen, but have not plummeted as in 2010.
This does not mean that long-term rates will not trend higher. However, they are more likely to creep higher rather than experience a spike. The street consensus as per a Bloomberg Survey indicates a consensus opinion of below 4.00% for the yield of the 10-year U.S. treasury note for year-end 2011.
The street consensus forecast for Fed Funds indicates no change to the Fed Funds rate this year with the first Fed action coming in Q1 2012. Three-month LIBOR, which is greatly influenced by the Fed Funds rate, has fallen from .33% to .26% during the past month. The one year forecast for three-month LIBOR is in the .75% to 1.00% area. Investors buying floating rate paper may be very disappointed with their investment choice.
Why may the rise of short-term rate be modest? This is because growth is not expected to be strong enough to move above the U.S. historical trend rate of 3.1%. Also, it must be remembered that QE is a form of easing (lowering rates in alternative fashion). Therefore, the removal of QE stimulus must be regarded as QT or Quantitative Tightening. When QT and rate increases are factored in together, it appears unlikely that the Fed will have to raise the Fed Funds rate very high during the coming interest rate / economic cycle, possibly not higher than 2.00%. I think we may be in for a few boring years as the economy adapts to new realities and housing prices languish until population growth provides the market with QUALIFIED buyers.
When the Fed ended QE1 last year, long-term interest rates declined (helped by Euro troubles). When the Fed announced the possibility of QE2, long-term rates began to climb. Long-term rates hit their highest levels since early 2010 last December following the launch of QE2. Now, with the Fed’s announcement that QE2 will end on schedule in June, but that the Fed will reinvest maturing assets, long-term U.S. treasury yields have fallen. The yield of the benchmark 10-year not dropped to 3.16% the other day.
The recent fall of long-term interest rates is not as counterintuitive as it may appear at first glance. When the Fed halted QE1 it was considered to be disinflationary. Many market participants took off their risk trades and headed into U.S. treasuries. When the Fed moved toward QE2, risk trades went back on and really took off when QE2 was launched. Risk trades include speculating in equities, commodities and junk bonds. Now with QE2 likely coming to an end, but with the economy showing a bit more life than last year, long-term rates have fallen, but have not plummeted as in 2010.
This does not mean that long-term rates will not trend higher. However, they are more likely to creep higher rather than experience a spike. The street consensus as per a Bloomberg Survey indicates a consensus opinion of below 4.00% for the yield of the 10-year U.S. treasury note for year-end 2011.
The street consensus forecast for Fed Funds indicates no change to the Fed Funds rate this year with the first Fed action coming in Q1 2012. Three-month LIBOR, which is greatly influenced by the Fed Funds rate, has fallen from .33% to .26% during the past month. The one year forecast for three-month LIBOR is in the .75% to 1.00% area. Investors buying floating rate paper may be very disappointed with their investment choice.
Why may the rise of short-term rate be modest? This is because growth is not expected to be strong enough to move above the U.S. historical trend rate of 3.1%. Also, it must be remembered that QE is a form of easing (lowering rates in alternative fashion). Therefore, the removal of QE stimulus must be regarded as QT or Quantitative Tightening. When QT and rate increases are factored in together, it appears unlikely that the Fed will have to raise the Fed Funds rate very high during the coming interest rate / economic cycle, possibly not higher than 2.00%. I think we may be in for a few boring years as the economy adapts to new realities and housing prices languish until population growth provides the market with QUALIFIED buyers.
Saturday, May 7, 2011
Grow Job
Yesterday’s employment data was reasonably strong with the economy adding 244,000 jobs. Although this is only 44,000 more jobs necessary to keep pace with population growth, it far exceeded the street consensus estimate of 185,000. Does this mean that job growth is set rocket higher? Probably not, as there are too many headwinds facing the U.S. / global economy.
Hiring at this pace will barely make a dent in the bloated number of people on the unemployment roles. Budgets cuts necessary to pass an agreement on raising the debt ceiling (or to keep the U.S. solvent without raising the debt ceiling), a persistently weak housing market and signs of slowing in emerging market economies promise to keep job growth, and the U.S. economic growth, modest. The fact that there are over 7 million people receiving unemployment benefits means that at anything close to the current pace, it could be several years or more to bring the unemployment rate down below 7.00%. If course by then the economic cycle could start a normal downward trend and nip the job recovery in the bud.
Speaking of the unemployment rate, many investors were confused about how the unemployment rated could tick higher from 8.8% to 9.0% in the face of better-than-expected job growth. This was due to how the so-called household survey is conducted. If a respondent answers that they are not working, but not actively seeking employment they are not considered to be unemployed. However, if a non-working respondent answers that they are seeking employment they are considered to be unemployed. Typically, as job prospects improve, non-working respondents become more confident and answer that they are seeking employment. Because of this, a rising unemployment rate in conjunction with a stronger Nonfarm Payrolls report is considered a positive phenomenon.
All signs continue to point toward a sustainable, but modest recovery. However, the fun may be over for commodities and the equity markets. Make no mistake, the spike in commodities prices during the past year was due in large part to Fed policy which weakened the dollar and had the potential (at least in theory) to cause a robust “v-shaped” recovery. Now we are seeing speculators take their profits and are going home. With their support out of the commodities prices have plummeted.
The equity markets have also benefited from Fed policy as low corporate financing rates and a weaker dollar making U.S.-made goods price-competitive in overseas markets. The result has been a sharp and stout balance sheet recovery. As the Fed removes stimulus, the equity markets could experience a correction. Sell in May and go away could be a good strategy this year. Autumn could be a better time to re-enter the equity markets.
I would wager many investors have interpreted the drop in commodities prices, especially oil prices, as being anti-inflationary. Au contraire, a drop in oil prices should make more consumer cash available to be spent in other, more productive, areas of the economy. Lower oil prices could in fact cause the Fed to act somewhat more aggressively to tighten monetary policy. To those who believed the Fed should have raised rates to combat higher oil prices my thinking may be confusing, but this speaks to the lack of knowledge of what inflation is measured and occurs within the investor community,
If the trend of weakening commodities continues the Fed may be better able to remove stimulus. The first action y the Fed will be to end QE2 purchases. Next, the Fed could cease re-investing maturing QE2 assets and increase the interest rate paid in reserved kept at the Fed. . Then the Fed is likely to engage in a combination of Fed Funds rate hikes and the selling of QE (1 and 2) assets,
Fed Funds rate hikes will likely be modest, few and, possibly, far between. Remember quantitative easing? Well the ending and removal of quantitative easing is quantitative tightening, Investors waiting for high Fed Funds rates are likely to be disappointed during the forthcoming economic cycle. Since U.S. dollar LIBOR is very much linked to the Fed Funds rate, Libor-based floating rates and preferreds are likely to disappoint investors.
Does this mean we will be faced with a stagnant economy in the near future? Probably not, but we could experience trend growth of approximately 3.00% during the next three to five years. What about unemployment? Without a bubble such as what we experience in tech during the 90s and housing during the first decade of the 2000s, the unemployment rate could remain above 7.00%.
Investors must understand that the growth experiences from the mid 80s to 2006 was not fundamentally sustainable, but was rather a Fed-induced and supported recovery from the poor policies of the mid-60s to the late 70s. As with every policy, the Fed’s overshot its mark with two bubbles (tech and housing) near the end of its run.
The low rate, high growth of the middle first decade of the 2000s was called the “Great Moderation.” I think “the “Great Moderation” will occur over the next five years or so. Growth, inflation and employment will all me moderate. After that, your guess is as good as mine.
Hiring at this pace will barely make a dent in the bloated number of people on the unemployment roles. Budgets cuts necessary to pass an agreement on raising the debt ceiling (or to keep the U.S. solvent without raising the debt ceiling), a persistently weak housing market and signs of slowing in emerging market economies promise to keep job growth, and the U.S. economic growth, modest. The fact that there are over 7 million people receiving unemployment benefits means that at anything close to the current pace, it could be several years or more to bring the unemployment rate down below 7.00%. If course by then the economic cycle could start a normal downward trend and nip the job recovery in the bud.
Speaking of the unemployment rate, many investors were confused about how the unemployment rated could tick higher from 8.8% to 9.0% in the face of better-than-expected job growth. This was due to how the so-called household survey is conducted. If a respondent answers that they are not working, but not actively seeking employment they are not considered to be unemployed. However, if a non-working respondent answers that they are seeking employment they are considered to be unemployed. Typically, as job prospects improve, non-working respondents become more confident and answer that they are seeking employment. Because of this, a rising unemployment rate in conjunction with a stronger Nonfarm Payrolls report is considered a positive phenomenon.
All signs continue to point toward a sustainable, but modest recovery. However, the fun may be over for commodities and the equity markets. Make no mistake, the spike in commodities prices during the past year was due in large part to Fed policy which weakened the dollar and had the potential (at least in theory) to cause a robust “v-shaped” recovery. Now we are seeing speculators take their profits and are going home. With their support out of the commodities prices have plummeted.
The equity markets have also benefited from Fed policy as low corporate financing rates and a weaker dollar making U.S.-made goods price-competitive in overseas markets. The result has been a sharp and stout balance sheet recovery. As the Fed removes stimulus, the equity markets could experience a correction. Sell in May and go away could be a good strategy this year. Autumn could be a better time to re-enter the equity markets.
I would wager many investors have interpreted the drop in commodities prices, especially oil prices, as being anti-inflationary. Au contraire, a drop in oil prices should make more consumer cash available to be spent in other, more productive, areas of the economy. Lower oil prices could in fact cause the Fed to act somewhat more aggressively to tighten monetary policy. To those who believed the Fed should have raised rates to combat higher oil prices my thinking may be confusing, but this speaks to the lack of knowledge of what inflation is measured and occurs within the investor community,
If the trend of weakening commodities continues the Fed may be better able to remove stimulus. The first action y the Fed will be to end QE2 purchases. Next, the Fed could cease re-investing maturing QE2 assets and increase the interest rate paid in reserved kept at the Fed. . Then the Fed is likely to engage in a combination of Fed Funds rate hikes and the selling of QE (1 and 2) assets,
Fed Funds rate hikes will likely be modest, few and, possibly, far between. Remember quantitative easing? Well the ending and removal of quantitative easing is quantitative tightening, Investors waiting for high Fed Funds rates are likely to be disappointed during the forthcoming economic cycle. Since U.S. dollar LIBOR is very much linked to the Fed Funds rate, Libor-based floating rates and preferreds are likely to disappoint investors.
Does this mean we will be faced with a stagnant economy in the near future? Probably not, but we could experience trend growth of approximately 3.00% during the next three to five years. What about unemployment? Without a bubble such as what we experience in tech during the 90s and housing during the first decade of the 2000s, the unemployment rate could remain above 7.00%.
Investors must understand that the growth experiences from the mid 80s to 2006 was not fundamentally sustainable, but was rather a Fed-induced and supported recovery from the poor policies of the mid-60s to the late 70s. As with every policy, the Fed’s overshot its mark with two bubbles (tech and housing) near the end of its run.
The low rate, high growth of the middle first decade of the 2000s was called the “Great Moderation.” I think “the “Great Moderation” will occur over the next five years or so. Growth, inflation and employment will all me moderate. After that, your guess is as good as mine.
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