It has been a long time, but I have started to experience that strange feeling that we might try out some techniques that have not worked so well in the past. The 1970s were noteworthy in this regard. At the first suggestion that there should be imposed a cap on Treasury yields, a.k.a. yield curve control, all I could think of was the freeze on wages and prices that President Nixon instituted in 1971 or just about 50 years ago. While most pundits agreed that the controls put in place back then served to take some of the steam out of inflation, most agreed that in the long run the experiment was a failure. Once price controls were lifted, rampant inflation “reared its ugly head” once again. The Nation had to call on Paul Volcker, Fed Chairman at the time, to put the flames out and to extract us from stagflation that was even worse. Higher rates constituted a very painful remedy.
Flip to today and we have rates seeking out the lows once again. The 30-year Treasury is at 1.43 as of this writing. Municipals are tracking the Treasury-equivalents, but many buyers are seeking out the long end for a continuation of outsized returns. Funds have been flowing into mutual funds once again. The question is whether this positive tone will continue given the yield declines. As one money manager suggested to me, it is challenging to get investors interested in a 1% municipal. However, on a day when equities fall by 1800 points on the Dow, the challenge one has must believe is not as great.
Which makes me return to the theme of why we need a cap on yields or not. Given what the pattern of rates has been lately in terms of gravitating to the lower end of the range, we are not readily convinced. However, we must keep two factors in mind. Chairman Powell reminded all of us that we may take quite some time before we fully recover. Low rates would undoubtedly assist in rebuilding the economy especially with the smaller to mid-size enterprises. The other factor that continues to weigh on the mind is just the sheer proportion of Treasury debt that will continue to need to be sold given the expanding deficit and the probability that some additional aid will be granted at some point. Concerning the latter, many politicians are invoking the rationale to wait for the precise reason that not all the aid that has been granted has been doled out to date.
Some are quicker to recognize the budget restrictions that are in the offing for states and localities. Given the government sector approximates 13% of total employment, more layoffs in the government sector will create a further drag on the economy. Without some additional provision, the government layoff scenario may become even more aggravated.
The flip side of low rates is always that the credit worthy issuers will be enticed to come to market on a more expedited timeframe than they would otherwise plan for on issuance. We are optimistic that not too many issuers will see the need to tap the MLF offered by the Fed. That option is really a fail-safe anyway.
I see some concerns that potential buyers are concerned that matters related to ESG bonds and climate change will fade given the overriding influences of the economy and Covid-19. I see quite a bit of evidence to the contrary. Many experts are continuing to write about the long-term implications of climate change and the need for action now. On the ESG front, I have participated in more than one Zoom meeting on the topic. There appears to be a relatively high degree of focus on ESG bonds because there is some conviction that this area will continue to grow in importance over time and that there will be greater returns for buyers by participating on the earlier side. Issuers are developing ever more favorable views towards ESG bonds to attract a wider array of potential buyers. The more perplexing part of the equation is that there is not a clear differential in terms of savings to the issuer in basis points. Some have pointed to better distribution here and there, but the pricing difference has some way to go to approach the benefit in the Eurozone.
We believe that yield caps have a long way to go before becoming a serious consideration. On a smaller scale, what would happen to ratios? The municipal market is accustomed to trading at a spread to a AAA synthetic scale. We suppose that fixed income markets would have to trade at a spread to high grade corporates and would take a breather on trading to the Treasury curve.
John Hallacy
John Hallacy Consulting LLC
06/12/20
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