Less Liquidity + Higher Debt = No Day at the Beach!

It’s summer, and the only liquidity we should be thinking about is a cold beverage on a warm beach. Summers in Seattle are way too short, and since the rainy season is always just around the corner we need to enjoy the sun while we can.

Despite the distractions offered by warmer weather, we are noticing some market developments that are far from bright and sunny. The first is liquidity and the second is debt, both of which were highlighted in a recent report produced by the Bank for International Settlements.  

We often talk about how the Federal Reserve is raising the fed funds rates and reducing its balance sheet. This is draining liquidity from the capital markets and will likely eventually lead to lower economic growth and the next recession. As the old saying goes, “Economic expansions do not die of old age, they are murdered by the Fed.” We know we are well along in this cycle of interest rate hikes, and it is important to note the Fed is not alone in taking away liquidity. Many of the world’s central banks are also planning on raising rates, which will impact the U.S. 

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Higher debt levels are a second important issue.  The financial crisis in 2007/2008 did not lead to lower debt levels as one would expect. As the crisis unfolded, central banks stepped in with aggressive liquidity measures to keep the world financial plumbing intact. Governments borrowed and spent with abandon to soften the recession, and corporations capitalized on ultra-cheap money to increase dividends, fund buybacks and make acquisitions. Only households modestly reduced debt directly after the recession. But some research suggests much of this debt reduction can be attributed to forgiveness of mortgage loans during foreclosures, not to debt repayment.  

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Note : AE = Advanced Economies, EME = Emerging Market Economies

So here we are trying to enjoy that cold beverage with the knowledge liquidity is draining, debt is piling up and the consequence will be more volatility and likely lower prices for risky assets. The good news is that as Seattle residents our rain jacket is always close at hand. We are currently positioning portfolios for more volatility by scaling back on credit risk, keeping liquidity high, and maintaining duration exposure close to home.

Enjoy the sun!

Sources: The Financial Times, Bloomberg, The Bank for International Settlements

The Steadiness of Investment Grade Comes to Bear

During a quarter in which the multitude of volatility-inducing market headlines seemed to run on a continuous loop, investment grade bonds proved relatively resilient, as returns were flat to slightly positive during the April through June time period. This comes despite a rate increase by the Federal Reserve, another in its series of well telegraphed steps down the path to policy normalization, and also despite a tick-up in inflation to levels more consistent with the Fed’s target of 2%. However, the uncertainty surrounding issues such as global economic growth, trade policy and the indebtedness of emerging economies (just to name a few) has created an environment where the “safe” nature of high quality bonds is in favor. And now that short-term interest rates are off of rock bottom levels, investors are once again reasonably well compensated for investing in fixed income, which we haven’t been able to say for many years now. 

2Q18 Index Returns                       ICE/BAML Intermediate Index Returns (1-10 Yr)
Treasuries                                              0.07%            
Municipals                                             0.76%            
Corporates                                             (0.15)%

Interest Rates

The Fed Funds rate was near 0% from 4Q08 to 4Q16, an abnormally low level for an extended period of time. While this measure helped stimulate the overall economy, it was not good for investors with money in the bank or for fixed income investors looking for income. But times are getting better as the Fed Funds rate target is now 1.75% - 2.0% and projected to go higher. If the Fed’s expectations come to fruition, the Fed Funds rate could be around 3.0% by the end of 2020. With longer rates having risen early in the year and now stabilized, the environment we have described previously as the “sweet spot” for bond investors may be upon us, where short-term bonds are producing more income and longer-term bonds are holding steady.  


Municipals are leading all sectors of the investment grade market this year after a tax-reform induced bout of volatility at the end of 2017. The tax reform bill that passed late last year is reducing the supply of municipal bonds, as the new law eliminated the ability for municipalities to issue advance refunding bonds on a tax–exempt basis. Less supply with steady demand has created a favorable technical backdrop. This, coupled with generally strong credit quality (absent a few problem children), is driving our expectation for the positive trend to continue as we move through the second half of 2018.


As in Q1, corporate credit spreads widened in Q2, which means investors are now demanding more yield compensation to lend money to corporations. Less demand from overseas buyers, concerns around trade policy and stretched balance sheets have all been contributing factors to the spread widening and, thus, the underperformance. While spreads are now more attractive than they were just a few months ago, and though we are finding some opportunities in short-maturity corporates, we believe the corporate volatility will likely continue, and as such are continuing to position portfolios conservatively. 


Our outlook for the second half of the year is not too dissimilar from our expectations coming into the first half. The Fed is likely to continue raising the Fed Funds rate, domestic and geopolitical headlines will continue to influence markets and investors will continue to assess just how much longer this economic cycle has to run. But against this backdrop bonds can still do well, and with interest rates now higher, income production will rise, which could help them perform even better moving forward.  

Sources: ICE/BAML Indices

Supreme Court Says Yes to Sales Taxes on Internet Sales

A ruling by the U.S. Supreme Court on June 21 will allow states to expand their collection of sales taxes revenues generated from out-of-state internet retailers. Under prior Supreme Court decisions, states have been limited in their collection of sales taxes on internet sales to those online vendors who have a physical presence in the taxing state. The ruling in South Dakota v. Wayfair overturns the prior physical presence requirements, which could provide an additional $8.5 to $13.4 billion of annual tax revenues for state and local governments, as estimated by the U.S. Government Accountability Office.

While the court decision could increase state and local sales tax revenues by 2.0% to 3.4% over current sales tax collections, we do not expect the potential increase to lead to a plethora of rating upgrades. We view the decision as a credit positive since it expands state and local tax revenue bases and helps prevent an erosion of sales tax revenue growth as the growth of internet sales continues to outpace the growth of retail sales from traditional “brick and mortar” stores. The potential influx of tax collections would also provide additional revenues to fund growing pension and health care costs and infrastructure initiatives. The actual impact on municipal bond credits will vary by sector and state.

State GO Sector and State Appropriation Debt:  General funds for states that collect sales taxes should benefit from the increased revenues. While California is projected to have the largest revenue impact ($1.0 to $1.7 billion annually), we expect states that are more dependent on sales taxes and do not levy income taxes (such as Florida, Texas and Washington) to be the biggest beneficiaries. For example, Florida’s general fund revenues could increase by 1.4% to 2.2% annually, while California’s general fund revenues would only increase 0.6% to 1.0%.

Local General Fund-Backed Debt:  Many cities and counties receive a local share of sales tax revenues, and the increased sales tax funds should provide more cushion in their general funds, particularly as pension contributions and other liabilities increase. The additional funds could help increase revenues available for debt service on appropriation debt.

Dedicated Tax Bonds:  Sales taxes are a common source of pledged revenues for dedicated tax bonds, particularly for state and local transportation agencies. The increased revenues would provide higher coverage levels for sales tax bonds and provide more funds to leverage for infrastructure projects.

We also expect that the actual realization of increased revenues will take some time. States may need to adopt new legislation to authorize the collection of sales taxes originating in state from internet sellers who do not have a presence in there, and procedures will need to be adopted by state tax agencies to implement the collection process.

Sources: Fitch, JP Morgan, National Association of Budget Officers, Standard & Poor’s, U.S. Government Accountability Office, U.S. Supreme Court

Why We Are Getting More Inquiries on Our Ultra Short Duration Strategies

It’s been almost ten years since short duration high quality fixed income earned more than inflation. The last decade has pretty much been a losing battle for the sector, as the Federal Reserve kept short-term interest rates artificially low to aid the U.S. economic recovery. It’s been painful to earn less than inflation for all these years, especially since a certain allocation to cash and high quality short term investment tends to be prudent. 

But thanks to recent rate hikes (an increase of 1.25% over the last 18 months) by the Federal Reserve, three-month treasury bills just recently have begun yielding more than inflation!  The three-month treasury yield of about 1.9% compares favorably to the Core Personal Consumption Expenditure (the Fed’s main measure of inflation) of 1.8% (see the chart below). This means that investors are no longer losing money on a real (inflation adjusted) basis. Quite frankly, it’s hard to find anything safer and shorter term than a three-month treasury!

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In practice it is not hard to do better than 1.9% while maintaining a high level of safety. Just extend the maturity a few months and add a little high quality credit spread exposure on top of the treasury yield and it is possible to earn 2.50%. That is the yield to worst (YTW) on SNW’s Ultra Short Taxable Strategy, which has a duration of ~1.0 year and holds about 50% of its investments in treasuries. Similar opportunities exist to beat inflation in tax-free municipals as well. The YTW on the SNW Ultra Short Tax Exempt Strategy is 1.80%, which is a tax equivalent rate of 2.77%. In comparison, the national average rate for a one-year bank certificate of deposit was 0.58% for the week ending June 11th. As for money market funds, Barron’s reported on June 18th the average 7-day yield on a government money market fund was 1.22%, and the 7-day yield on a tax free fund was 0.84%. 

Ten years is a long time to earn less than inflation! Now savers and fixed income investors can celebrate the return of safe income. It’s a good thing!

Sources: Bloomberg, BankRate.com, Barron’s

Central Banks Are Draining the Pool!

You could almost hear the sound of rushing water as central bankers drained liquidity from the deep pool of global financial assets last week. Both the Federal Reserve and our friends at the European Central Bank (ECB) took action, with the Fed in the lead.

The Fed was bailing the pool with both hands last week as Mr. Powell announced the Committee’s decision to raise the Fed Funds rate 25 bps to a target rate of 1.75%-2.00%. He also signaled, according to Fed watchers, that there likely will be two more rate increases this year and another three next year. Additionally, the Fed dropped previous crisis-era assurances it will keep rates below its longer-run norms. And just to make sure we got the No-Life-Guard-On-Duty notice, the Fed continued to shrink its balance sheet.

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The ECB is also taking action, but less aggressively than the Fed. Last week Mr. Draghi announced the ECB will wind up its €2.4 trillion bond-buying program by the end of this year. The ECB did not raise rates, but acknowledged the potential for an increase next year, stating it would keep interest rates unchanged at current record lows at least through the summer of 2019. In announcing a pullback in bond-buying, the ECB is betting the euro-area economy is robust enough to ride out both the recent slowdown and new political risks, which include U.S. trade tariffs and worries that Italy’s new populist government will spark another financial crisis.

So what does this mean for high quality fixed income investors? The benefits are the return of yield and the value of safety. As we have discussed previously, after a number of rate hikes  bond yields are now generally well above inflation rates, even for shorter-duration treasuries. And as liquidity is drained from the pool and risky assets become more volatile, high quality fixed income becomes a safe choice – sort of like using a floaty in the shallow end of the pool.

Sources: The Federal Reserve, ECB, Bloomberg, Financial Times, New York Times