SNW Impact Insight: Climate Change at the Fed

A quick note: To highlight the SNW Impact Strategy through 2019, we will be periodically sharing thoughts and observations from the team responsible for the research and ratings. These pieces are intended to share the context of how the ratings are derived, the philosophy behind ESG and impact ratings, and how the industry is currently positioned. They may feature entities that we do not currently invest in.

Glenn D. Rudebusch, senior policy adviser and executive vice president in the Federal Reserve Bank of San Francisco’s economic research department, outlined the economic impacts of climate change in an Economic Letter released on March 25th. The letter highlighted the likely direct and indirect impacts that will result from rising sea levels, increasing temperatures and changing weather patterns, as well as from resource reallocation to deal with these impacts and to increase climate resiliency in affected communities. This includes both near- and long-term impacts that may yield negative economic outcomes.

Referencing the latest National Climate Assessment released in November 2018, the FRBSF letter provides insight into how markets and central banks may react to climate change. Risks from climate change are of concern to central banks, including the Federal Reserve, as they may require a change in monetary policy. As Rudebusch points out, "Climate-related financial risks could affect the economy through elevated credit spreads, greater precautionary saving, and, in the extreme, a financial crisis. There could also be direct effects in the form of larger and more frequent macroeconomic shocks associated with the infrastructure damage, agricultural losses, and commodity price spikes caused by the droughts, floods, and hurricanes amplified by climate change." These factors, while initially local, may have global carry-on effects. Alongside these direct impacts, adaptation and resilient responses will require the diversion of resources from productive capital accumulation. In combination, as the letter points out, "Climate change is becoming relevant for a range of macroeconomic issues, including potential output growth, capital formation, productivity, and the long-run level of the real interest rate."

With that said, however, Rudebusch points out that the Federal Reserve's statutory mandate of price stability and full employment will restrict the actions the organization can take. The use of policy to support climate change mitigation through the transition to a low-carbon economy, through support for an appropriate pricing of carbon or through other direct actions focused on environmental sustainability are all beyond the remit of the Fed. However, the analysis and policy decisions undertaken by the Federal Reserve can and should take climate change and its effects into consideration as "the volatility induced by climate change and the efforts to adapt to new conditions and to limit or mitigate climate change" are increasingly relevant.

In January, twenty senators sent a letter to the Chairman of the Federal Reserve and to the Comptroller of the Currency urging them to bear in mind that their agencies are responsible for protecting the stability of the U.S. financial system and urging them to ensure that the nation's financial system is ready for climate change. In February, Chairman Powell of the Federal Reserve told legislators that the inquiry about climate change was a "fair question" to ask, and he promised to look into it. These financial risks are increasingly apparent, as what was once considered a long-term issue begins to express itself in more near-term impacts.

Our approach to credit analysis, even outside the holdings in our SNW Impact Strategy, includes an integrated approach to evaluating material and relevant climate and environmental factors in all sectors in which we invest. Our view continues to be that prudently managing risk and being aware of the full spectrum of origins of such risk is a critical responsibility. This includes near-, mid-, and long-term idiosyncratic risks that may affect the ability of issuers to repay their outstanding obligations. We will continue this approach and adjust strategy and positioning as needed.

The Fed Managed to Surprise Us Again

The Fed is on a roll. Just when we thought the Federal Open Market Committee (FOMC) couldn’t surprise markets with any more dovish (easy monetary policy) announcements, it did just that.

Following its two-day policy meeting last week, the FOMC announced on Wednesday the expectation for no additional rate hikes in 2019 (after expecting two hikes as recently as December) and only one 25 basis point increase next year. In addition, the FOMC announced an earlier than expected end to its balance sheet reduction process.

Both stock and bond markets reacted positively to the news on Wednesday and Thursday. Stocks because the Fed put is back, meaning that the Fed will do everything in its power to keep the current expansion in both the economy and financial markets going strong. Bonds because less monetary policy tightening is generally good for valuations, especially when inflation is under control.

Friday was a different story, however. On the back of weak economic data out of Europe, we saw a classic “risk-off” day. Stocks fell, corporate credit spreads widened and TIPS breakevens (a measure of inflation expectations) declined. Long-term U.S. Treasuries rallied and took certain yield curves into inversion territory, which historically has been a signal of a pending recession.

It now appears to us that financial markets have discounted much of the Fed’s dovishness. And with the Fed on-hold for further monetary policy announcements, moves in risk assets are likely to be driven mainly by how the economy evolves. Will the recent weakness in overseas economies, namely Europe and China, be transitory or more long-lasting, and will it bleed over into the U.S. economy, are the key questions moving forward. Any substantial change in inflation or inflation expectations will also be important to monitor.

High quality bonds such as tax-exempt municipals, U.S. Treasuries and highly rated corporate bonds have performed well, and will continue to encounter favorable conditions moving forward. The jury is still out for riskier assets such as lower rated corporates, however. Given the current environment, we think it’s prudent to position our strategies with a conservative bent, and remain patient to see how the situation evolves.

Source: Federal Reserve

Spring Is in the Air – We’ll see if the Fed Agrees

Spring is an optimistic time of year, with the smell of grass and fresh flowers, longer days and bright sunshine. And it is so predictable – it happens every year!

If only the economic cycle were as predictable! Recessions happen infrequently and the last one ended in June of 2009.

One of the classic tools for predicting recessions is the NY Fed’s “Probability of U.S. Recession Predicted by Treasury Spread – Twelve Months Ahead.” This model uses the difference between 10-year and 3-month Treasury rates to calculate the probability of a recession in the United States twelve months ahead. As you can imagine, the Fed has been tracking and analyzing this data for decades and it does a pretty good job.

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As the data indicates, it is hard to see a recession in 2019 with the U.S. economy still so strong. But as the chart also shows, the risk of a recession can rise or fall suddenly for any number of reasons. What we take way from this data is treasury spreads indicate the economic cycle is at least in late fall: leaves are turning red and gold and there is chill in the evening air.

We will get an update from the Fed this week when the Federal Open Market Committee meets to set monetary policy. The post-meeting statement and press conference will provide insights into the FOMC’s thinking on both the economy and interest rates. We don’t expect any changes to the Fed Funds Rate, but like so many previous meetings, all eyes will be on the dot plot, which highlights committee members expectations for future rate moves.

Markets also do a good job of anticipating the changing of the season and will move ahead of an actual recession. We note investment grade credit spreads appear to have reached their cyclical tights in February 2018, and the last S&P 500 top was in September 2018.

In the coming weeks we will start getting outside more often to enjoy the sunshine, and we will also ensure portfolios are getting ready for cooler weather.

Source: NY Federal Reserve

Munis Continue Their Hot Streak – Creates Opportunities for Crossover Investors

The municipal market has started off 2019 in a strong way, with tax-exempt municipal bonds now trading at some of the richest valuations versus taxable bonds on record. Driven by robust demand (as measured by mutual fund inflows) and light supply (as measured by new issuance), the positive technical environment has been one of the main drivers of the rally.

To measure the relative value of tax-free munis versus taxable bonds, we often analyze the ratio of municipal yields versus Treasury yields. As shown in the chart below, this ratio has dropped over the past 12 months, particularly for short to intermediate maturities such as five and ten years.

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While there are no immediate signs of this trend reversing, these absolute yield levels have created an opportunity for crossover investors to sell munis, purchase taxable bonds, and increase the after-tax yield generation on their portfolios. For example, the after-tax yield for investors in a mid-level tax bracket is 0.19% higher on a 1-year US Treasury Note as compared to a 1-year AAA municipal bond.

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The after-tax yield advantage is even more dramatic for corporate and taxable municipal bonds, which carry additional yield because of a credit spread premium.

These relationships are particularly relevant for our Blend Strategy, which has the leeway to invest in a mix of taxable and tax-free bonds. After increasing our allocation to tax-free municipals in the winter of 2017 during a muni market sell-off, we’ve been slowly capturing municipal outperformance by selling munis and buying taxable bonds. We executed on another leg of this trade last week as the after-tax yield opportunity has become too good to ignore.

Source: Barclays, Bloomberg

“Patience” May Be Replaced By “Flexible” As the Fed Debates Inflation

Fed Chair Powell gave his semi-annual testimony to Congress last week to present an assessment of the current state of the U.S. economy. To summarize his views, economic growth remains steady, the labor market remains strong and inflation is well contained. However, downside risks are visible, particularly those from what is becoming a pronounced slowdown in overseas economies, which has the potential to dent growth here at home. As such, the FOMC is committed to patience before raising the Fed Funds Rate in 2019 after hiking rates four times last year.

The word “patience” has become the most popular way to describe the Fed this year, but we would argue “flexible” may take the top spot moving forward. This is because Powell, along with a host of other committee members in recent weeks, has begun to highlight the months-long review of its policy framework, which appears to be centered around the current inflation target of 2%. The formal inflation target of 2% was introduced in 2012, but inflation has generally remained below that since the financial crisis.

Inflation ex. Food and Energy (Core)

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With inflation having lagged below target, the Fed is debating whether to become more flexible in how it assesses setting the Fed Funds Rate. Currently, the Fed targets 2% inflation each year, without regard to what has occurred in the past. One alternative would be to react to what happened previously by taking historical inflation into account when setting policy rates. For example, if inflation was below 2% last year, the FOMC could let inflation rise above 2% this year without raising rates. Another potential approach would be to target an average level of inflation at 2% over the course of the business cycle. As Powell put it, “think of ways of making that inflation 2% target highly credible, so that inflation averages around 2%, rather than only averaging 2% in good times and then averaging way less than that in bad times.”

In either approach, the flexibility around the current level of inflation and policy rates will be key. In a flexible environment, the Fed would avoid raising the Fed Funds Rate if inflation breaks above 2%. Longer-term bond yields would likely rise in this situation as higher inflation eats into the real value of future interest payments. Despite all this talk, the bond market has remained quite steady this year, which means investors aren’t concerned with inflation moving higher or this new approach being implemented, or a combination of the two.

Source: Bloomberg, NatWest Markets, WSJ