Too much of something can be a problem

Since the start of the Covid-19 pandemic in 2020, governments around the world have injected their respective economies with liquidity to prevent a full-scale economic recession through both fiscal and monetary policies.

For example, President Biden’s $1.9 trillion coronavirus relief package, which he signed in March, is mammoth in scope. In December last year, Congress passed a $900 billion relief bill, on top of more than $2.5 trillion of aid authorized during President Donald Trump’s final full year in office.

This has caused a bit of a problem in recent times. With the low interest rate next to zero, banks and money market managers have been eager to avoid negative yields and parked their excess cash with the FED through the latter overnight reverse repo program, though the return is zero. Banks and money market managers faced the impossible task of finding any instruments that could get them any form of return. On Thursday, the FED increase the facility payout from 0% to 0.05% and a record high of $756 billion flowed into the program on that day.

The excess liquidity in the system is forcing the short term rates to go into negative territory in which may potentially, disrupt the financial stability of the system. Banks and money market managers may no longer want to take in cash. By managing the interest paid on the RRP, it ensures that the RRP remains a strong floor for money market rates.

Flattening of the Yield curve

Source: US Treasury

The 10-year yield, which is the benchmark Treasury, fluctuated widely in the past week. After starting the week at about 1.45%, it moved higher right after the Fed meeting to as high as 1.59% but then fell back down to about 1.45% at Friday’s closing.

The continued falling of the 10-year treasury yield is a bad news for value stocks, but a great one for growth. This has been reflected in the price of banks and financial stocks since the start of June. Refer to the charts below.

XLF Price Chart
XLK Price Chart
10 Years Treasury Yield

In the last FOMC, Powell had said that the $120 billion bond purchase program will continue. This monthly $120 billion bond purchase includes $80 billion in Treasury securities and $40 billion in mortgage-backed securities. This means that the market will continue to be flooded with liquidity and the yield on the longer term bonds will continue to drop, flattening the curve even more, as the short term rates increases with the excess liquidity.

This phenomenon is expected to negatively affect those industries which are sensitive to rates like the banks. Traditionally, banks are in the business of borrowing short and lending long. With the short term rates increasing and the long term rates decreasing, this will negatively impact on banks’ profitability in the long run.

The Ever-important 10-Year Treasury Yield

10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity
10 Years Treasury Yield vs BAC and JPM (Blue: 10-years treasury yield, Green: BAC, Red: JPM)

From the chart above, we see that the banks’ share price is positively correlated to the 10-years treasury yield. The 10-year treasury yield is a proxy to the mortgage rates and an indicator of investors’ confidence as well. When confidence in the market is low, investors tend to snap up this instrument as it is perceived as a safe haven instrument with the US government backing them. The higher this 10-year treasury yield, the more banks and financial institutions can charge for the loans issued, which in turn positively impact the profitability of banks and financial institutions.

Yield Curve Control Underway

We see that somehow the current yield curve has been directly controlled by the FED as a result of QE, selling short term causing the yield to increase and buying longer term causing the yield to decrease.

On one hand, $120 billion worth of liquidity is injected into the financial system every month with the bond purchases. Liquidity is withdrawn from the other end through its overnight reverse repo program. We have seen a surge in the amount of funds parked with the FED through the program spiking in recent months. Refer to the chart below.

Overnight Reverse Repurchase Agreements: Treasury Securities Sold by the Federal Reserve in the Temporary Open Market Operations

Reducing the money supply in the system indirectly affect the speed of inflation which is a hot topic in the market currently. I believe that the FED is now concerned with the inflationary numbers that they are seeing, and putting in some action to manage this inflationary pressure.

China has recently stepped up its campaign to rein in commodity prices and reduce speculation in a bid to ease the threat to its pandemic rebound from soaring raw material costs.

The inflationary pressure has been felt throughout the world as a result of the global government accommodative fiscal and monetary policies implemented during the covid-19 crisis. The global recovery from the crisis was beyond expectations and hasten the rate of inflation. This recovery is expected to continue in the near future with the global vaccination in progress and countries slowly opening up to international travels.

I think this yield curve control needs to be rein in to control the speed of inflation. A runaway inflation can be very damaging to both investors and economies alike. Consumers’ purchasing power will be eroded and corporate debts faced the risks of higher interest rates which in turn, marginalised net margins. Real investment return may even be negative after factoring in inflation rates and deter investors from investing their funds. The market confidence will be badly shaken as a result.

The Taper Tantrum

In 2013, Federal Reserve Chair Ben Bernanke announced that the FED would, at some future date, reduce the volume of its bond purchases (Sounds familiar?). In the period since the 2008 financial crisis the FED had tripled the size of its balance sheet from around $1 trillion to around $3 trillion by purchasing almost $2 trillion in Treasury bonds and other financial assets to prop up the market. Investors had come to depend on ongoing massive Fed support for asset prices through its ongoing purchases. 

Recent balance sheet trends (Source: US Federal Reserve)

The intensity of FED’s bond purchase is way higher than that post Global Financial Crisis. The stock market rallied higher partly due to this mass liquidity in the market through this bond purchase program which unfortunately, also created inflationary pressure.

Prior to the FED hiking rates (2 rate hikes expected by the end of 2023),they will first need to reduce their bond purchases. With that in mind, the market reacted negatively in the past week, especially after the FOMC meeting. Refer to the chart below. Investors are worried about whether the FED may be hiking rates too early as a result of inflation numbers, prior to a full recovery in the US economy. And whether the economy can continue to grow post QE and a falling yield on the longer dated bonds (bearish investors’ sentiment).

Dow, S&P, Nasdaq performance during FOMC week.

Something similar happened in September 2011. The Operation Twist started with the FED selling short and buying long on the treasuries which is what we are experiencing now as well. There was volatility then as market started to worry about the falling 10-year treasury yield. Banks share prices consolidated during this period of time. However, with hindsight, we knew that the 10 year treasury yield did not stayed low, but started appreciating in April 2013. Refer to the chart below.

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10 Year Treasury Yield (Blue) vs JPM (Red) vs BAC (Green) September 2011 to December 2014.

In 2013, yields rose 75% between May and August alone. Investors sold off Treasuries when the Federal Reserve announced that it would taper its quantitative easing policy. In December of that year, it began reducing its $85 billion a month purchases of Treasuries’ and mortgage-backed securities. The Fed cut back as the global economy improved.

Post the above action, the Dow rallied 26.57%, S&P 34.69% and Nasdaq 48.41%. Refer to the chart below.

Dow, S&P, Nasdaq Performance May 2013 – December 2014
10-year Treasury Yield (Blue) vs JPM (Red) vs BAC (Green) September 2011 to December 2014

From the chart above, we see that though the 10-year yield fell during operation twist, the yield started to appreciate in May 2013 due to the recovery in the global economy and FED tapering off its bond purchases. Investor seeing an imminent raise in interest rates started selling treasuries which resulted in longer dated bond yield to rise. Banks’ share prices appreciated in tandem during this period of time.

Where are we now?

I think we are currently in the early phase of the cycle. FED maintained its position of buying $120 billion worth of bonds every month. We should be somewhere prior to May 2013 with reference to history (Refer to the chart below). Then, the yield on the 10-Year treasuries fell as well but probably due to operation twist by FED.

With the global economy facing a stronger than expected recovery and inflation worries surfacing, there will come a point of time in the near future (most probably 2022 depending on how fast the US employment and inflation numbers grow) that FED will start tapering off their bond purchase program. Till then, the yield on the 10-year treasuries will stay low, and thus, banks’ share prices may stay range-bound.

During the start of Operation Twist from September 2011 to May 2013 When FED announced scaling back of their bond purchases.

But once the FED tapers off its bond purchases, most probably we will see a rise in yield and a recovery on the banks’ share prices. The above chart shows the prices of JPM and BAC from September 2011 (Start of Operation Twist) to May 2013 when the FED Announced scaling back on its bond purchases. JPM share price was up 56.71% and BAC was up 84.55% during this period of time.

Accumulate banks shares during this period of adjustment. JPM and BAC are two banks that I am positive.

Of course, past performance is not a good indicator of future returns. And i still stress on the need to diversify one’s portfolio. Again the above are purely for informational purposes only and should not be taken as an advice to purchase securities. As of writing, I do hold JPM and BAC in my portfolio and my opinions may be biased. Do consult your financial advisor as the above-mentioned securities may not fit your risk profile or your investment objectives. Please read disclaimer.