TLT - Spotlight On Fed Rate Decision

2023-03-20 09:30:50 ET

Summary

• The Federal Reserve Open Market Committee meets on March 21 and 22.
• Pressure on the Fed to stop raising its federal funds rate target are mounting.
• Fear of things breaking is rising along with fears of recession and possible unemployment.
• Fed actions this week could have a significant impact on the stock, bond, and precious metal markets.

Introduction

The Federal Open Markets Committee ((FOMC)) meets on March 21-22 to determine what action, if any, to take regarding its targeted federal funds rate and securities reduction program. Market participants are more focused than usual on this meeting because of recent bank failures. Investor anxiety prior to this FOMC meeting is almost palpable.

A year ago, on March 16, 2022, the Fed initiated the first of eight increases in its targeted federal funds rate by raising the rate by 25 basis points (1%=100 basis points "bps") to a range of 0.25-0.50%. The targeted rate had been set at 0.00-0.25% since December 2018. The targeted rate now stands at 4.50-4.75%.

At its meeting a year ago, the FOMC also announced that it intended to reduce the Federal Reserve's securities holdings over time in a predictable manner primarily by adjusting the amounts reinvested of principal payments received from securities held in the System Open Market Account ((SOMA)). It set caps of $30B/month for U.S. Treasuries and $17.5B/month for agency mortgage-backs ((MBS)) for the months of June, July, and August 2022 and said those caps were to be raised to $60B/month for U.S. Treasuries and $35B/month for MBS beginning September 1, 2022.

Fed Goal

Since its announcement a year ago, the Fed has precisely achieved its federal funds rate objective. It has not been as precise in achieving its securities reduction goal. While it has come close to reducing U.S. Treasuries by the desired amount, the reduction in MBS securities has fallen far short of the desired amount.

Exhibit 1 shows the monthly decreases in U.S. Treasuries and MBS from June 2022 through March 15, 2023. It shows as of March 15 the Fed goal was to have reduced U.S. treasuries by $480B, but the actual reduction of $440.5B was short by $39.5B, or about 10%.

By comparison, the decline in MBS has fallen far short of the Fed's goal. Exhibit 1 shows during the 9 1/2 months from June 1 through March 15, 2023 the Fed's portfolio has declined by $98.7B, which is $129B or 56.7% below its reduction goal of $227.7B. Like other MBS investors, the Fed has experienced mortgage pre-payments far short of expectations as home owners stay in their homes to keep their low rate mortgages. The Fed is certainly not alone in experiencing an increase in the duration of its mortgage-back portfolio.

The Fed is not expected to alter its planned reduction in U.S. Treasuries or MBS securities. Furthermore, Chairman Powell has said that the Fed has not sold any securities in the past to achieve its goal and has no intention to do so.

Spotlight on FOMC

This FOMC meeting is experiencing heightened attention. Market observers are focusing on what the FOMC will do about the federal funds rate at its upcoming meeting. Prior to the recent failures of Silicon Valley Bank of SVB Financial Group ( SIVB ) and Signature Bank ( SB ), the prevailing view was that the Fed would increase the rate by 50bps, which would raise the targeted fed funds range to 5.00-5.25%. Since the bank failures, the expected 50bps increase has been taken off the table. The prevailing view now is that the FOMC will raise rates by 25bps.

Of course there is nothing to prevent the FOMC from either leaving the rate unchanged or cutting it. In fact, a growing number of influential people believe the Fed has raise rates too far too fast.

Bank Term Funding Program

The thoughtful introduction of the Bank Term Funding Program ((BTFP)) in response to the run instigated by a cabal of panicky, ultra-wealthy Venture Capitalists on Silicon Valley Bank has bought the Fed time to continue its war on inflation. If properly communicated and administered, BTFP should put an end to bank runs on U.S. banks for the foreseeable future.

By the Fed lending funds to any bank experiencing a surge in deposit withdrawals, it is fulfilling its role as the lender of last resort. Interestingly, it is also relieving pressure on the fixed income markets, since banks seeking BTFP loans would otherwise have to liquidate securities, which would tend to drive down prices and raise yields.

While some of the observed rally in U.S. Treasuries was attributable to disintermediation by fearful depositors, some was certainly due to market participants realizing that banks would not have to liquidate securities. The significant decline in the 2-yr and shorter U.S. Treasury securities also reflected the fact that investors decided the federal funds rate would not be raised by 50bps.

Exhibit 2 shows the rapid decrease in rates that occurred after the failures of SVB and SB. The 2-yr U.S. Treasury yield declined from 4.90% at the close on March 9 to 3.81% at the close on March 17. That 109bps decline in yield in six (6) trading days had not been experienced by the current generation of fixed income traders. Anecdotal evidence suggests that traders were short bonds and took large losses in the days after the two banks failed. Short covering by those traders certainly helped drive prices higher and yields lower.

Interestingly, the unrealized losses on the books of SVB and other banks fell sharply as yields declined. For example, a bank with a securities portfolio duration of 5 years saw the market value of its investments increase 3-5% in only a few days.

Exhibit 3 shows the daily change in yield on 2-yr U.S. Treasuries from 1984 to 2023. It reveals very little volatility in the yield on 2-yr U.S. Treasuries in 2009-2021 compared with 1984-2008 and 2022-2023. It is noteworthy that the one-day decline of about 60bps in the 2-yr yield on March 13 shown in Exhibit 3 exceeded historically significant peak, one-day declines that occurred on Black Monday in 1987, the World Trade Center attack in 2001, and Lehman's bankruptcy in 2008.

Exhibit 3

Market Impact of FOMC Rate Decision

Investors need to focus attention on effects the FOMC decision will have on financial markets. Since the Fed is not expected to alter its securities reduction program, investors need to concentrate on the FOMC interest rate decision.

Exhibit 4 shows four possible FOMC fed funds rate scenarios: raise rate by 50 bps, raise rate by 25 bps, leave rate unchanged, and lower rate by 25 bps. It shows the likely response of stocks, short-term and long-term fixed income securities, and gold after Chairman Powell announces the FOMC decision and holds his news conference on March 22.

Profiting From 50bps FOMC Rate Increase

A raise of 50 bps was widely expected prior to the well-publicized failures of SVB and SB, but such a raise is now a remote possibility. An increase of 50bps in the current atmosphere will cause short-term interest rates to rise significantly, while it will cause the stock market to decline due to increasing fears of recession and declining earnings. Gold, a traditional inflation hedge that has increased by 20% since October 2022, will likely experience a significant decline since a 50 bps increase will signify the Fed's determination to raise interest rates and reduce inflation. Long-term bond yields will likely drop as bond prices rise, since this category of investments benefits from low inflation. The stock market will likely decline because of expected earnings pressure. The rate on short-term bonds will increase in sympathy with fed funds. If you expect a 50 bps increase and want to profit. then you can short SPDR Gold Trust ETF (GLD), sell 2-yr U.S. Treasury futures (SPUST2TR), buy 30-year U.S. Treasury bond futures (SPUSTBTR) or iShares 20+ year ETF ( TLT ), or short SPY.

Profiting From 25bps FOMC Rate Increase

An increase of 25 bps will send a clear signal that the Fed is committed to continuing its war of inflation until it is satisfied by data that it has truly doused the embers of inflation. At the same time, it will allow Chairman Powell to unambiguously state that the Fed has the back of every bank in nation; and, through BFTP, it will provide whatever funds a bank needs to meet depositor withdrawals. Powell must unequivocally state the Fed is prepared to help every bank regardless of the size of the bank. These actions will cause an increase in short-term rates as people and companies stop fearfully rushing into U.S. Treasuries. The price of gold might come under some downward pressure, but any price decline is likely to be offset by fear of European banks failing, the Ukraine war, and concerns about the U.S. defaulting on its debt. Stocks and long-term bonds are likely to remain unaffected. The financial markets are now expecting a 25bps increase; therefore, the opportunity to take advantage of such a change is nonexistent.

Profiting From No FOMC Rate Change

If the FOMC decides to leave its targeted fed funds rate unchanged there is a possibility that market participants will take it as a sign the Fed is more concerned about the systemic nature of recent bank failures than they say. Leaving the fed funds target unchanged will also be construed as indicating Fed officials are starting to bow to pressure coming from wealthy, highly levered, politically powerful commercial real estate people who are feeling the pain of higher rates, Senator Warren, and others. If the FOMC leaves rates unchanged, Powell must do a masterful job convincing skeptics that the Fed is pausing only because of meaningful evidence that their previous actions are working after a longer than expected lag. He must also assure everyone that recent bank failures are not indicative of any systemic problem. Investors wanting to profit from the FOMC leaving the fed funds rate unchanged can buy SPY, buy GLD, or sell 30-year U.S. Treasury bond futures or short TLT.

Profiting From 25 bps FOMC Rate Decrease

If the FOMC announces a reduction in its targeted fed funds rate, it will be taken as a clear sign that its war on inflation is being put on the back burner. It will strongly suggest that the banking problems are systemic and serious problems exist. Powell will be unable to put a positive spin on the FOMC decision to cut rates. A feeling that the Fed has lost its courage to fight inflation will prevail. The stock market will initially embrace the news as the end of monetary tightness and experience a relief rally. Gold investors along with long-term bond investors will see the rate decrease as capitulation; therefore, the price of gold and the yield on long-term bonds will rise. Short-term yields will stay relatively unchanged and retain their recent rally. Investors wanting to profit from the FOMC lowering the fed funds rate should buy SPY, buy GLD, or sell 30-year U.S. Treasury bond futures or short TLT.

Summary

Recent bank failures have focused attention on the March 22 FOMC decision on interest rates. Eight straight increases in the Fed's targeted rate have not brought inflation down to the desired 2% rate. Fed increases in its target fed funds rate are however being met by mounting criticism.

Odds are that the Fed will raise the fed funds rate by 25bps. Chairman Powell can be expected to emphasize the continuing strength in the employment, the Fed's intention to make money available to any bank needing funds to meet deposit withdrawals, and the Fed's continuing commitment to bring inflation down.

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