By David Schawel, Economic Musings
And then there was one. By one, I mean, one “major” tenor on the US Treasury curve with positive real yields. Today, 30yr TIPS ended the day slightly under 60bps. Are inflation expectations falling or nominal yields falling, or both?
A few weeks ago in a post titled “Breaking down 2011’s Monster Move in USTs” , I noted how the lions share of the move in 10yr USTs was a move lower in real yields. (i.e. 10yr breakeven declined, but 10yr nominal yields fell much more substantially). With 10yr real yields recently moving into negative territory, currently at -31bps, it is only the 30yr (and 20s) that is left with positive real yields.
The manifestation of this process has been happening for a few months now (see: The Chase for Yield Picks up) – but the updated FOMC language has clearly changed the paradigm. Besides just watching the Bloomberg screen in awe, what are the implications of what’s unravelling before our eyes? Moreover, what happens to institutional behavior because of this?
It’s much more than “How low can yields go”, major institutions managing portfolios of investments against liabilities, (including banks, pension funds, and insurance companies) have some serious problems. A portfolio manager can no longer extend from 2s to 3s or from 5’s to 7’s to make up lost yield. Margins are at stake here, and the deterioration has already begun – recent earnings for banks have shown notable NIM contraction. JPM’s CFO noted the following on the conference call this month:
…for the outlook for the first quarter, we expect to see some downward pressure on NIM in the first quarter and that would be — well, as we continue this mix in our portfolio on the Loan side, greater growth in the Wholesale side and some runoff in the Consumer side, we’ll also see a little lower yielding loans that we add on. And the other piece I’d say is we’ve got a lower-yield investment securities, I think, expected in this rate environment.
Banks are not the only ones feeling the pinch. Take insurance companies for instance. Problems for insurance companies start with the overall economy as many are unprofitable underwriters. This is okay if they make up the difference through their investment portfolio. Trouble is, a company writing at 105%, for example, has to earn 5% to keep the company profitable. That is no small feat in this environment, so they are forced to: a) take credit risk b) interest risk c) re-allocate resources. Travelers for example, actually had a combined ratio of 95, meaning they had a $.05 profit for every $1 underwritten. Despite that, their investment portfolio shrunk by $100MM in the qtr. as roll off yield cost them 150 bps.
Bernanke & Co’s goals are now front and center – the only way to maintain margin is to extend duration or add credit. Accomplishing this through duration (dramatic flattening of the curve) has become nearly impossible (hello 2.5% 30yr current coupon MBS!!) and moving into some form of credit is what most are faced with now- and likely ilprepared. With the Fed sucking up supply of typical bank & insurance company Agency MBS, they must move somewhere else. Muni’s, lower grade corporates, CLO’s, and non-agency MBS are all target areas.
What is to stop positive 30yr real yields from evaporating? Everything seems to scream that these positive real yields will go away. The earnings streams of institutions are being threatened here – how will they respond? If the past few months are any indication, everyone is going to close their eyes and jump off of the “risk on” bridge – and probably hoping they are not alone.
The implications are long term in nature; many institutions are funding these assets with short term floating rate liabilities. This is all well and good if we stay at zero – however locking in fixed long term assets could be perilous in the future. There are no easy answers out there, and any solution will result in risk whether it be interest rate risk, credit risk, and/or earnings repricing risk. Finally, what happens to the stocks? Certainly, a company with a lower projected earnings stream should have a different valuation. Do banks and insurance companies (among others) reprice? Many questions and few answers. I hope this is all ends up working Mr. Bernanke.