by Gayl Mileszko
Stories about reversals make some of the best tales. We love it when the underdog turns everything around and wins: Rocky, David versus Goliath, the 1980 men’s Olympic Hockey team, the clever con man in Trading Places. We like being surprised by unexpected twists in the plot: Scarlet and Rhett, Rick and Ilsa, Luke Skywalker and Darth Vader. Lady Macbeth is known for bemoaning “What’s done cannot be undone” but the truth is that we undo and re-do things all the time, correcting mistakes, making things right, fixing problems that we ourselves created. Sometimes we make things better, sometimes not.
Quantitative Tightening Begins in Earnest
This September, while we are busy going back to school, adjusting to new work routines, celebrating holidays and enjoying the change of season, our central bank is starting to undertake one of the biggest reversals of all time. The Federal Reserve is beginning to pare down its portfolio of nearly $9 trillion, one that has grown exponentially since 2007, doubling in size since the start of the pandemic. Holdings currently include $5.59 trillion of U.S. Treasury bills, notes, bonds and inflation-protected securities; $2.3 billion of Fannie Mae, Freddie Mac and Federal Home Loan Bank securities; and $2.7 trillion of federal agency guaranteed mortgage-backed and commercial mortgage-backed securities. Back in September of 2007, when the Fed began reducing the federal funds rate from its peak of 5.25% in response to worries about liquidity — a full year before the Lehman bankruptcy in September 2008 — its portfolio totaled a mere $871 billion. By September of 2012, it had grown to $2.85 trillion. Prior to the pandemic in September 2019, the balance sheet totaled $3.76 trillion. One year later, in an effort to stabilize the markets, it ballooned to $7.01 trillion. Last September it further increased to $8.35 trillion and it is now sized at $8.82 trillion.
Fed Balance Sheet Reductions Increase: Quantitative Tightening (QT)
Efforts by the Fed to reduce its balance sheet actually began in June and they have so far quietly achieved a $139 billion cut by simply letting bills and notes mature. The pace is being stepped up this month as part of the “balance sheet policy normalization”. The target is to shrink Treasury holdings by $60 billion a month, and decrease mortgage-backed positions by $35 billion a month then phase in reductions to an eventual pace of $1.1 trillion a year so that by December of 2024, holdings fall to $6.7 trillion. A 25% reduction over two years does not appear very ambitious but the fact that it involves $2.1 trillion is unprecedented and almost incomprehensible, just as all the purchases since the Great Recession have been.
Perspective on the Target Reductions and Size of the Planned Runoffs
We all understand ounces and pounds, minutes and birthdays, miles and acreage but it is nearly impossible to comprehend the universe of units in which the Fed deals. One billion has nine zeroes, one trillion has twelve. One trillion equals one million times one million or one thousand times a billion. One billion seconds is equivalent to 31.7 years. One trillion seconds would amount to more than 31,709 years. This month on the Fed’s balance sheet, only about $43 billion of Treasury coupon securities are maturing, so the Fed will have to redeem more than $16 billion of Treasury bills to meet its goal. The numbers are staggering but, on a giant apples-to-apples basis, the Fed’s plans sound orderly and reasonable. The truth is that no one knows how these runoffs will impact our stock and bond markets, or global markets as a whole. The Fed itself, in a white paper published for the Jackson Hole summit, labeled the shrinking effort as “an uphill task.”
Uncertainty over the Impact of QT
Large and small investors alike cannot help but wonder: what happens when the Fed has fewer securities to lend to dealers in its daily operations and it becomes more expensive to borrow in the repo market? One major hedge fund is concerned that markets will fall into a liquidity hole. One major bank says it could lead to a 7% drop in stock prices. Many wonder who else will step in to buy all the new Treasuries being auctioned to finance all of the government’s activities, including all the recent stimulus. There are six auctions scheduled for this week alone, as eight Fed officials address groups around the country and three other central banks meet to discuss their own rate hike and tightening plans. Quantitative easing, the process of buying all these securities, had a tremendous impact on the markets so it would be silly to think that the tightening can be accomplished without volatility, higher rates, and a whole host of unexpected side effects. But the great reversal is now underway; Wall Street and Main Street will be closely monitoring the impact.
A Brutal August in the Market
Municipal bonds were not the only securities brutalized in the market last month but they happened to finish as the best of the worst in fixed income and many other asset classes. The S&P Main Muni Index posted a loss of -2.29% just ahead of Treasuries at -2.48% and investment grade corporate bonds at -2.93%. Stocks, bonds and currencies all tumbled in a gigantic fret over what the Fed is doing with rates and QT, concerns about stagflation, and worries that a recession is upon us. The Dow, S&P 500 and Nasdaq indices all finished the month down more than 4 percent. The VIX gauge of volatility rose 21%. Oil prices fell more than 9 percent to $89.55 a barrel. Gold fell by nearly 3 percent to $1,716 an ounce and silver prices tumbled by more than 11 percent to $18.05. Bitcoin lost 16 percent. The 2-year Treasury yield climbed 61 basis points to close the month at 3.49%, well above the 10-year at 3.19% and the 30-year at 3.29%. Munis recorded their weakest August in more than 30 years; in just 33 weeks, tax-exempt mutual funds and ETFs have had cumulative net outflows of $94 billion. The 2-year AAA rated municipal general obligation bond yield jumped 68 basis points to 2.28%. The 10-year closed 38 basis points higher at 2.59% and the 30-year rose 40 basis points to finish at 3.29%. Returns for basically every asset except coal, oil and natural gas were negative for the month and real returns are deeply negative year-to-date.
Market Movers This Week
There are many factors impacting markets this week include the OPEC+ decision to cut production by 100,000 barrels a day starting in October, the election of the new British prime minister, the declaration of a power grid emergency in California, and plans for $50+ billion of corporate bond sales despite a dim outlook for third quarter corporate earnings. Recession concerns continue to be reflected in the Treasury curve, which has been inverted for two straight months. At this writing, the two year Treasury yield at 3.49% is higher than the 10-year at 3.32% and the 30-year benchmark at 3.47%. Traders will be scrutinizing the Beige Book report on economic conditions in each of the twelve Federal Reserve districts, dissecting the remarks made by all the garrulous Fed speakers, and monitoring the size of rate hikes being announced by the central banks of Canada, Australia and the ECB. In Washington, the U.S. Senate is in session but the House is in recess until next week. The bill or bills to fund the government in the new fiscal year beginning October 1 are yet to be passed. Only nine weeks remain until the mid-term elections.
Municipal Sales This Week
During the Labor Day-shortened trading week, the municipal bond market calendar includes about $6 billion of new issues. Among the few high yield issues is a $21.7 million non-rated financing for the Academy of Health Sciences charter school in Rochester, New York with a unique marketing twist. They are looking to appeal to ESG buyers with a social bond offering, but – instead of relying upon and paying an independent third party to affirm or certify it – they are self-designating their transaction as having social impact.
Increase in Public Charter Schools Financings
At HJ Sims, we have recently expanded our public finance practice in the charter school and education sector. This segment of the market has been expanding incrementally since the first charter school opened in St. Paul, Minnesota in 1992 and now includes investment grade, below investment grade and non-rated securities. There are now more than 7,700 schools in 45 states and the District of Columbia with over 3.6 million students enrolled. Several states offer credit enhancements and/or intercepts of school aid that go directly to the bond trustee, and Texas has a guarantee program for eligible schools. Last week, even in the quiet run-up to Labor Day, there were seven charter schools in the market: Great Hearts Texas Academies had a state-guaranteed triple-A rated deal priced at 4.50% to yield 4.65 in 2057. BB+ rated Hawking STEAM Charter school in Chula Vista, California brought a deal sold in $250, 000 denominations that priced at 5.50% to yield 5.45% in 40 years. A non-rated financing for Global Village Academy in Colorado Springs had a single term due in 2029 priced at par to yield 5.85%. The $16.7 million non-rated start-up financing for AcadeMir Charter School of Osceola had 10-year bonds priced at par to yield 7%. A $19.4 million non-rated issue for Tulsa Classical Academy came with a 2057 term bond priced at par to yield 7.5%. Coral Academy of Science in Reno sold $18.2 million of non-rated bonds structured with a 40-year final maturity that priced at 6.00% to yield 6.12%. And Spectrum Academy in North Salt Lake, Utah had a $6.9 million transaction that came with rated Aa2 state credit enhancement; its 2053 term bonds priced at 4.50% to yield 4.73%.
We invite you to contact your HJ Sims representative for more information on charter schools as well as on any sector of the markets of interest to you. Ask us for a portfolio review or call to inquire about our current offerings. Our focus is on the outcome of income in this and every market cycle.
For more information on offerings or questions about current market conditions, please contact your HJ Sims representative.