Investor Advisory Committee on Financial Markets Member … · 2020-02-14 · Member Presentation...

Investor Advisory Committee on Financial Markets Member Presentation Materials

February 13, 2020

What outcomes do you expect from the monetary policy framework reviews at the Federal Reserve and ECB?

How might the conclusions of these reviews differ?

To what extent has there been an impact on financial markets?

Rick Rieder

CIO of Global Fixed Income and Global Allocation Funds

February 13, 2020

FOR USE WITH THE FEDERAL RESERVE IACFM ONLY – NOT TO BE REPRODUCED OR DISTRIBUTED FURTHER

The Structural Economic Backdrop: The medium/long-term risks to growth and inflation are skewed to the downside… The primary reasons for that are structural, like demographics; i.e. interest rate policy isn’t particularly effective in combating this

2FOR USE WITH THE FEDERAL RESERVE IACFM ONLY – NOT TO BE REPRODUCED OR DISTRIBUTED FURTHER

R² = 0.78

0%

2%

4%

6%

8%

10%

12%

-0.50% 1.50% 3.50%

Co

re P

CE

(In

fla

tio

n)

Yo

Y

20-44 Population Growth YoY

Core PCE (Inflation) Implied Avg Next 30Y

0%

2%

4%

6%

8%

10%

12%

14%

1950 1970 1990 2010 2030 2050

Yo

Y

Forecast

Nominal GDP

Demographic Model of Potential Growth

0%

1%

2%

3%

4%

5%

6%

7%

8%

1969 1979 1989 1999 2009 2019

PC

E

10Y Inflation Expectations (PCE)

*Estimated based on several data sources by the Federal Reserve

We are a decade into historically low rate policy, and still the risks to inflation are to the downside in a highly leveraged global economy; keeping rates low and stable becomes a structural prerequisite for policy, and yet there should also be a high bar for rate policy to evolve much from here in either direction…

Growth and Inflation operate with a stronger correlation to the demographic curve than is generally considered 1

With a backdrop of moderate growth and tepid inflation secularly entrenched, interest rates are anchored lower across the yield curve, which is an immensely different backdrop than we have seen over the prior 50 years…

Source: 1) Haver and World Bank, as of 12/31/2019 ; 2) Bloomberg and BlackRock, as of 1/31/2020; 3) Fed, Bloomberg and BlackRock, as of 10/1/2018

2

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

1991 1996 2001 2006 2011 2016

Yo

Y

UMich 5-10 Year Inflation Expectations2 3

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

0%

5%

10%

15%

20%

25%

30%

1960 1980 2000 2020 2040

Po

pu

latio

n G

row

th

Yo

Y

World Growth YoY World Prices YoY

20-44 Population YoY

-2%

-1%

0%

1%

2%

3%

4%

5%

6%

7%

8%

1985 1990 1995 2000 2005 2010 2015

Yie

ld

Average G7 10Y Real Rate

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

1943 1958 1973 1988 2003 2018

Stdev of MoM Goods Producing NFP

Stdev of MoM Services Providing NFP

3

Relatedly, developed economies – especially the US – are less sensitive to small changes in interest rates than this generation has ever seen as the shift to services is also structural…

-4,000

-3,000

-2,000

-1,000

0

1,000

2,000

3,000

4,000

1941 1956 1971 1986 2001 2016

Goods Producing NFP YoY

-4,000

-3,000

-2,000

-1,000

0

1,000

2,000

3,000

4,000

1941 1956 1971 1986 2001 2016

Services Providing NFP YoY

The goods sector, which used to be a much larger share of the economy, is much more rate-sensitive than the service sectors. The service sectors now make up >80% of GDP and the labor market, so the US economy today is much less sensitive to small changes in interest rates, which is reflected in much more stable and elongated stretches of labor market and output growth… 1

Financial Crisis

0

5

10

15

20

25

30

1950 1980 2000 2010 2017

% o

f G

DP

Contribution to US GDP (% of GDP)

Manufacturing

Finance, insurance, and real estate

Professional and business services

Educational services, health care, and social assistance

The SEP projections should reflect a projected path of low/stable rates for an extended period of time…

Not only are demographics dulling the influence of interest rates, but so is the structural shift to services… Considered together, lower and more stable rates should allow for continued economic stability, employment, and the lowest vol of inflation ever – i.e. price stability…

Source: 1) Bloomberg and BlackRock, as of 1/31/2019; 2) BEA and BlackRock, as of 12/31/2017

0%

1%

2%

3%

4%

1965 1973 1981 1989 1997 2005 2013

Vo

l

Rolling 5Y Volatility of Core Inflation

Rolling 5Y Volatility of Real GDP

Rolling 5Y Volatility of Nonfarm Payrolls

1

0

20000

40000

60000

80000

100000

120000

140000

1939 1954 1969 1984 1999 2014

Goods Producing NFP

Services Producing NFP

1 2


These structural shifts are changing how Productivity impacts the economy – it is no longer driven by goods-oriented sectors adding employees as they borrow funds to expand physical capacity in a typical business cycle that is influenced by interest rates…

4

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1958 1966 1974 1982 1990 1998 2006 2014

Co

rre

lati

on

Correlation of Productivity & Unemployment

Correlation of Productivity & Unemployment

Goods sectors: Productivity up and employment down 4 Services sectors: Productivity flat and employment up 4

The goods–oriented, manufacturing business cycle typified by demand for commodities/energy driving inflation higher is a thing of the past… Small moves in rates have virtually no impact today… So Fed inflation projections should reflect stability around 2%, especially since we are not at full employment yet (and certainly not creating wage-induced inflationary pressures…)

Source: 1) Bloomberg and BlackRock, as of 12/31/2019; 2) Bloomberg and BlackRock, as of 1/31/2020; 3) BLS, as of 1/31/2020; 4) BLS and BlackRock, as of 12/31/2015

Productivity today is driven by technology displacing labor in the goods sectors, thus increasing the size of the more stable services sector… This is playing out in real-time in the labor market – job growth is healthy, but the labor force is still expanding…

3M Avg 6M Avg 12M Avg

NFP Total 211 206 171

Private 198 190 156

Goods-producing 24 12 11

Mining and Logging -7 -4 -3

Construction 18 15 12

Manufacturing 14 1 2

Durable goods 11 -3 -1

Nondurable goods 3 4 3

Private service-producing 174 177 145

Prof. Business Services 24 30 33

Temp help 2 2 -1

Edu. and Health Services 56 54 53

Health Care and Social Assist. 43 46 45

Leisure and Hospitality 38 48 27

Other Serivces 11 6 7

1 2 3

GM Strike

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

1.7

1.8

1987 1992 1997 2002 2007 2012

Ind

ex

Food Services

Productivity Index

Employment Index

0.8

0.9

1

1.1

1.2

1.3

1.4

1993 1998 2003 2008 2013

Ind

ex

Hospitals

Productivity Index

Employment Index

0.0

0.5

1.0

1.5

2.0

2.5

1987 1993 1999 2005 2011

Ind

ex

Primary Metal Manufacturing

Productivity Index

Employment Index

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

1987 1993 1999 2005 2011

Ind

ex

Furniture Manufacturing

Productivity Index

Employment Index


Building on this backdrop for the Fed: The modern economy is less influenced by swings in investment, and increasingly typified by less volatile inputs such as R&D (the “business cycle” concept is alive only in part, and is permanently a much lower portion of the “old” economy)…

5

20%

22%

24%

26%

28%

30%

32%

34%

36%

60%

62%

64%

66%

68%

70%

72%

74%

76%

78%

80%

1990 1995 2000 2005 2010 2015

IP

Str

uc

ture

s &

Eq

uip

me

nt

Composition of US Nonresidential Investment

Structures + Equipment % IP %

0

50

100

150

200

250

300

350

400

450

1995 2000 2005 2010 2015U

SD

bn

Total Annual Investment (R&D + Capex)

Federal Gross InvestmentBig 5 Total Investment (FAAMG)Tech + Comm Services Total InvestmentEnergy + Industrials + Materials Total Investment

Non-resi investment is structurally going away from capex and towards R&D

The biggest spenders are services companies. Two sectors, tech and comm services, invest more than the Federal gov’t. In fact, spending is driven overwhelmingly by the 5 largest US companies.

Source: Capital IQ, Bloomberg and BlackRock, as of 12/31/2019

Recent drawdowns in the industrial complex (green) were not felt in the TMT sectors (pink)

But a host of secondary industries get supported: these 5 companies spend $643bn/yr to support growth; spending (and employment in transport, semiconductors, etc.) has been growing >10%/yr

0

100,000

200,000

300,000

400,000

500,000

600,000

700,000

1995 1999 2003 2007 2011 2015 2019

US

D m

m

FAAMG External Spending: COGS + R&D + Capex

COGS + Investment

0

200

400

600

800

1,000

1,200

1,400

1995 1999 2003 2007 2011 2015 2019

Em

plo

ye

ee

s (

'00

0)

FAAMG Mining & Logging Motor Vehicles & Parts

Companies (and sectors) that did not exist in prior cycles now account for a substantial part of employment gains in the US

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

-20% -10% 0% 10% 20%

Yo

Y C

ha

ng

e in

Po

lic

y R

ate

YoY Change in Employment

Change in Policy Rate vs Change in Mining & Logging + Motor Vehicles * Parts Employment

(last 25 years)

-6%

-5%

-4%

-3%

-2%

-1%

0%

1%

2%

3%

-10% 0% 10% 20% 30% 40% 50%Y

oY

Ch

an

ge

in P

oli

cy

Ra

teYoY Change in Employment

Change in Policy Rate vs Change in FAAMG Employment (last 25 years)

Monetary policy via the policy rate has an outsized impact on a shrinking part of the economy; sectors that are less influential on the employment rate

As the economy becomes increasingly oriented towards services, so does non-resi investment and employment →meaning these become less volatile and the spending plans of corporations driving investment today are much less sensitive to nominal GDP volatility.


0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1998 2001 2004 2007 2010 2013 2016

CF

O /

Ta

ng

ible

Bo

ok

S&P 500

0

2

4

6

8

10

12

1998 2001 2004 2007 2010 2013 2016

Pri

ce

to

Ta

ng

ible

Bo

ok

S&P 500

Real-time influences on Rates and Financial Conditions: Corporate balance sheets are not nearly as rate-sensitive/Fed influenced, or nearly as dangerous as many suggest…

6

But, value is increasingly in the “intangibles” (R&D v. CapEx), and the cash flow is profound

Either some asset is not being captured…

…or companies have become incredibly productive and profitable with their assets

* 2009 peak is due to the denominator contracting as vast amounts of assets were written off

The natural conclusion is that technology/intangible assets are increasingly driving cash flows…and corporate debt is increasingly being backed by the same intangible assets

0%

1%

2%

3%

4%

5%

6%

0%

5%

10%

15%

20%

25%

1998 Top 10 2004 Top 10 Today Top 10

% o

f Ma

rke

t Ca

p

% o

f M

ark

et

Ca

p

PP&E as % of Market Cap (rhs) Inventories as % of Market Cap

Intangibles as % of Market Cap

0

100

200

300

400

500

600

700

800

900

US

D

S&P 500 Book Value S&P 500 Tangible Book Value

0%

50%

100%

150%

200%

250%

300%

350%

400%

450%

500%

% o

f B

oo

k V

alu

e

S&P 500 Debt to Book Value

S&P 500 Debt to Tangible Book Value

0

5

10

15

20

25

2000 2003 2006 2009 2012 2015 2018

Pri

ce

to

CF

O

S&P 500 Average

FI0918U-607055-1890438

Fed policy should continue to reflect the broad economy’s structural dynamics influencing growth and inflation…

Gauging valuations against tangible assets suggests the market is in a bubble…

If measured against cash flows, valuations are in-line with historical averages

Source: Capital IQ and BlackRock, as of 9/30/2018;

We have observed that inventory is managed much more efficiently today, having the incredible impact of not only dulling the volatility of growth swings, but also of facilitating greater price competition (i.e. lower and more stable prices to the end-consumer)… These are hugely important macro influences from the shift in assets towards Intangibles, and with this, a profound shift in the corporate financing market…


0.0x

0.5x

1.0x

1.5x

2.0x

2.5x

3.0x

1995 2000 2005 2010 2015

Net Leverage (Net Debt / EBITDA)

0.0x

2.0x

4.0x

6.0x

8.0x

10.0x

12.0x

14.0x

1995 2000 2005 2010 2015

Net Debt / Free Cash Flow

-

1.0x

2.0x

3.0x

4.0x

5.0x

6.0x

1995 2000 2005 2010 2015

Free Cash Flow / Int. Exp.

0

50

100

150

200

250

300

350

400

450

500

2016 2017 2018 2019

US

D $

bn

s

US IG Supply

Non-Fin M&A issuance Non-Fin Other issuance

3.0%

3.5%

4.0%

4.5%

5.0%-20%

-10%

0%

10%

20%

30%

40%

Ra

te

Yo

Y, 3

M M

A

Mortgage Applications (YoY, 3M MA)

30Y Homeowner Commitment Rates (rhs; inverted)

Corporate debt exposures by sector show minimal relevance to history – many are less cyclical, cash-flow engines with lower sensitivity to interest rates – while others are de-levering…

7

So much of corporate debt growth is coming from large, fast-growing, highly-profitable, high-cash-balance companies in the Tech, Media, Communications, and Healthcare sectors… much of it to fund M&A or, prior to 2017, fund share buybacks against cash held overseas 1

-250

0

250

500

750

1,000

1,250

2010 2012 2014 2016 2018

US

D (

bn

s)

Change in Debt by Sector

Consumer Discret + Telecom

Consumer Staples

Energy

Healthcare

Industrials

Information Technology

Materials

Utilities

26%

25%

8%

16%

10%

6%

4%2% 2% Communication Services

Health Care

Consumer Discretionary

Energy

Industrials

Consumer Staples

Information Technology

Materials

Real Estate

BBB debt by Sector$980bn,

34%

$563bn, 20%

$562bn, 20%

M&A issuance

The transmission of interest rates into the broad economy is muted, with sensitivity really only coming from large moves in rates or financial conditions… But, since there is limited downside on rates (zero bound), policy should reflect the downside skew of risks… Thus, the Fed is rightly not suggesting small tweaks of rate policy from here…

Source: 1) Capital IQ and BlackRock, as of 9/30/2019; 2) Capital IQ and BlackRock, as of 6/30/2018

Housing is still rate sensitive though, so big rate moves higher should be avoided 2

Some old-line sectors are levered, and thus interest rate sensitive, but the underlying drivers of today’s economy make headline leverage less scary… especially against free cash flow 2


-3

-2

-1

0

1

2

3

4

2014 2016 2018 2020

Sp

rea

d (

Yie

ld)

US High Div Earnings Yield - HY BB

US High Div Div Yield - HY BB

5

Further on Financial Conditions: These corporate debt trends are, however, rightly feeding into a real debate today on how easy financial conditions actually are in the modern economy, especially as the “financial economy” has overtaken the “real economy” in its scale…

8

2.5%

2.7%

2.9%

3.1%

3.3%

3.5%

3.7%

3.9%

4.1%

4.3%

4.5%

5.0%

5.5%

6.0%

6.5%

7.0%

7.5%

8.0%

8.5%

2018 2019 2020

Yie

ld

Yie

ld

HY (lhs) IG (rhs)

Financial Conditions will warrant potentially just as much attention as growth and inflation going forward because the Financial Economy is in many ways the tail that wags the dog in today’s economy given the structural downside risks…

Equity valuations are higher, but in a stable growth, moderate inflation environment, are they really too high?

40

60

80

100

120

140

160

2005 2008 2011 2014 2017U

SD

(tn

s)

Total Indexed Financial Market Capitalization

World GDP

Financial assets have a larger influence on the economy than ever in a very reflexive way –corporate confidence/sentiment feed through to investment and hiring decisions

… but one could clearly suggest that credit conditions and availability are too easy today… 6

0%

2%

4%

6%

8%

10%

12%

14%

1945 1958 1971 1984 1997 2010

Fin

an

cia

l A

ss

ets

% o

f G

DP

Total Financial Assets of All Sectors as a Share of GDP

Key Contributors to NBER-Dated US Recessions

Recession Industrial Oil Monetary Financial Fiscal

Aug 1918 1

Jan 1920 1 1

May 1923 1

Oct 1926 1

Aug 1929 1

May 1937 1 1

Feb 1945 1

Nov 1948 1

Jul 1953 1

Aug 1957 1

Apr 1960 1

Dec 1969 1 1

Nov 1973 1 1

Jan 1980 1 1

Jul 1981 1

Jul 1990 1 1 1

Mar 2001 1

Dec 2007 1

The most recent recessions suggest financial conditions are increasingly important in driving economic outcomes 3

Source: 1) Fed and BlackRock, as of 4/1/2018; 2) Bloomberg and BlackRock, as of 1/31/2020 ; 3) Goldman Sachs, as of 2/26/2019; 4) Bloomberg and BlackRock, as of 12/31/2019; 5) Bloomberg and BlackRock, as of 1/13/2018; 6) Bloomberg and BlackRock, as of 1/10/2020

1 2

4

Relative to prices in the credit market, equities could actually be considered cheap to fair

S&P 500 PEEarnings

Yield

EV/

EBITDA

Price to

FCF

FCF

Yield

Current 19.4 5.2% 13.1 27.1 3.7%

1y Avg 17.9 5.6% 12.2 23.2 4.3%

5y Avg 17.5 5.7% 10.9 20.1 5.0%

10y Avg 16.0 6.2% 9.7 17.3 5.8%


The ECB: Europe is also services oriented – but not as much – and more importantly, investment activity is stuck on low-growth, tangible asset sectors… Hence, rate policy matters more, but needs an “equilibrium level” relative to the associated costs of keeping rates too low…

9

0%

20%

40%

60%

80%

100%

US Euro area Brazil Japan Russia India China

% o

f G

DP

Share of GDP

Goods Services

The existing policy of negative rates, and potentially lower rates from here, should and will be debated. The ECB should rightlyreview the existing policy to determine if it is really having a positive economic/inflationary effect vs. the cost of keeping rates in deeply negative territory…

Economies which are driven more by tangible investment, as is the case in much of Europe, are growing more slowly. But lending is much more important for tangible-based economies… 2

GDP is tilted to services, but investment that drives future GDP growth is geared too heavily to industrial sectors 1

Last week’s data:

• Q4 German manufacturing fell by the fastest rate since 2009. The level of manufacturing is back to where it was in early 2013.

• Production machinery for food processing fell -15% year-over-year in December

• Production machinery for apparel fell -22% YoY in December

• Paper machinery was down -18% YoY in December

• Plastics and rubber machinery were down -11% YoY in December

Source: 1) CS, OECD as of 10/2/2017; 2) Capitalism without Capital: The Rise of the Intangible Economy by Jonathan Haskel and Stian Westlake, as of 11/28/2017

US United States

UK United Kingdom

FI Finland

FR France

NL The Netherlands

SE Sweden

DK Denmark

ES Spain

AT Austria

IT Italy

DE Germany


0%

2%

4%

6%

8%

10%

12%

14%

-1%

0%

1%

2%

3%

4%

5%

2005 2009 2013 2017

Eq

uit

y R

isk

Pre

miu

m

10

yr B

un

d Y

ield

10yr Bund Yield

Earnings Risk Premium

We believe negative interest rate policy has been ineffective in supporting economic growth. Hence, equity capital is generally expensive because the growth outlook has been anemic…

10

Despite Bund yields falling 500bps since ‘05, P/Es are unchanged… ERP keeps rising 2

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

9,000

10,000

2004 2007 2010 2013 2016

US

D

SIE Net Income

The CAPM model is clear: projects will get off the ground only if the risk that an investor is taking gets compensated by adequate return 1

…because Net Income isn’t growing… stocks need growth, not negative rates 2

Meaning, there is no marginal benefit from lowering rates further (in Europe), i.e. to stimulate investment, the COE must be lowered instead

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

2

4

6

8

10

12

14

16

2003 2006 2009 2012 2015 2018

CO

D

Le

ve

rag

e

SX5E Leverage SX5E Net Leverage EU Cost of Debt (rhs)

COD in Europe is 0%, yet leverage is lower, suggesting easy policy isn’t inducing velocity-creating projects… 3

Effective policy needs to jump start the system by reducing the cost of equity capital and raising growth prospects through productivity-enhancing investment, thus incentivizing further private investment…

0.0x

5.0x

10.0x

15.0x

20.0x

25.0x

30.0x

35.0x

40.0x

-30% -20% -10% 0% 10% 20% 30%

SP

X P

E R

ati

o

10Y Real Yield

1871-2017 2017 Poly. (1871-2017)

Relationship between rates and risk is parabolic; rates too low doesn’t necessarily reduce cost of equity/ boost equity valuations 4

Source: 1) Bloomberg and BlackRock, as of 12/31/2019; 2) Siemens, Bloomberg and BlackRock, as of 12/31/2019; 3) Bloomberg and BlackRock, as of 3/29/2019; 4) Bloomberg, Shiller and BlackRock, as of 1/10/2020

0

1

2

3

4

5

6

2000 2004 2008 2012 2016

Co

st

of

Ca

pit

al

EU Cost of Debt (after-tax)

US Cost of Debt (after-tax)

6

8

10

12

14

16

18

2000 2004 2008 2012 2016

Co

st

of

Ca

pit

al

EU Cost of Equity

US Cost of Equity

No financier is going to lend at 0% to invest in a project with 11% risk (COD v. COE)


11

Conclusions for future FED and ECB policy reviews, the impact on Financial Markets, and Liquidity as a tool to be considered within those reviews:

The Fed:

• Fed officials (and the ECB too) shouldn’t be singularly focused on inflation as a risk – especially given the longer-term headwinds – rather, the primary risk to accommodative monetary policy today is overly easy financial conditions

• in essence, rates should stay in a stable, lower range to reflect the downside skew of risks (SEP projections should reflect a path of low rates for an extended period of time), and policy action should shift to liquidity…

• The Fed should recognize that small moves in rates have virtually no economic impact today given the muted transmission of interest rates into a services and R&D led economy

• Monetary policy officials should acknowledge the relationship between interest rates and the economy is not a linear one – it is parabolic: policy rates hurt the economy when they are too high or too low…

• So while there will need to be a high bar for rate hikes going forward, interest rates shouldn’t be too low either (and definitely not negative in the US) – because rates that are too low can actually hurt more than help, which is playing out in the markets today…

The ECB:

• Review the existing negative rate policy for its economic/inflationary effect versus the cost of keeping rates in deeply negative territory…

• Recognize that further lowering the cost of debt from here is very unlikely to have any positive impact… rather it is much more likely to continue to dull the velocity of real investment in the sectors which can promote broader and durable growth

• In fact, the providers of capital (banks, insurance companies, and pension funds) in to the sectors that can actually drive sustainable growth improvement will benefit from HIGHER rates/steeper curves.

• Either these investment institutions will have to drive that growth-capital or the ECB should do it directly (through national partnerships in innovative EQUITY-based investment)

Source: BlackRock, as of 2/10/2020


Financial Market Impact: lower rates helped repair government, household and corporate balance sheets post-crisis, and then promoted some re-leveraging… but private sector debt loads are moderating here… and there is an organic demand to meet the new supply…

170%

180%

190%

200%

210%

220%

230%

240%

2000 2004 2008 2012 2016

Total Nonfinancial Debt/ GDP (US, Euro Area, Japan, China)

12

Global debt, particularly DM sovereigns, has grown concerningly, but many companies are de-levering, and financial institutions and individuals are being judicious on borrowing… 1

0

500

1,000

1,500

2,000

2,500

3,000

2003 2007 2011 2015 2019

US

D (

bn

s)

Change in JP 65+ Financial Asset DemandChange in EU 65+ Financial Asset DemandChange in US 65+ Financial Asset DemandGlobal Fixed Income Net Supply, Net of Central Bank Purchases

0%

5%

10%

15%

20%

1995 2005 2015 2018

Vo

l

Inherent Volatility of Assets to Reach 7.5% Return

Bonds US Large Cap US Small Cap Non-US Equity Real Estate Private Equity

Source: 1) World Bank, Census and BlackRock, as of 12/31/2018; 2) JPM, MS and BlackRock, as of 12/31/2019; 3) Fed, as of 12/31/2016; 4) Bloomberg and BlackRock, as of 2/10/2020

Meaning new debt supply is not as high today: annual net supply of fixed income isn’t keeping up with demographic demand 2

4%

10%

17% 18%

In order to hit mid-to-high single-digit return targets, investors are being pushed in to an increasingly volatile asset portfolio 4

0%

2%

4%

6%

8%

10%

12%

-

500

1,000

1,500

2,000

2,500

1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

Yie

ldUS

D (

bn

s)

HH Interest Income, Yield % on Financial Assets, ex. Equity (rhs)

HH Interest Income

HH Interest Income @ 4.0% Yield

Rates too low harms individual and institutional investors alike, reducing income and creating an incentive to take on more volatility, likely contributing to financial market imbalances if unchecked… 3

But pushing rates too low (or negative) can lead to unintended negative consequences in financial markets (and in the real economy)


13

70

75

80

85

90

95

100

105-20%

-10%

0%

10%

20%

30%

40%

2010 2012 2014 2016 2018 2020

Yo

Y

Yo

Y

Fed Assets (USD bns) YoYFed Assets (USD bns) Base Case Projection YoYDXY

Total

Global

Liquidity

Central

Bank

Balance

Sheets

Fed Assets S&P

6/30/2011 38% 38% 50% 80%

10/31/2012 14% 14% -1% 7%

9/30/2014 12% 14% 58% 40%

1/31/2018 24% 35% -1% 43%

8/31/2019 -3% -6% -15% 4%

12/31/2019 2% 3% 11% 10%-10%

0%

10%

20%

30%

-5%

0%

5%

10%

15%

2013 2015 2017 2019

Yo

Y

Yo

Y

Total Global Liquidity (USD bns) YoY Projection S&P YoY

Liquidity: Many suggest there is little or no transmission of liquidity growth into the real economy, but there absolutely is... global liquidity impacts growth directly via global supply chains that finance MOST of global trade in wholesale US$ funding markets… when liquidity deficits crowd-out marginal borrowers, global trade slows and vice versa…

Moreover, global liquidity impacts the real economy indirectly via the ebb and flow of sentiment from financial asset prices…

The unprecedented liquidity drain in 2018-19 was a systemic shock that pressured the USD higher, with many associated ‘blow-ups’ that had their roots in some combination of slower global growth and tighter financing conditions for Emerging Markets… a strong US$ is a barometer that global liquidity is insufficient to support both the real and the financial economies

This was the influence that played a large part in the ‘risk-off’ in late 2018, and risk-on in late 2019 through today…

Attempts to withdraw liquidity outright result in financial market consternation, which influences the real economy…

S&P 500 was flat (including a very nasty drawdown) from Jan. ‘18 to Aug. ’19 when the Fed’s balance sheet contracted -15%

Source: 1) Fed, PBOC, ECB, BoJ, Haver, Bloomberg and BlackRock, as of 12/31/2019; 2) BoE, as of 8/23/2019; 3) Bloomberg and BlackRock, as of 10/15/2019

1

1

2 3

1

-15

-10

-5

0

5

10

15

20

-5 5 15 25

Wo

rld

Tra

de

Vo

lum

e Y

oY

BTWD YoY

Broad Trade Weighted Dollar (BTWD) vs World Trade Volume

World Trade volumes have always been negative when USD +5% or more

2 3


14

The 2020 liquidity influence looks set to stay profoundly robust… It’s very important to track this at the global level - we are projecting a total of $1.1tr increase in liquidity this year 2

0

10,000

20,000

30,000

2004 2007 2010 2013 2016 2019

US

D (

bn

s)

World FX Reserves ex-China (USD bns)

PBOC Assets (USD bns)

BoJ Assets (USD bns)

ECB Assets (USD bns)

Fed Assets (USD bns)

At $30tr, Global Liquidity is more important than ever, with growth coming from all five major components today, something that only happened once before 2

0%

1%

2%

3%

4%

5%

6%

7%

8%

01/19 04/19 07/19 10/19 01/20

General Collateral %

And of course, the liquidity contraction clearly impacted the funding issues that have been affecting the market since September 2019 1

731 650 624

0

100

200

300

400

500

600

700

800

S&P 500buybacks

Bond Flows Money MarketFlows

US

D b

ns

2019 Cumulative Flows

The headlines will grow in earnest as risk markets move with liquidity swings (reducing TOMO in Q1 will provide the first test and possibly be the first episode here)…

The “crowding in” effect is leading to massive inflows for asset markets so far in 2020. Investors are increasingly facing a diminished opportunity set as surging demand meets a deficit of supply in markets as we have discussed…

15,000

20,000

25,000

30,000

2010 2012 2014 2016 2018 2020

US

D (

bn

s)

Global Liquidity

Global Liquidity Projection

…compounded by immense household and pension rebalancing and corporate buyback flows 3

Source: 1) Bloomberg and BlackRock, as of 1/10/2020; 2) Fed, PBOC, ECB, BoJ, Haver, Bloomberg and BlackRock, as of 12/31/2019; 3) GS, as of 9/30/2019

$140

$260

$200

$280

$300

$1,180

$0

$200

$400

$600

$800

$1,000

$1,200

$1,400

US

D (

bn

s)

2020 Projected Total Liquidity Injection

Fed ECB

BoJ PBoC

FX Reserves ex China Total


1971

15

Global FX Reserves Grow

DM Central Banks ease via rate cuts and new asset

purchases

Nearly all sources of Global Liquidity rise, risk assets rally, and volatility collapses

DM Central banks feel good about economic growth but

nervous about easy Financial Conditions – they announce

plans to tighten. Risk markets wobble.

DM central banks taper purchases, reduce balance sheets, and/ or raise policy

rates

Global FX Reserves contract

All sources of Global Liquidity fall

Global risk-off theme kicks in,

funding stresses appear

USD weakens and EM central banks are enabled

to pursue pro-cyclical easing

USD rallies and G10 rates rise; EM central banks are forced into pro-

cyclical tightening

With global liquidity now amply supplied, global central banks should endeavor to seek a liquidity equilibrium that provides the necessary liquidity infusion sufficient to underpin real and financial economy stability, without overdoing it and creating systemic imbalances. Tapering down the size of the liquidity infusion makes a lot of sense today given the aforementioned financial conditions…

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

2010 2012 2014 2016 2018 2020

Yo

Y

Fed Assets (USD bns) YoYECB Assets (USD bns) YoYBoJ Assets (USD bns) YoYPBOC Assets (USD bns) YoYWorld FX Reserves ex-China (USD bns) YoY

Renewed Fed and ECB balance sheet growth in 2019 removed the

stubborn roadblock to a much needed reboot of this cycle

H1 2020

The liquidity cycle is remarkably persistent: A neutral or accommodative Fed soothes global

credit conditions, facilitating capital flow towards marginal global borrowers and affording the PBOC and EM central banks greater scope to be accommodative without the risk of capital flight. A restrictive Fed squeezes marginal global creditors and forces them to seek reliable US$ funding sources, raising the tail risk of capital flight from China and the rest of EM…

Source: Fed, PBOC, ECB, BoJ, Haver, Bloomberg and BlackRock, as of 12/31/2019


16

Fed & ECB Reviews

Expectation for Framework Reviews

- Moving toward ‘soft’ average inflation targeting in the US and Europe

- This is very prudent as the medium/ long-term risks to growth/ inflation are skewed significantly to the downside

- There should be a high bar to evolve rate policy from here

- "The Committee affirms its judgment that inflation, as measured by the annual change in the price index for personal consumptionexpenditures, at the rate of 2 percent on average over the longer run is most consistent with the Federal Reserve’s statutory mandate. As a result, the Committee would be concerned if inflation were running persistently above or below this objective."

- Rates should be low in acknowledgement of longer-term headwinds to growth and inflation (but still positive)

- Developed economies – especially the US – are less sensitive to small changes in interest rates today

- The rate markets are pricing this in today

- ECB’s negative rates will remain in place for a while (as their efficacy will and should be debated), while the discussion regarding fiscal policy will gain traction (and maybe some moderate implementation)

- The expectation is that if the economy goes into a downturn central banks will use ‘lower for longer’ rate policy and more near-term influential asset purchase programs

- The expectation is for increased acknowledgement of financial stability and potential focus here largely due to easy Credit conditions

- Again, this is very prudent as the real and financial economies are more inter-dependent than ever

- Liquidity and the USD are both extremely important for financial stability – both should be thought of in a global context

Conclusions

- The focus of monetary policy is shifting from rate policy to liquidity (at all times – not just during downturns); central banksshould err on the side of more reserves in the system than less – and liquidity should be monitored on a global basis

- The 2019 liquidity response was excellent and continues to be in 2020, with evolution of the size from the Fed and ECB going forward

- Allowing global liquidity to contract creates funding crises and financial market unwinds, which perpetuate directly into real economy contractions, but tapering the size of infusions when financial (credit) conditions are too easy should occur, and is showing some tangible signs of that making sense

- Tapering down the liquidity infusion size is expected by the markets and can be done deliberately if communicated adequately to markets, especially if it is allowed to grow modestly and permanently alongside of the growth of the economy


17

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Important Notes


Be careful what you wish for

Paul Tudor Jones

February 13th, 2020

A deep-seated belief among investors, policymakers is that low interest rates are here to

stay. This is also now canonized in the President’s budget forecasts.

The 10y yield minus CPI inflation has averaged 2.1% since WWII; it is -0.8% currently.

2Data Source: Haver and Tudor calculations

-15

-10

-5

0

5

10

15

1921 1931 1941 1951 1961 1971 1981 1991 2001 2011

Recessions

10y real yield

Average since 1950

US 10y real yield 10y yield deflated by actual y/y CPI, %

The low interest rate belief is supported by the perception that inflation is and will stay

low. At 1.6%, core PCE is the lowest reading of all underlying inflation metrics.

Is it prudent to use the tail inflation index for capturing inflation dynamics?

3

Measures of underlying inflation and expectations Dec-19

Underlying inflation (average of A and B indicators) 2.2

excluding core PCE 2.3

A. Average of CPI indicators 2.5

A.1 Core 2.2

A.2 Trimmed means, Cleveland Fed 2.4

A.3 Median, Cleveland Fed 2.9

A.4 Core sticky price, Atlanta Fed 2.7

A.5 Underlying Inflation Gauge, New York Fed 2.1

UIG including non-price data, New York Fed 2.4

B. Average of PCE indicators 1.8

B.1 Core 1.6

B.2 Trimmed means, Dallas Fed 2.0

B.3 Median, San Francisco Fed 2.0

Average of expectations indicators 1.9

C.1 Fed 5y5y breakeven inflation 1.8

C.2 Survey of professional forecasters, 10y ahead CPI 2.2

C.3 Survey of professional forecasters, 10y ahead PCE 2.0

C.4 Cleveland Fed survey, 10y ahead expectations 1.7

Data Source: Haver

0

1

2

3

4

1993 1995 1997 1999 2000 2002 2004 2006 2007 2009 2011 2013 2014 2016 2018

Core sticky prices, Atlanta Fed

Median, Cleveland Fed

NY Fed UIG

Trimmed means, Cleveland Fed

Core CPI

Core PCE

Median PCE, San Fran Fed

Trimmed mean PCE, Dallas Fed

Tudor underlying inflation

US underlying inflation y/y %

The Fed’s focus on core PCE has potentially led it to pursue overly stimulative policy. We

measure the degree of monetary policy stimulation as the deviation of the policy rate from

the Taylor rule, which produces the policy rate consistent with bringing inflation to target

and the unemployment rate to neutral. The current policy rate is below the Taylor rule,

suggesting over-stimulation (a finding robust to alternative Taylor rule specifications).

4

-8

-4

0

4

8

12

16

55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 15 18

Effective Fed funds rate

Policy rate consistent with Taylor (1999) rule

US monetary policy Taylor rule 1/

%

1/ The Taylor rule prescribes a value for the Federal Funds rate based on the distance of inflation from target and on the degree of economic slack, here measured by the unemployment gap.

Data Source: Haver and Atlanta Fed

The monetary pulse metric based on the Taylor rule 1999 suggests current policy is

stimulative. The other period in history that saw a greater degree of policy stimulation

than currently was the second half of the 1960s.

5

-0.71

-3

-2

-1

0

1

2

3

55 59 63 67 71 75 79 83 87 91 95 99 03 07 11 15 19

Deviation of Fed funds rate from Taylor rule prescription

US Degree of monetary stimulation based on the Taylor rule 1999 1/

z-score

1/ Equals the unemployment rate (UR) minus the natural rate of unemployment (U*)

1/ The Taylor-rule uses the following assumptions: natural interest rate based on Laubach-Williams model; resource gap based on twice the CBO U-gap; inflation measure based on the Dallas Fed trimmed mean PCE.

Under stimulation

Over stimulation


It is possible that monetary policy stimulation enables expansionary fiscal policy. Fiscal

outcomes are generally driven by the economic cycle (when employment falls, tax receipts

fall thereby widening the deficit, and vice versa). There have been two exceptions: the late

1960s & today. Are large deficits with low unemployment a sign of policy over stimulation?

6

-3

-2

-1

0

1

2

3

4

5-10

-8

-6

-4

-2

0

2

4

55 58 61 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 09 12 15 18 21 24 27

CBO Proj. Overall balance (LHS; reverse scale) Unemployment gap (UR - U*) 1/

US fiscal outcomes tend to be driven by the economic cycle

Overall balance, % GDP Unemployment gap, %


Data Source: Haver

We track the degree of fiscal stimulation in two ways. First, by looking at the deviation of

the fiscal balance from the fiscal balance that is explained by economic fluctuations

(captured by the unemployment gap1/). This metric suggests a significant degree of fiscal

policy stimulation, seen before only in the late 60s.

1/ Unemployment gap = unemployment rate minus natural rate of unemployment estimated by the CBO

7

-3

-2

-1

0

1

2

3

55 59 63 67 71 75 79 83 87 91 95 99 03 07 11 15 19

Deviation of overall balance from the overall balance explained by the U-Gap

US Degree of fiscal stimulation based on the evolution of the unemployment gap

z-score


Under stimulation

Over stimulation

Data Source: Haver

The second way we assess the degree of fiscal stimulation is by looking at the distance between the actual deficit and the deficit that stabilizes the debt ratio. To stabilize the federal debt at its current ratio, the (primary) deficit would need to be cut by1½–2% GDP bringing the overall deficit from 4.6% to below 3% of GDP. A negative value in the metric below suggests the debt ratio will continue to increase unless the deficit is reduced.

8

-4

-3

-2

-1

0

1

2

3

55 59 63 67 71 75 79 83 87 91 95 99 03 07 11 15 19

Deviation of primary balance from debt-stabilizing primary balance

US Degree of fiscal stimulation, based on debt stabilization

z-score


Under stimulation

Over stimulation

Data Source: Haver

The debt-sustainability metric in the prior chart does not take into account the large future liabilities due to ballooning mandatory spending on social security and healthcare. As such, the true adjustment required to stabilize debt at the current ratio would be much larger than indicated in the prior slide: put differently, our fiscal policy tracker based on debt-sustainability lowballs the current degree of stimulus.

9

0

20

40

60

80

100

120

140

160

180

55 59 63 67 71 75 79 83 87 91 95 99 03 07 11 15 19 23 27 31 35 39 43 47

CBO Proj.

Federal debt, in percent of GDP (CBO projections)

US Federal debt, CBO projections

% GDP

Data Source: Haver and Congressional Budget Office

Combining the two ways of measuring stimulation based on the cycle and on debt

sustainability, we obtain a simple fiscal policy pulse tracker. As a z-score, the current

policy pulse at -1.7x st.dev. suggests a 2½-3% GDP degree of fiscal over-stimulation

10

-1.72

-4

-3

-2

-1

0

1

2

3

55 59 63 67 71 75 79 83 87 91 95 99 03 07 11 15 19

Tudor fiscal pulse tracker

US Tudor fiscal pulse

z-score

1/ Average of the z-scores of (i) the deviation of overall balance from overall balance explained by the U-Gap and (ii) the deviation of the primary balance from the debt-stabilizing primary balance

Under stimulation

Over stimulation


Since both monetary and fiscal policy can be powerful drivers of economic and financial

cycles, we combine the fiscal pulse with the monetary pulse to capture the degree of

stimulation of the policy mix. We call this the Tudor policy pulse. It shows that the current

degree of policy stimulation has not been seen since the 1960s.

11

-2.15

-4

-3

-2

-1

0

1

2

3

55 59 63 67 71 75 79 83 87 91 95 99 03 07 11 15 19

Tudor policy pulse tracker

US Tudor policy pulse 1/

z-score

1/ Average of the z-scores of (i) the Tudor fiscal pulse (capturing the distance of fiscal outcomes from those consistent with the cycle and debt stabilization) and (ii) the monetary policy pulse based on a Taylor rule

Under stimulation

Over stimulation


Policy stimulation is encouraging significant risk taking. We measure risk appetite in two

ways: (1) the ratio of the stock market capitalization to GDP, which hit a record-high of

188%, surpassing the previous peak of 174% during the tech bubble.

12

0

25

50

75

100

125

150

175

200

1924 1934 1944 1954 1964 1974 1984 1994 2004 2014

Recession US stock market capitalization/GDP Smoothed

US stock market capitalization as share of GDPNYSE and NASDAQ combined capitalization in % of GDP; last observation is Feb 10th, 2020

Data Source: Haver

A complementary gauge of risk-taking is the degree of leverage in the economy: (2) the

economy-wide debt ratio to GDP has reached a new high of 250% of GDP. The flattish

evolution of this metric since the Global Financial Crisis masks offsetting trends: a sharp

increase in corporate and government debt and a noticeable decline in household debt

13

100

125

150

175

200

225

250

275

1945 1955 1965 1975 1985 1995 2005 2015

Recession Economy-wide debt

US economy-wide debt as share of GDPHousehold + corporate + federal and state & local government debt, in percent of GDP

Data Source: Haver and BIS

A simple way to capture overall risk-taking in the economy is to combine the economy-

wide debt ratio with the stock market capitalization ratio. Our risk-taking tracker has risen

to a record high of 438% of GDP.

14Data Source: Haver and BIS

100

150

200

250

300

350

400

450

1952 1962 1972 1982 1992 2002 2012

Recession Tudor financialization index Smoothed

US Tudor financialization index Stock market capitalization + economy-wide debt, in percent of GDP

Fluctuations around our risk-taking tracker capture well the financial cycle: booms

associated with excessive leverage and/or equity appreciation followed by busts


-50

-25

0

25

50

75

1952 1962 1972 1982 1992 2002 2012

Recession Tudor boom-bust tracker

US Tudor boom-bust tracker 4y change in the Tudor financialization index; % of GDP

The financial cycle captured by our boom-bust tracker shows leading properties for the

economic cycle over the last 40 years: booms coincide with low/falling unemployment;

busts are followed by sharp increases in unemployment.


-3

-2

-1

0

1

2

3

4

5

6-50

-25

0

25

50

75

1980 1985 1990 1995 2000 2005 2010 2015

Recession Tudor boom-bust tracker

Latest value of the boom-bust tracker U gap (Unemployment rate - NAIRU), RHS

US Tudor boom-bust tracker and unemployment gap

4y change in Tudor financialization index, % of GDP U-gap, % (reverse scale)

Persevering with current policy stimulation in a hot labor market would continue to

support risk-taking, thereby exposing the economy to a boom-bust cycle

Based on the pattern of financial cycles since 1980, we could be 1½ years away from the top of

the boom. By then, the unemployment rate could fall to 3.0% and another 25% of GDP could be

added to our boom-bust tracker. This could be accomplished in one of two ways:

Increased leverage. If increased risk-taking manifested fully in rising leverage (corporate,

government?), the marginal addition of 25% of GDP to our boom-bust tracker would be

commensurate to the increase in mortgage borrowing in the five years preceding the Global

Financial Crisis.

Equity market appreciation. If the stock market rallied by just 12% from here, it would be

enough to increase our boom-bust tracker by 25% of GDP.

The fall from the top over the following 2½-3½ years would be quite painful using historical

patterns: the boom-bust tracker would shed 60% of GDP, implying that the equity market would

correct sharply (e.g., the bursting of the tech bubble led to a peak to trough decline in equity

market capitalization of 80% of GDP). Over time, the economy would also be forced to de-lever.

As public debt tends to rise during recessions (25% of GDP during the GFC), the adjustment on

the private sector would be wrenching. On the real economy side, the unemployment rate would

increase by more than 3% to almost 7% if we followed historical patterns of booms and busts.

17

Anecdotally, we are cognizant of two potential parallels: (1) 1999 and (2) the 1960s.Now, as in 1999, appetite for equities seems insatiable; the Fed has delivered 3x insurance cuts; core PCE is 1.6% y/y; the labor market is hot (U-gap was -1.0% vs. -0.9% now); and the President has been impeached. The critical divergence is that we are now running a fiscal deficit vs a surplus in 1999. There is a heightened risk of equities becoming unhinged to the upside until fiscal and monetary stimulation is removed

18

0.5

1.0

1.5

2.0

2.5

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

1997/2018 1998/2019 1999/2020 2000/2021

CPI core, 1997-2000

CPI core, 2018-20

PCE core, 1997-2000

PCE core, 2018-20

Core inflation: 1998-99 vs 2019-201998-99 analogue based on end-2000 PCE vintage; y/y %

-1.5

-1.0

-0.5

0.0


1997/2018 1998/2019 1999/2020 2000/2021

U-gap, 1997-2000

U-gap, 2018-20

Unemployment gap: 1998-99 vs 2019-20UR minus CBO NAIRU; %

-5.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0


1997/2018 1998/2019 1999/2020 2000/2021

Overall balance, 1997-2000

Overall balance, 2018-20

Fiscal policy, overall balance: 1998-99 vs 2019-20% GDP

Data Source: Haver

As in 1999, commodity prices are not pricing nearly as much future growth as equity

prices—a sign of excessive exuberance in equity markets?

19

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019

SPX/GSCI SPX/BCOMIN

US S&P vs commodity prices Ratio of S&P to GSCI and BCOMIN (Industrial commodity prices)

Data Source: Haver

The second parallel we are watching is the 1960s. The current policy mix is as stimulative

as the mid-60s. What if this stimulation finally delivers higher inflation? This is what we

all wish for, right? Be careful what you wish for…

Today’s fiscal and monetary policy stimulation is reminiscent of the mid-1960s. (See slide 11.)

In the mid-1960s, like today, the unemployment rate was low and the natural rate of unemployment

was perceived to be even lower. Yet, like today, core PCE inflation had been low (below 2%) and

stable for many years, leading to low and stable inflation expectations. However, inflation jumped

to more than 3% between 1965 and 1966 after the U-gap fell to -1.0%

Based on this evidence, Stock and Watson (2009) concluded that inflation does not respond

significantly to labor market tightness until the unemployment rate falls 1 percentage point or more

below the natural rate of unemployment. (The Phillips curve is non-linear). Currently, the U-Gap

is -0.9%. Could we be close to an inflation tipping point?

If inflation eventually rises, any Fed-required tightening would have to be more decisive than if

the Phillips curve had been steeper.

Such a tightening due to increased inflation may well prick current bubbly market conditions, as a

new generation of traders will scramble to Google the meaning of “inflation risk premium,” a

concept now thought to be obsolete.

20

1960s analogue. Data aligned by degree of slack in labor markets at end 2019 (Chart 1):

in 2019Q4, U-Gap was -0.9%; in 1965Q2 the U-Gap was similar at -1.0%

21Data Source: Haver

22

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Investor Advisory Committee on Financial Markets

February 13th, 2020

Mary Erdoes

What impact, if any, have the Federal Reserve’s repo operations and reserve management practices had on

broader financial conditions?

1 | FOR PROFESSIONAL CLIENTS/QUALIFIED INVESTORS ONLY. NOT FOR RETAIL USE OR DISTRIBUTION

Executive Summary

• The Fed’s actions alleviated money market strains experienced in September 2019.

• Financial conditions eased around the same time as Chair Powell’s October 8 announcement to act.

• Market participants added risk following the Chair’s announcement although other factors motivated investors

such as the resolution on US/China trade and Brexit.

• JPMorgan believes that balance sheet expansion via bill purchases impacts investors, though the magnitude is

less than purchases of mortgage-based securities or Treasury notes.


Recap: What Happened?

In mid-September, the broad General Collateral Rate (aka repo

rate) spiked higher.

Source: TradeWeb Daily Repo Commentary, Federal Reserve, Bloomberg, JPMAM

Sept 17: NY Fed offers $75bn in O/N repo

Sept 18: Federal Reserve cuts the funds rate, makes O/N repo

available as necessary

Sept 20: NY Fed offers 3 tranches of $35B in 14-day Repo ahead

of quarter end

Oct 4: O/N repo available through November & term repo ranging

from 6-days to 15-days and up to $35B

Oct 8: Chair Powell announces Bill purchases

Oct 11: $60B per month in Bill purchases, target higher reserve

level and repo purchases to continue into 2020

-1

0

1

2

3

4

-90

-85

-80

-75

-70

-65

-60

-55

-50

-45

-40

-35

-30

-25

-20

-15

-10 -5 0 5

10

15

20

25

30

35

40

45

50

55

Fu

nd

ing

Sp

rea

d (

%)

Days before / after funding issues

2019 - Reserve Fears (GC Repo / Fed Funds)

1998 - LTCM (GC Repo / Fed Funds)

2008 - GFC (LIBOR / Fed Funds)

Market participants feared the dislocation might signal a hidden

problem.

The Federal Reserve’s response was quick & effective.

Morning Notes from the Trading Desk*

9/13/19: : “GC has opened at 2.30% which is firmer than had been expected and 2.0 bps above yesterday’s

opening level. GC finished yesterday at 2.07% so the likely path for the day is to lower rates.”

9/16/19: “GC opens 2.16% bid at 2.13% which is 9.0 bps firmer than yesterday’s opening level and 41.0 bps

above the closing level of 1.65%.” Corporate tax payments cause the Treasury General Account to rise at

the Fed, taking liquidity out of the system. Repo rates jump higher into the close touching as high as

8% on light volume.

9/17/19: “GC has exploded higher to 9.00% as perfect storm of high funding continues for a 2nd day.

GC started today at 3.85% and has spiked the as high as 9.00% in morning trading.” NY Fed announces it will

offer $75B of overnight repo funding at 2.1% at around 10AM. Repo rates begin to stabilize but move higher

toward 4.25% into the close on low volume

9/18/19: Stresses remain as GC opens rich at 2.8%. NY Fed commits to continued support of the market.

Funding rates continue to decline throughout most of the day. Close above 3% is still elevated but NY Fed has

lowered GC repo rate consistent with a decrease of the Fed Funds Rate at the FOMC meeting

09/20/19: NY Fed announce term repo operations aimed at addressing quarter-end strains. GC repo rates

continue to normalize and dispersion between intra-day borrowing narrows

2%

8%

0

1

2

3

4

5

6

7

8

9

Broad General Collateral Rate, %99th Percentile vs 1st Percentile Executed


The Federal Reserve’s actions have been successful in alleviating money market strains

The decline in reserve balances has reversed

The Fed’s repo operations and reserve management

purchases were designed to alleviate stresses in short-term

funding markets.

These stresses were caused by:

• Bank reserve scarcity, after the Fed’s balance sheet reduction

had drained $900bn of reserves (lower chart).

• The increase in the US Treasury’s cash holdings on September

16th (corporate tax payments).

• Inefficient distribution of reserves due to regulatory constraints

• Intraday liquidity buffers held by banks to avoid the stigma of

intraday borrowing.

Source: Federal Reserve, Bloomberg, JPMAM Calculations

The Fed’s actions since September have been successful. Money

market rates have returned to normal levels, including over year end.

Other indicators of USD funding conditions have loosened, in some

cases considerably, including term money market spreads (Libor-

OIS) and cross-currency basis swaps.

10/8/2019

1000

1500

2000

2500

3000

2015 2016 2017 2018 2019

$bnReserve balances

The decline in the Fed’s balance sheet has reversed

3500

3600

3700

3800

3900

4000

4100

4200

4300

4400

4500

Jan-18 Jul-18 Jan-19 Jul-19 Jan-20 Jul-20 Jan-21 Jul-21

Actual Balance Sheet

Projected Balance Sheet based on March 2019 Normailzation Principles

New Minimum Balance Sheet size (August 2019 Reserve Level)

Overshoot

$bn


Financial conditions have loosened since the Fed signaled balance sheet expansion

Financial conditions have eased

Risk assets have performed strongly since Chair Powell signaled

renewed securities purchases on October 8th, with that date appearing to

be an inflection point after several months of broadly flat returns.

Consistent with this improvement of risk sentiment, inflation breakevens

have increased and the yield curve has steepened slightly, indicating less

concern about imminent recession.

Source: Federal Reserve, Bloomberg, JPMAM

Financial conditions index

Source: Goldman Sachs. Includes short and long-term yields, corporate spreads, S&P and USD.

There have been several important supportive factors for risk assets since

October, chiefly the reduction in trade tensions between the US and China,

and the related improvement leading indicators of trade and manufacturing.

98

99

100

101

16 17 18 19

Goldman Sachs Index

Tighter conditions

Easier conditions

10/8/201907-Oct 11-Feb Change

S&P 500 2,939 3,357.8 14.3%

US Dollar Index 99.0 98.7 -0.2%

Gold ($/oz) 1,498 1,565.6 4.5%

VIX (%) 17.9 15.2 -2.7

High Yield OAS (%) 4.09 3.52 -57

EM Sovereign OAS (%) 3.21 2.97 -24

IG Corporate OAS (%) 1.19 0.97 -22

10 Year Treasuries (%) 1.56 1.60 4

10 Year Inflation Breakeven (%) 1.51 1.65 14

Fed Balance Sheet ($Bn) 3,582 3,805 6.2%


-

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000 98

99

100

101

102

103

104

08 09 10 11 12 13 14 15 16 17 18 19

Financial Conditons Index DM (Fed, ECB & BOJ) Balance Sheet, Billions (RHS)

1,000

2,000

3,000

4,000

5,000 98

99

100

101

102

103

104

08 09 10 11 12 13 14 15 16 17 18 19

Stage 1- QE Stage 2 - No QEStage 3 - Balance Sheet Reduction Stage 4 - Current PurchasesFinancial Conditons Index Fed Balance Sheet, Billions (RHS)

Inflection points in the Fed balance sheet have often coincided with inflection points in financial conditions

S&P 500 stronger during balance sheet expansion

The strong performance of risk assets since October is consistent with the

historical pattern of risk assets performing more strongly during periods of

central bank balance sheet expansion (left chart).

Over the past decade, inflection points in the Fed balance sheet have

often coincided with inflection points in financial conditions (right

charts).

There are two main channels though which central bank purchases affect

asset prices: a portfolio rebalancing channel, and a confidence and signaling

channel.

Source: Federal Reserve, Bloomberg, JPMAM

Financial conditions vs Fed balance sheet

Source: Goldman Sachs, JPMAM

Financial conditions vs DM (Fed, ECB & BOJ) balance sheet

Easier Conditions

Tighter

Conditions

Tighter

Conditions

ECB QE

Re-Start

Sept 2019ECB

Expanded QE

Starts

Mar 2015

BOJ QE

Starts

Oct 2010

Easier Conditions

0%

5%

10%

15%

20%

25%

30%

35%

Stage 1 - QE Stage 2 - No QE Stage 3 - Balancesheet reduction

Current purchases

Per cent, S&P 500 return and volatility Annualized Return

Total Return

Annualized Volatility


0

500

1000

1500

2000

2500

08 09 10 11 12 13 14 15 16 17 18 19

10 Y

ear

Equiv

ale

nt

Dura

tion*

($B

illio

n)

Stage 1 - QE Stage 2 - No QE Stage 3 - Balance Sheet Reduction

Stage 4 - Current Purchases Fed Treasury Portfolio, 10yr Equivalents

Portfolio rebalancing

A key transmission channel of portfolio rebalancing comes though lowering

real yields and credit spreads. That in turn boosts equity prices by lowering

the discount rate, and by making it more attractive for companies to borrow

to fund share buybacks.

The impact of asset purchases should be larger when the central bank is

buying riskier assets that are far removed from cash and so creating a

greater need for private investors to rebalance their portfolios. In that light,

the Fed’s purchases of longer-maturity Treasuries and mortgage-backed

securities had a significant market impact.

Source: Bloomberg, JPMAM

*Fed Treasury Portfolio in 10yr Equivalents is impacted by interest rate movements, convexity and the composition of re-investments

Little duration impact from current purchase programme

Previous QE episodes absorbed a significant amount of interest rate

duration from the market. The recent Treasury Bill purchases (circled)

have increased the size of the Fed’s portfolio, but with little duration

impact.


Bill Purchases Announced

-60

-40

-20

0

20

40

60

Dec-18 Mar-19 Jun-19 Sep-19 Dec-19

Cut 1 Cut 2 Cut 3 3m10yr Yield Curve Spread, Basis Points

Bill Purchases Announced

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

1.2

Dec-18 Mar-19 Jun-19 Sep-19 Dec-19

Cut 1 Cut 2 Cut 3 5y Real Yield

Confidence and signaling

Traditionally central bank asset purchases have been a signal that

short-term interest rates will remain low for a long time. In this episode,

the Fed was clear that no monetary policy signal was intended from these

Treasury Bill purchases. However, we believe there are other positive

signalling channels from these purchases.

First, the Fed’s prompt and effective response to an episode of market

stress increased market confidence, including the confidence to buy riskier

assets. Volatility in interest rate and other markets has fallen since October,

although this also reflects the reduction in trade tensions.

Source: Bloomberg, JPMAM Source: Bloomberg, JPMAM

Second, market participants are highly conscious of the historically

stronger performance of riskier assets during periods of balance sheet

expansion. The fact that this relationship has been borne out during this latest

episode, even with purchases of Treasury bills instead of long-term Treasuries,

will only deepen confidence in this relationship.

Yield Curve (3 Month T-Bills to 10 Year)

…and the Yield Curve

turned positive

5yr Real Yields

Since the Fed announcement

Real Yields have rallied…

% Bps


Key Takeaways

• Chair Powell’s intention was to make a technical adjustment and this was not to be confused with QE

Michael Feroli, in a recent research note aptly described the intention of this adjustment:

“It would be a better analogy to see what the Fed is doing as removing each

$10 bill of Monopoly money and replacing it with two $5 bills [Monopoly money]”

• Investors viewed the Fed’s action as a backstop for financial stability. As investors’ confidence improved, their

risk exposures increased, as demonstrated by market data.

• Concern: as FOMC tapers and eventually ends Bill purchases, market reaction could be poor.


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Any research in this document has been obtained and may have been acted upon by J.P. Morgan Asset Management for its own purpose. The results of such research are being made available as additional information and do not necessarily reflect the views of J.P.Morgan Asset Management.

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