In this episode, we review everything that's been going on recently with the economy and markets. I also share four simple questions that can help you navigate these challenging markets.
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Bond Investment Mentor, episode four.
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[Music]
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Hi there, welcome to Bond Investment Mentor! I'm your host Chris Nelson and this is a podcast dedicated to helping community financial institutions master the art of fixed income investments. If you're working for a community bank or credit union, and you have responsibilities for the investment portfolio, you've come to the right place! I'll be your personal investment guide as we help you boost your fixed income investment knowledge, level up your portfolio management skills, and help you gain the know-how you need to help your institution achieve its financial goals. In this episode, we're going to catch up on everything that's happened with the economy and markets recently, and I'm also going to spend some time talking about how to deal with the head-spinning that you're probably experiencing when it comes to figuring out what to do now with your investment portfolio. But no worries! I have four simple questions to share with you that will help you navigate these challenging markets. Ready to learn more? Then let's get started!
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Welcome to another episode of Bond Investment Mentor! How's it going? I hope that you're doing well and I'm glad you decided to join me today. On the pandemic front, we have finally started to see things slowly reopening here in Maine. Hopefully, things are starting to move in the right direction where you are. So as I mentioned in the last episode, a lot has happened in the past couple of months. I know it might seem like it's been longer, but we've really seen most of the market action play out in about the last 60 days or so. Somebody shared with me a change in the old saying recently. They said 30 days hath September, April, June and November. All the rest have 31, except for February, which has 28 and March, which has 8,000! That's kind of what March felt like. It was crazy.
And since the beginning of March we've experienced the major outbreak of the COVID-19 pandemic, and following that, the U. S. and global economies basically grinding to a halt. You know, we saw GDP come in at -4.8% on an annualized basis on the last quarterly report. The outlook for the next quarter, this quarter, is going to be I believe somewhere between -30% and minus 35% annualized. That's the current consensus and we're not really sure where things are going to go going forward in terms of the coming quarter and the rest of 2020. Unemployment came in at about 14.5%, and really it was closer to 20% because of a statistical error according to the Bureau of Labor Statistics. Nonfarm payrolls dropped by 20 and a half million in April, so a lot there. And all the statistical reports for the economy are just unprecedented, a word that's getting overused a lot lately.
We ended up with a $2 trillion stimulus package. I really consider it a rescue package. It wasn't really stimulating anything. It was kind of backstopping the U S economy. A big part of that was the Paycheck Protection Program, which I know a lot of you have been very involved in with your institutions, getting the loans in place, getting them loaded and so forth. And because of all of this stimulus and all of this spending, the U. S. Treasury has said that they're going to be borrowing $3 trillion in the second quarter, just the second quarter, to fund the deficit. And that includes new 20-year Treasury bonds. We haven't seen 20-year Treasury bonds since 1986, it's been quite a while. So, that was their announcement.
Now here's a piece of trivia for you. We've been hearing a lot about millions and billions and trillions in the news and all of these stimulus packages, it's all been juggling around. But I just want to give you some perspective. If you took a stack of $1 bills and you had a million of them, you would end up with a stack that's approximately 360 feet tall. That's about the size of a 40-story building. So that would be a million dollars stacked up. If you were to take a stack of $1 bills and stack up 1 billion of them, you would end up with a stack that was about 68 miles high. If you put that in perspective, that would put the top of the stack right around the edge of the Earth's atmosphere. Now let's talk about a trillion dollars. If you took a stack of $1 bills and you had 1 trillion of them, you would end up with a stack that was about 68,000 miles high. That's about a third of the way to the moon. So, you figure these 2 trillion, $3 trillion packages, we're talking some sizable numbers here, but it gets lost sometimes when we're just batting these phrases around a lot. So that's the trivia lesson for today!
So, we had all of this stimulus coming out of Washington, and then there was the Fed and boy did they get involved! We saw interest rates cut twice! In early March, they did a 50-basis point emergency cut. It was the first emergency move since late 2008. And then two weeks later, they weren't done. Two weeks later, they cut rates again, 100 basis points, something that we just haven't seen in a long, long time. And with that move, plus the previous move in March, the Federal Reserve basically unwound five years of monetary tightening, monetary policy. And they weren't finished!
They began open-ended securities purchases and have continued to do so. They've been purchasing Treasuries and mortgage securities and so forth. Their balance sheet, the Fed's balance sheet, has ballooned from just below $4 trillion to approximately $6.2 trillion in just the last two months, so they've been busy buying for sure. They've bought about $1.5 trillion of Treasuries. They've bought approximately $300 billion in mortgage securities and that doesn't count some of the other programs and the central bank swaps that they've been doing and so forth. And then, in addition to all of that, the purchase activity they, brought back or introduced a whole group, a hodgepodge if you will, of funding programs and lending facilities. And I looked at this list, I'll share this with you and this is, it's a long list! Here's the list of programs that the Fed is using currently in this crisis. There's the Paycheck Protection Program Liquidity Facility, the Money Market Mutual Fund Liquidity Facility, the Municipal Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, the Primary Market Corporate Credit Facility, the Secondary Market Corporate Credit Facility, the Term Asset-backed Securities Loan Facility, the Main Street Lending Program, the Central Bank Liquidity Swap Facilities and the Temporary Foreign and International Monetary Authorities Repo Facility. That's a mouthful! Those are all of the programs that the Fed is doing in addition to the purchasing, in addition to the interest rate action. So they've had a lot going on.
Now, as you would expect in the financial markets with what's been going on in the last few weeks, going back to the beginning of March, stocks sold off. We saw the S & P 500 plunge about 33%. It's since recovered about half of that, but it's still very volatile. Oil prices, of course, collapsed. We had oil sitting at about $45 a barrel. It dropped to about $20 a barrel and has come back up a bit from there. We actually had a point back in April where the futures contracts went negative. That was just a lot of hedging activity and unwinding activity, but still negative $37 a barrel was definitely eye-opening.
Interest rates have dropped quite a bit. The 10-year Treasury is now trading about at about 70 basis points, give or take, down about 45 basis points from where it was back in late February, early March. The five-year Treasury is trading at about 35 basis points, down about 60 basis points from where it was. And the two-year Treasury is paying an amazing 17 basis points right now! That's down about 75 basis points. Historical lows across the board. Now, I suppose if you're looking for some good news, you'll find it here, maybe. The yield curve has steepened again. We had a yield curve that was extremely flat. There was actually some inversion in there, but with what we've seen happen with the Fed and with the markets, the yield curve actually looks normal again for the first time in a while. And if you're kind of one of those people that follow some of the standard spreads on the yield curve, the 2s/10s part of the curve, meaning the comparison of two-year Treasury rates to 10-year Treasury rates, that got to about as flat as 10 to 15 basis points. The difference between those two terms, it's opened back up to about 50 basis points now, which is the most we've seen in about two years now. We've definitely had higher spreads in that, in that stretch, going back to the financial crisis in 2008, but still we've had a little more spread in the curve than we've seen in quite some time.
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So, given everything that's happened, it's really easy for a community banker's head to be really spinning on a swivel right now. You and others have been heads down during the past couple of months. I know that a big focus in talking with community bankers has been figuring out the new PPP loan program, how to get through the process and also how to fund the loans. Are you going to use the PPP liquidity facility or not? That's been a question I know many community bankers have been asking themselves.
For some of you, there's also been a focus and thinking a lot about liquidity management given the volatile conditions. I've talked to some community bankers and I've heard kind of two versions of this liquidity story. The first one is relating to deposit growth, with what is anticipated to be some pretty big growth in deposits coming down the road. The question is, well, what do we do about that? What do we do with the funding that's coming in, particularly if loan growth pulls back a little bit? And then the second version is actually on the deposit withdrawal side. I know of at least one or two community banks where they've been, they've received phone calls from some of their larger depositors. And in these cases, these were depositors that had funds that had just kind of been parked there, they had been there and had been stable for quite some time. And basically, the message was, "Hey, we expect we're going to need to tap into some of those funds now. So we just wanted to give you a heads up and it might be sizable." And so from a liquidity management standpoint, what do you do about that and how does that affect what you've got going on at this point?
And then, people are finally starting to poke their heads up and look at the bond markets after paying attention to so many other things over the last month or so. And really, there's kind of a shock for them. It's like, "What just happened?" Many bankers that I've spoken with are experiencing what I will term sticker shock with respect to yields, because they're certainly lower than they were even a couple of months ago materially. We've also seen for some portfolios, lots of calls on bonds, lots of bond calls, and mortgage securities prepayments have risen.
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So, you're seeing that start to play a role here. And given what you're holding in your portfolio, particularly if you hold things like municipal bonds, a lot of bankers are starting to really wonder about what risks might lie within that portfolio. And it's going to, we're going to have to spend a lot of time doing a lot more work to make sure that the bonds we own are bonds that we're going to be comfortable with. So trying to figure all of this out and figuring out what to do next can be a real challenge. And, you know, the temptation here is just to grab whatever yields you can and just hold on for this ride, you know? But first, let me share some thoughts with you. We're kind of in what I would refer to as the "messy middle." We've been here before. For those of you that were doing this back in the 2008 financial crisis, you may recall we were in that period where we had no real idea how things were going to play out.
We're back there again now. We don't know how things are going to go for the rest of the year. We don't know what the "new normal" might look like because it's still being shaped and formed. And so we're in this kind of limbo, this transition phase, and it's easy to get caught up with the financial media and so forth these days as they're covering what's going on in the markets, what's happening with interest rates, what's going on with the economy. There's just so much coming in now in terms of information. It's coming in in your email inbox, it's coming in on calls from various sources, it's stuff you're seeing every day. There's just so much happening.
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And the thing that I want to share with you here is what's important first and foremost, is to focus on managing your balance sheet and your investment portfolio. That's a key focus and as you begin to develop investment strategies in this new world, I want to share with you something that was really helpful for me over the years as I was managing bank investment portfolio assets. These are four questions that I found helped me stay the course in challenging markets. More importantly, these four simple questions really ensured that I had covered my bases on investment decisions. It helped out a lot, not just when I was developing investment strategies, but also later on when questions came up either from myself or from others. So let's review them, these four questions.
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The first two questions usually are teamed up. Question number one is this: "What are we doing?" Question number two is 'Why are we doing it?" So what are we doing and why are we doing it? These two questions form the foundation of good strategy development.
Now, what's important here is that you need to define exactly what your objective or goal is with the investment decision that you're making. You want to make this as detailed as possible. You don't want to just say, well, we're putting money to work or we're replacing investment runoff or we're seeking a good yield on our investment purchases. This is almost like a personal goal setting exercise. You want to be detailed as possible to help you shape what this strategy is. Let me give you some examples. One example would be, "We're temporarily putting excess funds to work in bonds that will produce liquidity cash flow to help pay for loan growth later this year." That's a good answer to those two questions. It clearly states what we're doing and why we're doing it. Here's another example, "We're investing to help manage the existing risk exposures on our balance sheet." Clear, straightforward, answers questions one and two. A third example, "We have excess deposit growth and limited loan origination options, so we're investing to generate better income than leaving the money in cash at the Fed." Again, answering both the what and the why. And then finally, "We own some muni or some corporate bonds that may have increased credit risks, so we want to consider the benefits and costs of an outright sale or a buy/sell swap." You're going to want to spend time making sure that you've covered the answers to both of these questions before you move on with any of the further questions. So these examples I just gave you are some ideas to maybe help you kind of think that through. So we're halfway there. Question one, question two, check!
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Next question, question three, "How can it go wrong?" This is a question that sometimes gets lost in the decision-making process. For many people, they answer question one, they answer question two, and they're done. Question three, this is an important one to consider upfront. This question is all about risk assessment and kind of predetermining the risks associated with the investment transaction or strategy that you're considering. It's important to take the time to consider the underlying risks associated with the investment. So before you decide or execute the trade, ask, "What types of risk are present?" And they might be things like credit risk or optionality. Do you have any optionality in your investment and how could that affect things? Do you have exposure to prepayment risk? Or on the other hand, do you have exposure to extension risk? What about interest rate risk or liquidity risk? How will changing market conditions affect the behavior of this bond that we're about to purchase? It's better to think about and discuss these things now before you actually pull the trigger rather than when the investment starts to bubble up and cause problems. It's also a good idea to make a note of the answers to this question, so you have them as a reference later in case you need to go back and take a look at it. So that's question three. Question three, "How can it go wrong?"
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And then lastly, question four, "What will we do if it does?" What do I mean by that? Well, how will we respond if the risks that we identified in question number three become a reality? What we're talking about here is contingency planning. We've identified some risks. So given those risks, what will we do if they actually occur? So what will you do in this case? Would you sell the bond? Would you ride the situation out? You might just sit tight. Maybe you'll make adjustments within the portfolio that will act as an offset to the risks that are now occurring with the previous purchase. Like question three. It's better to think about the contingencies now instead of waiting for the fire drill later.
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So those are the four questions to help you get through these tough times. "What are we doing? Why are we doing it? How can it go wrong? And what will we do if it does?" The key is to think about these four questions beforehand and have answers. Now I'm going to share a little secret with you. These questions are really timeless. They're not just for the current market conditions. Personally, I have let these questions guide me through many different markets, many different changes and shifts, and they've been really helpful for me. It's not about the market conditions, it's about having a solid strategy that allows you to proceed confidently while covering your bases if something goes wrong.
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So, I hope that you found this helpful today. If you have questions regarding anything that I've covered, please drop me an email at Chris @ BondInvestmentMentor.com. I would love to hear from you! Also, if you have any topic suggestions for future episodes. I'd really like to know, you know, what are some things you'd like to learn more about? What are some questions that you'd like to have answered? Drop me a line, let me know and we'll see what we can do about getting those on future episodes. If you found this information helpful and you know someone who could benefit, please share this episode and this podcast with them. I want to make sure we get this message out to as many community bankers as possible. If you listen via Apple Podcasts, would you do me a favor and please leave a review? It helps others discover and learn more about the podcast. I actually had a review recently from someone named "Chicago CFA." A five-star review, thank you for that! They said, "Chris knows what he is talking about and, just as importantly, he has the rare ability to clearly explain his decision-making process. This is good stuff for the experienced portfolio manager and great stuff for the beginner or those moving into portfolio or balance sheet management from the lending or accounting/reporting sides of the business." Thank you so much for that review. I'd also like to invite you to subscribe to the podcast. You can subscribe on any of the major platforms, Apple Podcasts, Spotify, Google Podcasts, and many others out there. Please subscribe, that way you don't miss a single episode when I publish one. If you're looking for more information, please check out the website, BondInvestmentMentor.com. You'll find articles, tips, and resources that you can use there. You can connect with me via social media. Please reach out to me on LinkedIn at “Christopher Nelson CFA,” or on Facebook at “Bond Investment Mentor.” I would love to hear from you, let's connect! I look forward to catching up with you soon. Thanks for stopping by and have a good one!
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