The Fed and the Consumer
We recently sat down with fixed income portfolio manager Henry Song, CFA, to discuss the health of the consumer and the Fed’s balance sheet.
How much of the challenges in the bond market this year are coming from interest rates rising and how much has come from spread widening?
Henry Song, CFA: When I look at the market, it’s definitely a combination of both, but I think the narrative has been more focused on rising interest rates. I think if you look closely, you will start to see spread widening happening in most corners of the bond market.
Certainly, the bond market had a historical run in 2020 that extended into 2021 on the heels of the QE (quantitative easing) that the Fed steered to the market during the COVID pandemic. But if you think about specific market sectors like agency asset-backed mortgages, the Fed never fully exited that area of the market dating back to the global financial crisis. It’s been well over a decade now with a brief period of unwinding before dislocations in the money markets caused the Fed to jump back into buying (September 2019), followed soon thereafter by the pandemic. So, the agency mortgage market never returned to its true full valuation. During the pandemic, after the Fed started purchasing again, the option adjusted spread (OAS) was basically zero, so there was no point in owning any agency mortgages. Fast forward to today, and we see the OAS on newly issued Agency MBS has wound out to 30 bps, even 40 on some days. So, valuation has at least in part returned to the market.
As bottom-up investors, this is a great sign for us. Chaos creates opportunity and this is no different. I think this is a great time to be active investors, to be able to pick bonds that you can do the credit work on and feel good about investing in for the long term. If we look at the market today, the bond market looks a lot more attractive to me. Additionally, if you are someone who relies on income from a bond portfolio, now you’re actually getting some reasonable income. So, while it’s been a painful year thus far, I think there’s a lot of opportunity to outperform in the future going forward.
The consumer has started to feel the pressure from rising energy prices and increasing mortgage rates. At the same time, the labor market remains strong and wage growth has been on the rise. From your perspective, how do you evaluate the strength of the consumer today and how does it impact securitized assets?
Henry Song, CFA: There’s certainly a lot of talk about the uptick in credit card utilization. We’re also seeing an uptick in delinquency rates in the market across the board, but we are only now getting back to delinquency rates that we saw pre-COVID. But as you mentioned, the labor market is still strong by historical standards, and if you look back to where we were before the pandemic, consumer balance sheets overall are still healthier at this point. We essentially had two years of lower average spending and higher average savings. Also, you could argue that prior to the latest inflation spikes that wage growth has been higher than what we have seen in a very long time. So, a lot of consumers are doing well.
That said, I think there is definitely a big dichotomy between consumer sentiment and consumers’ ability to service debt. Sentiment is still relatively low right now, but that hasn’t been reflected in spending patterns yet. If we come to a point where consumers feel too much of a hit from inflation and higher energy prices, spending will start to dial back, and they will start saving more resulting in a better ability to service their debt. So, from a fundamental credit perspective, just looking at consumer balance sheets, we are still a long way away from unemployment ratcheting up.
The housing market is softening a bit, as existing home sales have now fallen for a sixth month in a row due to rising rates and list prices that remain significantly higher than year-ago prices. But we aren’t seeing a crash where people are feeling bad about their balance sheets. Consumers probably don’t feel as bullish if they’re making some tradeoffs in terms of where to spend their money, e.g., premium products versus store brands. But overall, I think balance sheets continue to look strong. And for all the lenders we talked to recently, they’re also being more cautious. So that’s been also helpful for all the outstanding debt.
It seems like everyone’s focused on the Fed this year. Does the focus on the fed funds rate seem appropriate to you or are we perhaps missing something more important in terms of balance sheet normalization?
Henry Song, CFA: I think it depends on investment strategy. For more macro-oriented strategies, that 50 basis point or 75 basis point increase matters a lot. At Diamond Hill, we take a long-term view when we invest in the fixed income markets. So, forecasting the ultimate destination of the fed funds rate for this cycle isn’t really that impactful to our investment process. And frankly, even if you forecast accurately, it’s near impossible to forecast how the market is going to behave to certain news.
I think the part that hasn’t been talked about as much is what the Fed is going to do with the existing balance sheet. Though we’re starting to hear some chatter about it, there’s still a lot of mystery behind how the Fed plans to unwind its mortgage portfolio. As rates have climbed higher, the pace of mortgage pay downs has slowed with refinancing existing mortgages becoming less and less attractive. This means that it will take longer and longer for mortgages to pay down, especially for the Fed’s holdings of MBS that have coupons at 2.5% or less which make up the bulk of its portfolio. And I think that certainly has serious implications for the fixed income market. As I mentioned, the agency mortgage-backed securities market is the second largest component of the Bloomberg US Aggregate Bond behind only Treasury debt and if/when the Fed starts selling, this could have serious spread consequences, creating a lot of short-term volatility and noise in the marketplace. But again, from my view, the sooner the Fed can exit some of these markets and unwind the balance sheet, the sooner we’ll see more opportunity return to the fixed income market. I’m not sure if they will actually do it, but I would welcome it as a bottom-up investor since volatility often creates opportunity.
Bloomberg US Aggregate Bond Index measures the performance of investment grade, fixed-rate taxable bond market and includes government and corporate bonds, agency mortgage-backed, asset-backed and commercial mortgage-backed securities (agency and non-agency). The index is unmanaged, includes net reinvested dividends, does not reflect fees or expenses (which would lower the return) and is not available for direct investment. Index data source: Bloomberg Index Services Limited. See diamond-hill.com/disclosures for a full copy of the disclaimer.
The views expressed are those of the author as of August 2022 and are subject to change without notice. These opinions are not intended to be a forecast of future events, a guarantee of future results or investment advice. Investing involves risk, including the possible loss of principal. Past performance is not a guarantee of future results.
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