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Posted on MAY 31, 2017

Johnson Bank Wealth Weekly Investment Commentary | Wednesday, May 31

This is part of an ongoing series of Weekly Commentary articles published by Johnson Financial Group.
This week's issue is written by Brian Andrew, SVP, Chief Investment Officer.

Avocados and Central Banks

Have you noticed that you can't find a BLT sandwich anywhere on a menu? It seems that everyone has added avocado so the only offerings are BALTs. It seems that avocados are everywhere. In salads, shakes, at breakfast, lunch and dinner. In fact, consumption of avocados has gone from 3.5 pounds per consumer in 2006 to 6.9 pounds in 2016. Not surprisingly, a 22 pound box of Hass avocados (the preferred type) has gone up from 150 pesos in 2015 to 530 pesos (pesos because 82% of U.S. imported avocados come from Mexico), the highest price in 19 years.

Graph showing the pesos per 10kg box of avocados from May 2015 through today.

The basic economic law of supply and demand is at work. When the growth rate of demand exceeds that of supply, prices rise. We can use this thought process in understanding how central bank activities may affect bond prices and interest rates.

Quantitative Easing

Collectively, the central banks of Europe, the U.S. and Japan have gone on a bond buying spree (in Japan they are also buying stocks) off and on over the last 8 years. These bond purchase programs are known as quantitative easing. They are considered unusual measures, taken because the usual monetary policy tool, interest rates, had been lowered to 0% and the bankers wanted to keep pushing stimulus to aid with economic growth. While the U.S. central bank, known as the Federal Reserve, stopped new purchases it continues to roll over maturities, at least for now. In Europe and Japan, central bankers have maintained that their purchase programs will last well into 2018.

Like avocados, when the demand for something increases faster than the supply, prices go up. In the case of bonds, when prices go up, bond yields go down. In other words, there is some downward pressure on interest rates that stems from the unusual demand created when central bankers buy their own sovereign debt, and in the case of the Fed, other securities like mortgage backed bonds.

The Fed ended its unusual policy purchases over two years ago. These purchases resulted in a much larger balance sheet -- on the asset side it owns bonds and on the liability side it owes reserves to the banks from whom it has purchased bonds. The Fed's balance sheet is now over $4.5 trillion dollars. When the financial crisis began, its bond holdings were less than $1 trillion. That's a lot of demand from one bond investor.

Last week, the Fed released minutes of its last Open Market Committee meeting and indicated it is beginning to discuss how it will unwind its balance sheet holdings. Bond investors are keenly monitoring this discussion because it will almost certainly have an impact on bond yields and prices.

Unwinding the Balance Sheet

The Fed indicated it wouldn't begin reducing its bond holdings before late 2017 and that the change “should be communicated to the public well in advance of the actual change.” It discussed a program in which it would cap the amount of bonds it allows to mature from its portfolio each month without being replaced. The current estimate suggests that the Fed reduce its portfolio by approximately $320 billion per year until 2022 or $1.7 trillion. This will leave the balance sheet nearly three times its level in 2007, but accounting for currency growth, only 20 to 25% larger.

a graph showing the expected changes and rates of the Fed's balance sheet from 2009 until 2023.

This is important because it suggests a programmatic approach with a long implementation timeframe. It should allow investors to digest the increase in bond supply and the resultant increase in interest rates could be stable and predictable. In its communication, the Fed seems to indicate that once the program has begun, it will not alter course. It is interested in returning to a more normal course for monetary policy. Chair Yellen noted that buying bonds is “not a tool that we would want to use as a routine tool.” This actually helps the bond market digest the new supply because it knows it won't be interrupted by changes in economic growth or levels of inflation. It tells us that the Fed is more interested in getting back to normal policy than it is worried about disrupting its primary objectives.


In 2010, the former Fed Chairman, Ben Bernanke, noted that the Fed's program of buying Treasury and mortgage backed securities almost certainly pushed investors into “other assets with similar characteristics.” He was saying that investors likely purchased things like corporate bonds and eventually riskier yield assets such as preferred stocks, real estate investment trust stocks and other high dividend paying equities.

The Fed's demand for Treasuries and mortgage backed securities led investors to buy alternatives. The supposition is that when it reverses course, demand for these other investments may decline and so the premium built into their price will be reduced.

This is true for Treasury yields. In a recent Morgan Stanley research piece they noted that “a large programmatic buyer (the Fed) will be exiting the market, increasing the amount of fixed income assets needing to be absorbed by price-sensitive buyers.” These price-sensitive buyers are you and me. We will likely be more interested in the yield we earn than the Fed was, so our demand will impact bond yields and price.

Still, because the program is suggested to last at least five years, the impact on rates should be low on an annual basis. If we assume that the yield on a 10-year Treasury is held artificially low by the Fed's purchases, its reduction in balance sheet assets at a pace of $300 to $350 billion per year, could result in yields rising by 5 to 10 basis points per year or .05% to .10%. Over five years this would equal .25% to .50%.

Of course the demand for other yield investments will be affected as well. As interest rates rise, the need to “reach” for yield will lessen as will demand for other income investments. This will likely have a deleterious effect on the premium in price for the excess demand. We know that the size of U.S. credit markets has doubled since 2007, while average credit quality has declined and leverage increased. This just means that the bond market will be more susceptible to volatility when liquidity disruptions take place or investors question the future level of economic growth or inflation.

In addition, the Fed is hiking interest rates. This coupled with a declining balance sheet will limit its ability to absorb shocks to the system. So while we believe that effect on yields will be low and steady, the volatility we experience could begin to move higher. This is all part of the process of normalizing the bond market. For us, it would be a welcome return to normal.

Much the same as if a new study extolling the virtues of some other fruit or vegetable might reduce the demand for avocados reducing the price and making them more palatable.

Brian Andrew
As Chief Investment Officer, Brian Andrew leads Johnson Financial Group's investment strategy
to provide consistent, actionable investment solutions for our clients.

This information is for educational and illustrative purposes only and should not be used or construed as financial advice, an offer to sell, a solicitation, an offer to buy or a recommendation for any security. Opinions expressed herein are as of the date of this report and do not necessarily represent the views of Johnson Financial Group and/or its affiliates. Johnson Financial Group and/or its affiliates may issue reports or have opinions that are inconsistent with this report. Johnson Financial Group and/or its affiliates do not warrant the accuracy or completeness of information contained herein. Such information is subject to change without notice and is not intended to influence your investment decisions. Johnson Financial Group and/or its affiliates do not provide legal or tax advice to clients. You should review your particular circumstances with your independent legal and tax advisors. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. Certain investments, like real estate, equity investments and fixed income securities, carry a certain degree of risk and may not be suitable for all investors. An investor could lose all or a substantial amount of his or her investment. Johnson Financial Group is the parent company of Johnson Bank, Cleary Gull Advisors Inc. and Johnson Insurance Services LLC. NOT FDIC INSURED * NO BANK GUARANTEE * MAY LOSE VALUE

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