March 2021 completed a year since the liquidity crisis in March-April 2020 at the beginning of the COVID-19 pandemic. The Federal Reserve (Fed) lowered the target funds rate to 0.00%–0.25% range. The liquidity and economic crisis have subsided with some of the COVID-19 restrictions having eased. The economy appears appear poised for a strong recovery.
Accelerated distribution of COVID-19 vaccinations and the $1.9 trillion America Rescue Plan Act (ARP), which passed in March 2021 increased market expectations for a strong economic recovery. Inflation concerns, increased Treasury yields for five-year maturities and longer causing the yield curve to steepen.
The markets took a risk-on approach to investments. The S&P 500 hit new highs and the bond market saw yield-seeking investors gravitate to high yield bonds. Corporate leverage stabilized as companies held higher cash balances. The use of cash for share buybacks had slowed due to high stock valuations. Global mergers and acquisitions have increased.
Congress approved and President Biden signed the $1.9 trillion American Rescue Plan Act (ARP) fiscal package in March 2021. Improving Covid-19 vaccine distribution and extraordinary fiscal and monetary stimulus during the first quarter supported above-trend economic growth.
President Biden announced a $2.25 trillion infrastructure plan that would increase government spending over 8 years and would potentially boost economic growth.
On March 17, 2021, the Federal Open Market Committee (FOMC) meeting stated that it is committed to keeping the Fed funds rate in the 0% - .25% range for an extended period. The Fed Chair Powell stated that the FOMC will continue to be accommodative until actual progress in employment and inflation is achieved. It will act in a methodical and well announced fashion so that the market is not surprised by its actions.
The Fed’s goal is to reach maximum labor market employment. The Fed Chair reiterated that it is willing to tolerate inflation running above 2% to achieve its employment goals. Last year the Fed introduced targeting average inflation to allow it to accommodate shorter-term inflation increases that may result from fiscal stimulus or pent-up demand.
The FOMC released its quarterly assessment of Summary of Economic Projections, or dot plot. The dot plot is a not a committee forecast but a compilation of what each member projects. Most FOMC members feel the Fed will keep the target funds rate at the current level through 2023. The economic outlook has improved but remains uncertain and policy will remain supportive to mitigate any potential downside risks. The Fed’s QE monthly purchases of $120 billion will continue through 2021.
The inflation narrative continued with stronger economic data. The Producer Price index headline and core figures both increased at rates that were higher than recent months.
As of April 1, 2021, the Federal Reserve (Fed) Bank of Atlanta forecast that 1Q2021 GDP growth at 6% an annualized basis. Economic growth will be boosted by the vaccine rollout and additional stimulus programs including the proposed infrastructure plan. Economists forecast real U.S. GDP will grow at a seasonally adjusted annual rate of 8.1% in 2Q2021.
As of February 2021, the unemployment rate was 6.2%. The Labor Department reported that employers added 916,000 jobs in March 2021 well above consensus estimates of around 650,000, and the most since last August 2020. 280,000 jobs were added in leisure and hospitality industries. February job openings were almost 7.4 million, the highest since January 2019. However, initial jobless claims had hit their highest level of 744,000.
The service sector ISM measure hit its highest level on record. The manufacturing ISM also reached its highest level in forty years. The ISM report also showed strong, with broad-based strength in employment, new orders, and business activity which offset weakness in inventories and export orders.
As of January 2021, the year-over-year core PCE inflation rate was 1.5%. Inflation was seen with higher prices for production inputs. The Bureau of Labor Statistics reported that producer prices rose by 1% in March which was a year-over-year increase to 4.2%. There were supply chain pressures arising from delays at U.S. ports and a global semiconductor shortage that led to temporary shutdowns in auto production lines.
The consumer price index rose 0.6% in March from the previous month and 2.6% from a year ago. Gasoline prices surged 9.1% and accounted for half of the price increase. Economists widely expect consumer prices to keep climbing in the months ahead after nearly a year of muted overall inflation.
The Fed’s one-year supplementary leverage ratio (SLR) capital relief program for large U.S. banks expired on March 31, 2021. The Fed had eased the rules beginning April 1, 2020 allowing banks to exclude U.S. Treasuries and banks’ deposits at the Fed from its calculation of banks’ SLR. Without the exclusion, the SLR margins would have been slimmer than GSIBs (global systemically important banks) typically prefer.
The largest U.S. banks may limit absolute balance sheet growth after the elimination of the exclusion. The banks could also issue additional Tier 1 capital, qualifying preferred stock and/or retain earnings. These decisions would likely not impact the banks’ credit ratings. This regulatory change is being viewed as an improvement for banks’ outlook for this year.
On balance, regulatory or market conditions that boost bank capital requirements and heighten attention to physical and transitional climate risks should strengthen balance sheets and reduce overall risks to generally favor credit ratings and bank bondholders.
Money Market Funds
The US Treasury continued raising cash each month by selling ever-larger amounts of notes and bonds further out the curve instead of selling short-term Treasury bills. The reduction in T-bill supply has depressed short-term government yields toward 0%.
LIBOR an SOFR
LIBOR was scheduled to be discontinued by year-end 2021 and to be replaced by Secured Overnight Financing Rate’s (SOFR). There is serious consideration to extending the transition from year-end 2021 to the end of June 2023. This would be favorable to legacy asset classes that lack adequate transition language in their debentures.
The Federal Reserve and several organizations including ISDA, ICE, and ARRC (Alternative Reference Rates Committee) that are coordinating the regulation and transition.
Many securitizations are governed by New York law. In March, 2021 New York state passed legislation that amends fallback language for legacy (LIBOR) securities and contracts. The bill clarifies asset-backed securities such as credit card and PFFELP student loans that do not have fallback language. The bill provides a path for the transition from LIBOR to SOFR.
There may be additional Federal legislation and state of Delaware where many corporate issuers are incorporated. The Fed has stated that the stability and success of the transition is important and will try to achieve a smooth transition.
On March 5, 2021 ICE, a benchmark provider, announced that they will no longer publish US LIBOR on June 30, 2021. ARRC considers this a “Benchmark Transition Event” that will facilitate bond indenture language for asset-backed securities. Recent securitized bonds issued in 201902020 have fallback language that will allow a transition to a SOFR coupon in mid-2023.
Impacted securities will still need to be reviewed individually until a consistent federal rule is issued.
Pre-COVID-19, the US Treasury held $400 billion in cash balances as a precaution for liquidity purposes. With the declaration of the global pandemic, the US Treasury increased its cash balance in its Treasury General Account (TGA) to over $1.8 trillion in 2020. In February 2021, the cash balance is over $1.6 trillion. Under US Treasurer Janet Yellen, the US Treasury intends to reduce the TGA to $500 billion by the mid-2021. By March 31, the balance was $1.122 trillion as a result of the increased deficit spending and low Treasury bill supply.
The yield curve steepened for maturities beyond 5 years with the yield on the 10-year Treasury surpassing 1.70 %.
Investment grade corporate bond new issuance increased sharply in March 2021 with $201 billion of new issues which was a 45% increase from February. During 1Q2021, $524 billion investment grade bonds were issued rebounding from 4Q2020 low issuance. There continues to be steady purchases by insurance companies and non-US investors.
Rating agency downgrade activity is moderating based on stabilizing fundamentals. The number of investment grade issuers downgraded to below investment grade or “fallen angels” declined in 1Q2021 as corporate profits improved. As the economy recovers, corporate revenues and earnings may rebound sharply, which will drive improved credit fundamentals across most sectors.
Corporate credit fundamentals improved due to corporate cash management policies during 2020. Corporations refinanced their debt by replacing short-term debt with longer, maturity debt that strengthened their cash flow and balance sheets. As business conditions improve, companies may start share buybacks, mergers and acquisitions and special dividends. Global M & A has increased during 1Q2021. These activities tend to have a negative effect on credit ratings.
Corporate tax increases have been proposed that could over the long term could impact projected earnings growth.
Interest rate spreads for AAA-rated mortgage-backed securities (MBS) and agency commercial MBS (ACMBS) were rangebound while spreads for AAA-rated asset-backed securities (ABS) widened moderately.
In early March, the broad strength in MBS stretched across different coupon levels. The 1.5% coupon MBS was actively used for hedging. During the quarter, the Fed decided to drop the 1.5% coupon MBS from its buying program.
Th expiration of the pandemic-related forbearance programs may accelerate prepayments in the agency MBS or Government National Mortgage Association (GNMA) MBS. The Fed also decided to stop buying agency CMBS (commercial mortgages) mid-March which had little effect on the market due to the continued high demand for high quality securities.