US Federal Reserve tightens the noose

The US Federal Reserve, much to nobody’s surprise, raised interest rates another 0.25% for a target rate of 1.75-2.00%.

In the implementation note, they also stated the interest to be paid on bank reserves would be 1.95%, which is a departure from the usual top of the range (2%) by 5 basis points. This will probably pin the effective short-term rate at 1.95% instead of at 2%.

The other news, which is equally not surprising, is an increase in the repurchase amounts of treasury and mortgage-backed securities held by the reserve:

The Committee directs the Desk to continue rolling over at auction the amount of principal payments from the Federal Reserve’s holdings of Treasury securities maturing during June that exceeds $18 billion, and to continue reinvesting in agency mortgage-backed securities the amount of principal payments from the Federal Reserve’s holdings of agency debt and agency mortgage-backed securities received during June that exceeds $12 billion. Effective in July, the Committee directs the Desk to roll over at auction the amount of principal payments from the Federal Reserve’s holdings of Treasury securities maturing during each calendar month that exceeds $24 billion, and to reinvest in agency mortgage-backed securities the amount of principal payments from the Federal Reserve’s holdings of agency debt and agency mortgage-backed securities received during each calendar month that exceeds $16 billion. Small deviations from these amounts for operational reasons are acceptable.

This quota (currently $18 billion in treasuries and $12 billion in mortgage-backed securities per month) has been continually rising every quarter. Now this will be $24 billion and $16 billion per month, respectively.

As you can see by very far right-hand side within the chart above, the amounts involved are still a drop in the bucket – between July and September will be another USD$120 billion removed. But the slope of the curve, every quarter, will continue to get steeper and steeper.

Although short-term interest rates are still exceptionally low from a historical perspective, without a doubt the monetary situation is going to create an increasing headwind. This is akin to running on the treadmill and adjusting the elevation from flat to a 1% incline – while the running is still relatively easy, it takes a bit more energy to achieve the same distance. For each increment that the Federal Reserve raises rates, the incline gets higher and higher and eventually you’ll have to stop and catch your breath.

That’s probably the ideal time to invest again. Until then, safety and capital preservation is the name of the game.

Finally, my other comment is that I would view it as more probable than not that the Bank of Canada will match the Federal Reserve’s rate increase on their July 11th meeting.

Safe cash parking in USD

I’ve spoken about US dollar cash parking in the past (back in 2011!). Since then the offerings have not changed tremendously – the standard option is VGSH which gives you 2-year duration exposure to US interest rates. Whenever interest rate hikes abate, this ETF should do reasonably well – unless if there is a massive inflationary spike.

Interactive Brokers gives out 1.2% on US cash balances. This is not a terrible option if you don’t want to engage in transactions to eek out another 80 basis points or so of “nearly risk-free” money. However, other brokers generally don’t give out interest income on their idle cash balances and thus it makes it worthwhile to shop for short-term options if you have high cash balances while you wait for better investment options (as you can tell, I’m in that situation currently).

VGSH has been a perennial standby, but the duration risk over the past couple years really shows itself in the charts:

Interestingly over the past two weeks the 2-year US treasury dropped in yield from about 2.58% to 2.32% and hence this was enough to take the ETF up about 0.6% which is very unusual volatility historically. VGSH right now has a YTM of 2.5% and an MER of 0.07%, which still makes it very cheap for short-term exposure to 2-year AA-rated debt.

Still, one annoyance is that if you were unlucky to hit the rising interest rate lottery and be one of those September 2017 investors in VGSH, it can be annoying especially when you know you’re still in a tightening interest rate environment. Since 2011, there is an alternative ETF class that seems to offer a solution: target-date maturity ETFs.

In particular, BSCI will terminate at the end of December and contains investment-grade corporate ETFs that will mature throughout 2018. After June, the ETF will accumulate cash (by maturities) and invest the proceeds in T-Bills until the final termination at the end of the year. The yield to maturity on this fund is 2.17% and MER is 0.1%, so this is not a bad way to skim a couple percentage points while waiting. The ETF is also exceptionally liquid (spreads are a penny wide in size).

The main competitor to this is IBDH, and it is slated to mature on December 15, 2018. It is mostly the same product as BSCI except that it is already in its cash accumulation phase (47.5% in a short-term treasury fund). This will give 2.1% minus 0.1% in MERs. Liquidity is also typically a penny on the exchanges.

Barring a massive financial crash of cataclysmic proportions (e.g. something bigger than 9/11 – I’m thinking around the scale of multiple nuclear detonations in major US cities where we would have bigger problems than how to liquidate our investments from the radioactive ashes), these ETFs are modestly safer than VGSH by virtue of their lower duration. They seem to be a good vehicle to park cash in a rising interest rate environment.

The Canada-USA trade war is not going to end well

The US administration is using a tariff on steel and aluminum imported from Canada, Mexico and the EU. They had threatened to do that before in March, but exempted Canada and Mexico during that round (notably Prime Minister Justin Trudeau took “credit” for this). Now the tariffs are in place, effective yesterday.

Presumably this is part of a negotiation concerning NAFTA which hasn’t gotten the results the US administration wants.

Canada’s response is here, which they claim to consist of CAD$16.6 billion that the USA will levy against Canadians.

Included is not only steel and aluminum, but other household products. This includes yogurt, roasted coffee (although not decaffeinated!), strawberry jam, non-frozen orange juice… in other words, my breakfast is going to get 10% more expensive!

Here’s the big problem with the “tit-for-tat” strategy that Canada is employing: The USA has a lot more money than Canada does. If the USA decides to raise the stakes and put on another $50 billion in tariffs, what US imports are Canada going to go after next?

It’s pretty clear where this end-game is going to go – the purchasing power of the Canadian dollar will drop.

My other comment is that Ontario is the most sensitive province to steel and aluminum import tariffs. They are also undergoing a provincial election at the moment which has a strong possibility of a minority government (which means paralysis). Finally, Ontario is 40% of Canada’s GDP, so the US tariffs hit the correct part if the USA wanted to make some political impact. They clearly know what they’re doing.

Short-term Canadian Interest Rates

The Bank of Canada’s next interest rate decision will be on May 30th.

Pundits are saying the bank will stand pat, citing various economic statistics, trade uncertainty with NAFTA, lunar cycles, etc.

There is one other statistic that matters much more than others, and it is the following chart (10-year government bond yield):

As long as the spread between short-term rates and the 10-year yield remains greater than a percentage point, this gives them clearance to raise rates, especially when lock-step with the Federal Reserve.

My prediction, if it wasn’t obvious by the tone of the previous writing is, that barring some major change or news over the next week, the Bank of Canada will raise the short-term target rate to 1.5% (up 0.25%) on May 30th of this year.

Right now the 3-month Bankers’ Acceptance is at 1.69% which translates into 98.31 on the futures contract. Currently the June 2018 BAX Futures are trading at 1.81% (98.19), which also factors in some interest rate probability concerning the July 11, 2018 decision.

(Update, May 29, 2018: Given that 2, 5 and 10 year rates have dropped significantly in the past week, I’m withdrawing my prediction. Next cycle will depend on the rate spread between short-term and 10-year yields.)

Teekay Q1-2018: Still a leveraged mess

I won’t go into extensive detail over reading Teekay Corporation’s quarterly report (and daughter entities), but my summary is that the corporation and their daughters are still a leveraged mess.

The blood-letting at the Offshore (NYSE: TOO) subsidiary (no longer consolidated since Brookfield now formally is calling the shots) appears to be normalized, but management is on the verge of losing the Tankers subsidiary (NYSE: TNK). They just came to the realization that offering a dividend while trying to de-leverage the company is not so wise. The Tankers entity is bleeding cash with no recovery in sight. Shipping has been a miserable industry for half a decade now as overcapacity persists.

Teekay was trying to keep up the appearance of a minimal dividend since it was directly feeding into the cash flows of the parent (Teekay) entity, but the game is almost up – the only entity worth anything for Teekay is the LNG group (NYSE: TGP) which isn’t doing that badly – they are actually making money, but right now it is very slow in relation to the overall debt required to finance everything.

I wouldn’t be surprised if there was another debt crisis coming up for Teekay – why their January 2020 unsecured debt trades at around a 6.1% YTM is beyond me. I dumped out of their debt early this year (at 5 cents over par).

Teekay has value on its balance sheet as it does still own considerable equity interests in TOO, TGP and TNK, but operationally the only entity that will be feeding cash into it will be TGP, and immediate cash flows are going to be undoubtedly de-leveraging, especially as interest rates rise.