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Tweets at the and #FOMC

@federalreserve Don’t be afraid to #raiserates at #FOMC meeting. Don’t be afraid to sell some of your QE portfolio!

“But I still haven’t found what I’m looking for” -U2

he Minutes from recent Federal Open Market Committee (FOMC) meetings are filled with economic excuses. Whether it’s global equity volatility, the falling T commodity complex, one month’s unexpected weak nonfarm payroll report (i.e., May 2016 report) or Brexit, the FOMC has done a masterful job of finding any and all excuses to not raise interest rates. According to the often-followed Taylor Rule, at this level of economic activity, the rate should be at 3.45% by now. Yet, we are stuck at 0.5%. As in the U2 song, the FOMC still hasn’t found the data they are looking for.

While nominally Fed members have been stating that they are economic “data-dependent” in their approach to policy, empirically, they have been primarily financial markets- and geopolitical-dependent. Economic data has taken a back seat of late in terms of FOMC concerns, overshadowed by well-covered global events. As global equity markets sell off, the succeeding FOMC minutes lean towards dovishness; and as equity markets rebound, the hawkish verbiage reappears.

From a behavioral perspective, it is understandable for Committee members to be reactive to financial markets for several reasons. First, global markets act as an economic scorecard. Financial markets often reflect the efficacy of , providing constant feedback to policymakers. Second, the scorecard is easy to follow. Via Bloomberg, CNBC, Yahoo Finance,WSJ.com and others, anyone can find minute-by-minute values of significantly traded markets in a flash. Third, the media’s impact on our daily behavior is skewed because bearish events are often more newsworthy than bullish, and typically more impactful on our psyche. Plus, central bankers are often pushed to respond to headline events in press conferences, which offer free and rich content for news-hungry business media outlets. It’s easy to see why FOMC members react to changing global assets and events as they consider policy. We all do it.

I would wager, however, that the FOMC’s interest rate policy approach would change if members considered the change in value of global liabilities in the same manner they consider the volatility of global assets. Perhaps the language in the Minutes would not change as much if both sides of the economic ledger were considered. Unfortunately, none of us see the daily or minute-by-minute change in value of major global liabilities. Whether municipal or corporate, pension fund liabilities are not marked-to-market on exchanges. Similarly, we can’t get the daily mark-to-market of a life insurance company’s long-dated insurance policies. We know intuitively that these long-dated contracts are being

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negatively impacted by monetary policy decisions, but we’re not quite sure by how much; and out of sight . . . out of mind.

Just imagine if the economic value of major liabilities of enormous financial entities like How big are the major pension-driven CalPERS (California Public Employees entities? Retirement System) and CalSTRS (California Just how big is CalPERS? Based on assets State Teachers’ Retirement System) were quoted of more than $300 billion, CalPERS would on CNBC data-feeds or Bloomberg terminals for be the 5th largest insurance company in all to see. If we could see the recent skyrocketing the US, and the 10th largest bank, and this changes in value of IBM’s, ’s and UPS’ is an employee pension system for just pension obligations, we would see not only the for one state. There are going-concern pension systems for the 50 states, their enormous capital erosion of these pension plans major cities, and various corporate caused by global policies, but also pension plans as well. In addition, the top the massive interest-rate volatility that these 100 corporate pension plans have total entities contain. If the media covered the liabilities well in excess of $1.8 trillion. negative impact on these pension-related deficits with the same fervor as falling commodity prices or a Tesla blurb, then we might have an FOMC unafraid to raise interest rates. Members would see the significantly deleterious impact of global ZIRP (zero interest rate policy) in real time. More importantly, they would likely see that for many pension plans and financial institutions, their funded status (and capital) would likely outperform and improve if rates were to rise – even with a meaningful sell-off of global assets. This is a point worth emphasizing: a number of major economic institutions in the US have the opportunity to materially outperform if the Fed were to raise rates – or heaven forbid – were to sell some of its longer-maturing QE (Quantitative Easing) portfolio.

“It’s not time to worry yet” -Harper Lee

e continue to live in an abnormally low interest rate environment, which has exacerbated public and corporate pension underfunded status, and impacted the W capital profile of insurance companies and reinsurers (e.g., many publicly-traded insurers trade below tangible book value). Many of these entities have two things in common. First, they have extremely long-term liabilities – some with cash flows exceeding 40 - 50 years, and many with interest-rate durations between 10 and 15 years. Second, they often have assets that are less sensitive to changes in interest rates than their liabilities. Why have these entities been so severely impacted? Hasn’t monetary policy helped them? In short, yes and no.

Using the Global Dow Index as a proxy, global risk asset prices have increased, on average, 25% since the Federal Reserve initiated its QE portfolio in 2012, clearly helping the asset side of the pension equation. However, on the liability side, values have increased even more. Monetary policy initiatives like ZIRP, QE, Operation Twist (i.e., purchase of long- term Treasuries and selling short-term Treasuries), and the recent global bull-flattener rally of most major global interest rate markets (i.e., negative rates) have materially impacted discount rates for long-term pension obligors. This, in turn, impacts their funded status profile. Consequently, global monetary policy has done more harm than good for insurance and pension-related entities (i.e., institutional savers). Just how bad is it? It’s bad.

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U.S. corporate pensions funded at 76% on average in June 2016

In June 2016, according to Milliman, the 100 largest corporate pension plans had an overall funded status of 76%, as highlighted in the chart below. The funded-status trend has not been good even with recent all-time highs in the US stock market. The deficit amount for the top 100 plans is near all-time highs, with the aggregate underfunded amount now reaching -$447 billion in Milliman's 100 Largest U.S. Corporate Defined Benefit Pensions June 2016, worse by $140 110% 7.0% billion since December

105% 6.5% 2015. This means that the economic present value of 100% 6.0% pension-related liabilities 95% 5.5% has grown faster than global

90% 5.0% risk assets pumped up on central bank steroids. 85% 4.5% 80% 4.0% To appreciate the magnitude

75% 3.5% of a $447 billion deficit, the unfunded amount is more 70% 3.0% than the individual market capitalization of every stock Pension Funded Ratio (Left) Discount Rate (Right) in the S&P 500 index, except for Apple and , and is nearly 45% of the annual earnings of all 500 companies in the index. (Perhaps purely coincidental, neither Apple nor Microsoft have a qualified pension plan.) In short, plugging this pension hole will be a major future corporate earnings burden borne by shareholders. What’s more, this predicament is even worse at the municipal level, where the burden is borne by future taxpayers.

State and local public pensions funded at 74% in 2015

Last year, the largest 160 state and local public pensions were funded at 74% on a Governmental Accounting Standards Board (GASB) basis, according to the Center for Retirement Research at Boston College. Moreover, the aggregate unfunded liability among the group was $1.2 trillion in 2015. Although the aggregate was 74% funded, there was much variability among plans, with approximately 38% of plans funded over 80% and 20% of plans less than 60%. Some large state pension plans were funded at less than 50%. For example, the Illinois State Employees Retirement System was funded at 36%, and the Connecticut State Employee Retirement System was 43%. Extrapolating from Milliman’s corporate index, the municipal funded status is likely even worse in 2016.

Plus, the deficit amount could be much worse depending on which discounting methodology is used. There is much debate among practitioners, academics and regulators on suitable discount rates for municipal and corporate plans. Even the Federal Reserve uses a smoothing (i.e., mean-reverting) technique in evaluating pension liabilities, materially understating the economic exposure. However, in all cases, we know with reasonable certainty that the change in any pension discount rate will be highly correlated to changes in yields of long-term Treasuries. With 10- and 30-year Treasury yields near record lows, it certainly bodes poorly for any plan’s funded status – whether corporate or municipal.

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State and Local Pensions Funded Status How big is a $1.2 trillion municipal pension shortfall? It’s nearly three times larger than the comparable corporate burden and nearly four times larger than the combined 2016 state annual budgets of California, New York and Texas. That is a lot of future state and local taxes – approximately $8,000 per U.S. taxpayer.

It is essential to recognize that, at the municipal level, things will likely get Source: Center for Retirement Research at Boston College worse before they get better for two reasons. First, substantially all municipal pension plans are “open plans”. This means that they allow newly hired public employees to participate in the retirement system, ensuring that the number of active pension participants will continue to grow. This is unlike the corporate market, where a traditional open pension plan is now in the minority, largely thanks to the Pension Protection Act of 2006, which effectively discouraged the use of defined benefit plans in favor of defined contribution plans.

Second, many pension compensation packages (e.g., benefits calculated based on years of service and percentage of final salary) were designed in an environment where expected asset returns and interest rates were much higher than today. Thus, a new public- Ben S. Bernanke March 2015 service entrant is enjoying above-market “Ultimately, the best way to improve the benefits, rather than having future benefits returns attainable by savers was to…keep adjusted to reflect prevailing lower expected rates low…, so that the economy could recover returns. Not only is the municipal liability and more quickly reach the point of producing growing, it is being awarded at a premium. healthier investment returns.”

So, where the ultimate personal savings vehicle is a pension fund, operating in an environment of near and record stock markets, yet municipal and corporate savers are facing near record deficits. Well, Harper Lee, and the FOMC, maybe it is time to worry.

@federalreserve If u’re worried about #globalassets falling as interest rates rise, remember that #globalliabilities can fall even more

@federalreserve #raisingrates can be good for many entities

fter the Global Dow hit 2-year lows in mid-February, the March 16th Federal Reserve press release included the following statement: “However, global A economic and financial developments continue to pose risks.” But after financial markets quickly snapped back in March, this cautionary language disappeared in the April 27th press release. The message: all clear, safe to go back into the economic water.

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We can reasonably infer that the Fed believes that a decline in global risk assets poses risk, and a stock market rally eliminates risk. However, what if global markets reached record highs, yet global liabilities continue to go even higher (i.e., our current predicament)? Shouldn’t that “continue to pose risks”? And even more fanciful, what if global liabilities fall in value more than global assets? Shouldn’t that reduce risk? Let’s focus on how the latter can happen.

In evaluating the macro US pension complex (i.e., the 100 largest corporate and 160 largest municipal plans), not only is it important for monetary policymakers to consider the funded status of plans, but it is just as important to consider their hedge ratios (i.e., a plan’s asset and liability sensitivity to changes in interest rates). Recall that, on average, most corporate and municipal plans are unfunded by more than 20-30%, which means if they were private stand-alone entities, they would be bankrupt. What most don’t appreciate, however, is just how “short” pension plans are in terms of their exposure to U.S. interest rates.

Table 1: Pension Complex and Estimated Current Funded Status and Hedge Ratio

$ $ Funded / US pension complex assets US pension complex liabilities trillions trillions hedged % Asset allocation Liability Exposure Fixed Income Assets 30% $ 1.49 Fixed Income 100% $ 6.60 Global Risk Assets 70% $ 3.47 Global Risk 0% $ - Total 100% $ 4.95 Total 100% $ 6.60 75% Est. fixed income duration (yrs.) 6 Est. fixed income duration (yrs.) 15 Est. plan asset $ duration $ 0.09 Est. plan liability $ duration $ 0.99 9%

Most pension plans generally have hedge ratios under 25%, with “closed” corporate plans (i.e., new employees no longer eligible) having the highest hedge ratios and poorly funded “open” municipal plans typically having the lowest. This means that if and when long- term interest rates rise, the funded status of most plans (and especially municipal plans) could actually improve dramatically. The present value of the PBO (pension benefit obligation) could fall more than the value of plan assets – effectively, injecting capital into these entities without raising a single dime in taxes or impinging on corporate cash flow. Table 1 estimates the funded status and hedge ratio of the combined municipal and corporate pension universe. It is noteworthy that - even with an approximate 30% allocation to fixed income assets - the pension universe has such a low hedge ratio. This is due to the long-maturity profile of the PBO relative to the broader fixed income markets.

Thus, as the Fed considers scenarios of raising rates – or selling some of its $4.2 trillion QE portfolio (or at least not reinvesting), it should take comfort in knowing that, with such low prevailing hedge ratios, there is a high likelihood that the macro funded status of the pension universe will improve if long-term interest rates were to rise. Since plans are short duration by approximately $800-$900 billion, in order to be worse off in a rate-hike scenario, global risk assets would need to sell off dramatically. Table 2 below highlights a break-even scenario where interest rates rise by 100 , and global risk assets would need to sell off by more than 19% ($3.47T falling to $2.81T) for pension plans to be worse off versus their current position.

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Table 2: Rates Rise 100 bps – Global Risk Assets break-even analysis

$ $ Funded / US pension complex assets US pension complex liabilities trillions trillions hedged % Asset allocation Liability Exposure Fixed Income Assets 33% $ 1.40 Fixed Income 100% $ 5.61 Global Risk Assets 67% $ 2.81 Global Risk 0% $ - Total 100% $ 4.21 Total 100% $ 5.61 75% Est. fixed income duration (yrs.) 6 Est. fixed income duration (yrs.) 15 Est. plan asset $ duration $ 0.08 Est. plan liability $ duration $ 0.84 10%

Based on a garden-variety correlation matrix, which commonly suggest that changes in long-term Treasury yields are often positively correlated to changes in value of most global risk assets, the expectation should be for funded-status levels to improve markedly.

It is often said that worry is interest paid on debt that you may never owe. But in the case of the US pension fund complex, if the FOMC keeps worrying about “global economic and financial developments”, then pension funds might not be able FOMC’s unwitting municipal pension conundrum to service the debt it owes. Much of the Fed’s recent verbiage in rationalizing ZIRP has focused on global symmetry, such that while a saver is harmed

by low rates there is a direct offsetting benefit of lower capital Richard F. Dolan, CEO costs for borrowers, allowing the economy to prosper. First Principles Capital Management, LLC The problem with symmetrical analysis is that it breaks down when an unfunded municipal pension plan is introduced into the mix. With an unfunded plan created by low interest rates, the increase in value of the PBO isn’t offset by a change in value of publicly-traded securities. Rather, the offset is on the personal ledger of plan participants of their long-dated pension receivables, which they can’t value or appreciate – and where there is certainly no wealth effect.

Public-service plan participants have long-dated IOUs from their municipalities, most of which are collateralized by financial assets, while 20-40% is unsecured exposure. As long- term interest rates fall, the unsecured amount grows, and vice versa. If the unsecured amount gets too big, an unintended consequence could result where the pensioner may start to worry about the quality of the receivable, creating a potential negative wealth effect, confounding the FOMC.

The ultimate irony of monetary policy is that while QE was originally intended to spur , if left unchecked QE may eventually lead to deflation in the form of reduced wages from the retirement savings complex unable to meet future pension obligations. FPCM

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