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Fed Chair Powell focuses on the consumer, and so do we

Timely insights from portfolio managers and industry experts on key financial, economic and political issues.

The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness.

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      By Matthew Buckley, CFAInvestment Grade Fixed Income Portfolio Manager, Eaton Vance Management

      Boston - On Wednesday, during a press conference after the Federal Open Market Committee (FOMC) announced another 25 basis point cut in the target rate, U.S. Federal Reserve (Fed) Chair Powell said that "monetary policy is supporting household spending and home buying by keeping the labor market strong, worker's income rising and consumer confidence at high levels."

      That almost perfectly reflects our investment thesis as we evaluate the market for asset-backed securities (ABS). In our view, the backdrop for employment — arguably the most fundamental factor sustaining consumer sentiment — has remained robust. So as interest rates have come down, mortgage issuance for new purchases and refinancing (refi) has accelerated, which has given the consumer more discretionary income. That, in turn, has helped to boost spending on durable goods like autos, as well as nondurables.

      It came as no surprise to us, then, to hear Powell describe the effects of more accommodative monetary policy on various kinds of consumer activity, citing strong durable goods sales and housing as key contributors to growth. Among the components of U.S. gross domestic product (GDP), personal consumption expenditures (PCE) rose 2.9% in the third quarter, more than economists had expected.1 And with their investments in the stock market reaching new highs, consumers may have even more confidence to sustain a strong U.S. economy.

      Keeping an eye on the financial obligations ratio

      Using statistics obtained from the National Income and Product Accounts, the Fed calculates the household Debt Service Ratio (DSR) as the ratio of total required household debt payments to total disposable income. For our purposes, we pay attention to the Financial Obligations Ratio (FOR) — a broader measure that also includes rent payments on tenant-occupied property, auto lease payments, homeowners' insurance and property tax payments.2

      Lower interest rates have helped to limit the financial obligations ratio. ChartFOR_99q2@19q2_680px

      Source: Federal Reserve Board. Household financial obligations as a percentage of disposable personal income; seasonally adjusted from 1999 Q2 to 2019 Q2. https://www.federalreserve.gov/releases/housedebt/default.htm

      Even though the debt/income ratio may be relatively flat over time, the FOR we observe has come down because rates on mortgages, auto loans and other forms of non-revolving credit (with fixed repayment schedules) are lower.

      Investing in housing-related securities

      Among our investments in this sector, we've been more interested in residential mortgage credit than in agency mortgage-backed securities (MBS). Refis have been positive because they tend to delever the structure, removing risk from the pools where we have exposure.

      Lest there be any fear that the perils of cash-out refinancing may come back to haunt us, we don't see a material issue now — not with lending standards in the mortgage market remaining tight and debt/income ratios moderate.

      Along with stimulating mortgage refis and new purchases, rate cuts help to sustain home price appreciation (HPA), which also supports mortgage credit. And we've found opportunities in the homebuilders and home center retailers that have benefited from elevated HPA.

      Admittedly, overall affordability and ability to pay could be tested today because of monthly expenses relative to income. Thanks to the rate cuts, however, monthly payments can be lower even if the loan value is higher. For a simple example, refinancing a $100,000 loan at 5% with a $105,000 loan at 4% would still result in a lower monthly payment.

      Considering other rate-sensitive investments

      Apart from the impact on consumers and residential MBS, we have exposure to commercial MBS, where rate cuts have also facilitated refis. That's been supportive of cap rates3 and continued commercial property price appreciation, helping to sustain values in our commercial MBS investments.

      Overall, with interest rates low and the yield curve unusually flat, we've seen corporations extend their near-term maturities. That gives them a better liquidity profile, which has been positive for the stability of the corporate bond sector, as well.

      Bottom line: After reducing one source of liabilities through lower mortgage rates and refis, the consumer has become stronger. Add to that the advantages to corporate borrowers, and lower rates have been beneficial across many of our exposures.