Letter to the Shareholders: September 30, 2017

Dear Shareholder:

The Federal Open Market Committee (“FOMC”) met on September 19-20 and, as expected, left the federal funds target rate (“FFTR”) unchanged at 1.00-1.25%. The FOMC’s assessment of the economy was mostly upbeat; however, the FOMC acknowledged continued concern about persistently low inflation. Conventional economic theory would dictate that prices for goods and services should be moving up, not down, in an economy that’s in its ninth year of expansion and nearing full employment levels. The Fed continues to insist that this “lowflation” is transitory in nature and will correct itself. However, other prominent central bankers and economists think this may be a more worrisome problem caused by long-term structural issues impacting advanced economies (other countries are also experiencing this). I feel certain we will hear more about this lively economic debate in the coming months.

The FOMC’s updated “dot plots” which attempt to forecast the future path of the FFTR contained a mixed message. The FOMC’s near-term (2017 & 2018) median FFTR estimates were unchanged. Financial markets interpreted this data as mostly “hawkish” meaning that that the FOMC would likely move forward with one additional quarter point rate hike this year, followed by three additional quarter point rate hikes in 2018 (resulting in a FFTR of 2.00-2.25% by the end of 2018). However, the FOMC lowered its FFTR median estimate for the end of 2019 to 2.7% from 2.9%. It also lowered its longer-run median FFTR estimate to 2.8% from 3.0%. Financial market s generally interpreted these downward revisions to the FOMC’s longer-term interest rate forecasts as “dovish”, hence, the mixed message. From our perspective, the changes to the Fed’s forecasts on the longer end reinforce our belief that the “lower for longer” thesis remains a viable one.

In an announcement perhaps more important than its updated economic projections, the FOMC also stated that it will initiate its balance sheet normalization program in October.  In August of 2007 before the financial meltdown, the Fed had a balance sheet that totalled approximately $869 billion. In an attempt to pump more money into the economy and stabilize financial markets, the Fed implemented a series of quantitative easing (“QE”) measures starting in late 2008 that involved purchasing U.S. Treasury and U.S. Government securities, including those issued by U.S. Government agencies, in the open market. The FOMC ultimately stopped purchasing these securities, but a couple of years ago it introduced reinvestment as a sort of “QE Lite” which essentially has allowed the Fed to buy bonds without growing assets. The Fed’ s current balance sheet is estimated to be just under $4.5 trillion.

Under the balance sheet normalization program, the FOMC will begin trimming reinvestments in U.S. Treasury securities by $6 billion per month and mortgage backed securities by $4 billion. The cuts to reinvestment will be gradually increased on a quarterly basis until they reach $30 billion per month for U.S. Treasury securities and $20 billion per month in mortgage backed securities. The FOMC did not specify an end date to its balance sheet normalization program, but most economists speculate that the Fed will continue to shed assets until its balance sheet approaches the $2.0-2.5 trillion range. Even when the FOMC completes its balance sheet normalization program, it will have a balance sheet substantially larger than it has carried in the past.

Now that the FOMC has outlined its balance sheet reduction plan, the critical question becomes how this might impact financial markets and, more specifically, bond yields? The honest answer to this question is nobody really knows for sure. The fact of the matter is the FOMC is in uncharted waters. Fed Chair Janet Yellen has expressed hope that the reduction in the size of the balance sheet will be “like watching paint dry.” While it remains to be seen how financial markets actually respond, we think there are a number of reasons to believe that the market impact will be relatively muted.

First and foremost, the Fed’s balance sheet reduction plan is passive in nature. We think this is an important point because the balance sheet will ultimately be reduced, not by active sales of assets, but rather by phasing out the practice of rolling over maturing assets. By allowing the balance sheet to shrink in this manner over an extended period of time it should, in theory, maximize predictability and minimize potential market disruption. Financial markets do not like surprises.

Second, the Fed is set to reduce the size of its balance sheet by roughly $300 billion over the next 12 months. Keep in mind that this is a relatively small number in the overall scheme of things. In the aggregate, the G4 central banks around the world have expanded their balance sheets by approximately $11 trillion since 2009. A number of economists have noted that ongoing asset purchases by the European Central Bank and the Bank of Japan, both of which still maintain active QE programs, are sufficiently large to offset the assets shed by the FOMC over the next year.

Third, although this may be somewhat counterintuitive, there appears to be little correlation between the Fed’s ownership share of the Treasury market and yields. If you look at a graph of Treasury yields versus the percentage of total marketable Treasury securities held by the Fed, it reveals that yields have both increased and decreased in the periods after the Fed started purchasing assets. As a practical matter, the Fed’s share of outstanding Treasuries has been in decline since 2015, during which time Treasury yields have actually declined. A wide variety of factors affect bond yields. In short, we’re not convinced that bond yields will move significantly higher as a result of the Fed’s unwinding.

Our annual shareholder meeting will be held on Tuesday, October 24, 2017 at 10:00 a.m. at the Hilton Lexington Downtown Hotel which is located at 369 West Vine Street in Lexington. Proxies have been mailed beginning on September 20, 2017 to shareholders of record as of September 6, 2017. If you haven’t done so already, please sign and return your proxy so that we can ensure that we have a quorum at the meeting.

As always, we appreciate the confidence you have placed in us.


Very truly yours,
Allen E. Grimes, III
Executive Vice President