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Reactions to the March FOMC - High Quality Credit Spreads

FICC Podcasts March 17, 2021
FICC Podcasts March 17, 2021

 

Dan Krieter and Dan Belton discuss their takeaways from the Fed meeting, and what it might mean for the path of credit and swap spreads.


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About Macro Horizons
BMO's Fixed Income, Currencies, and Commodities (FICC) Macro Strategy group led by Margaret Kerins and other special guests provide weekly and monthly updates on the FICC markets through three Macro Horizons channels; US Rates - The Week Ahead, Monthly Roundtable and High Quality Credit Spreads.

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Dan Krieter:

Hello and welcome to Macro Horizons, high quality spreads for the week of March 17th, reactions to the March FOMC. I'm your host Dan Krieter here with Dan Belton, as we break down an action packed March Fed meeting and what it might mean for the near term direction of both credit and swap spreads.

Dan Krieter:

Each week, we offer a view on credit spreads, ranging from the highest quality sectors such as agencies and SSAs, to investment grade corporates. We also focus on US dollar swap spreads and all the factors that entails including funding markets, cross currency markets and the transition from LIBOR to SOFR. The topics that come up most frequently in conversations with clients and listeners form the basis for each episode so please don't hesitate to reach out to us with questions or topics you would like to hear discussed. We can be found on Bloomberg or emailed directly at dan.krieter, K-R-I-E-T-E-R@bmo.com. We value and greatly appreciate your input.

Speaker 2:

The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries.

Dan Krieter:

Good afternoon, everybody. Dan and I here are recording this in the minutes following the conclusion of Chair Powell's press conference. And I think a lot to unpack from today's Fed meeting, maybe not in the statement itself. Actually very few changes to the statement from the January meeting, but a lot going on away from the statement. We have modifications to the SEP dot plot. We have some tweaks to the RRP and some tweaks to the counterparty limit there, which has some implications for both what the Fed might do in the future, as well as the short end now. And maybe some guidance on what to expect from the SLR. Obviously not very transparent. Maybe we should start there. Dan, what did we learn on SLR?

Dan Belton:

Yeah, it was interesting. I think it was the second question of the press conference and Chair Powell wouldn't go there. He was asked about the SLR and he just said, "We'll have something to announce in the coming days." He actually, I think let the reporter ask a separate question because it was a blanket no comment on the SLR, but the market took it as an indication likely that it would be extended. We had five year swap spreads bounce about a basis point and a half as much as almost two basis points on that statement from Powell. They've since retraced some of this move, but I think it's interesting that we didn't have anything from Chair Powell today. It's possible that they're waiting for a Friday afternoon sort of news dump to announce something that's politically somewhat unpopular. That seems to be one theory out there. What do you think?

Dan Krieter:

Yeah, I think let's look at what Chair Powell actually said, his quote or something close to it was, "We'll have an announcement on that in coming days." And so I agree, the market interpreted that as a sort of nod to the SLR. And I guess I have to agree because it's not the most groundbreaking analysis in the whole world, but they're making an announcement. And if the Fed was going to let the exemption expire, they would just have to do nothing. They would have to make no announcement.

Dan Krieter:

Now I get that there's been a lot of focus on this topic so maybe the Fed has to make an announcement either way, but if they were going to let it expire, I find a sort of hard to believe that they would make a separate, big announcement. Like, "Hey everyone, we're letting this thing expire." No, I think it's more likely the way you read it. They're going to tuck it into maybe a Friday afternoon slower part of the news cycle and put forth an extension, at least some form of an extension. I think your assessment to the market's reaction to it, yes, they priced in an extension. Yes, I think that's the most likely outcome at this point, but I don't think it's a given.

Dan Belton:

Yeah. I disagree somewhat about them allowing it to expire without an announcement. I think they would have to make some announcement, but I agree that's not necessarily the base case anymore, but the type of extension that the details around it are still going to be important. Is this going to be for Treasuries and reserves? Is it just going to be for reserves? I think that would be a pretty negative reaction from the market, but that's possible too.

Dan Krieter:

Yeah. And I think all options are on the table. I think we should talk about each of the possibilities in a bit more detail, but first I think just from a high level, it's worth saying, SLR is very likely going to be going away at some point in the next few months. In looking at say swap spreads, we approached the Fed meeting, anyone that reads our written material, knows that we were coming into the Fed meeting preferring to be long swap spreads for a couple reasons. First, we thought that the Fed would provide an extension to the SLR. That hasn't happened, but sort of we think it might. And also we thought that there wouldn't be any upward adjustments to IOER slash RRP. And there was not. There was, we'll talk about the RRP in a little bit, but again, met our expectations to expect some swap spread widening in reaction to the Fed.

Dan Krieter:

We've gotten that, but to underscore the whole point, SLR is going to go away at some point. This narrowing pressure that we've seen for the past couple of weeks, as a result of us SLR, it's going to return. We're in this pretty well defined range now with swap spreads. It's widened out a little bit in 2021, we've had more extremes, but still we're in a range. And if we do see spreads start to get up toward the top of that range, maybe when we see an actual extension to the SLR, particularly if it's say for a longer, maybe six months or includes both Treasuries and reserves, we could see another surge. And it's that point that you'd think about selling swap spreads. We're going to stay in the range I think no matter what. SLR is going to go away no matter what at some point. We want to take advantage of when we get to some of those more extreme observations.

Dan Krieter:

But looking at the potential format for an SLR extension we get here in the coming days that Chairman Powell alluded to, I guess I'll start with the length of the extension. So far three to six months has been what's thrown out most commonly, but do you think there's the possibility for an extension longer than that? Or even for these ratios to become permanent? And if not permanent, maybe for another year or two, because the question that was asked during the conference actually did explicitly mention the direct impact of monetary policy on the SLR.

Dan Belton:

Yeah. I think that goes to support the notion that maybe a more permanent exemption for reserves would be appropriate. This increase in bank reserves has been driven by the Fed and the level of reserves in the banking system is more or less fixed by the Fed. And so while reserves could be more evenly distributed among the banking system, the point is that it's something of a game of hot potato with respect to large banks holding reserves. And so I think you could see a more structural change to this rule by the Fed. Would that happen for Treasuries? I think probably not. It's more likely that the Fed is going to keep Treasuries in the denominator for the SLR. We could see something permanent for reserves.

Dan Krieter:

I agree with that assessment and it's an important distinction to make, because I think if you see a headline that the Fed has extended the exemption for reserves but will no longer have the exemption for Treasuries, whether that exemption expires after three months or immediately, whatever form this takes, I think the market's going to look at that as bad news for Treasuries. But I don't necessarily think that will be the case. We've done the full analysis and it's more reserves than Treasures that sit on bank balance sheets. And so if suddenly Treasuries have to count towards the SLR again, but not reserves. I don't think that that's going to precipitate too much selling. We've talked about already, even if you include reserves and Treasuries onto their balance sheets, they're still in compliance with the SLR just maybe not at levels that you'd consider comfortable.

Dan Krieter:

Well, if you exempt reserves, but now they have to include Treasuries, you're going to be above the minimum by even more than our analysis originally implied. You might not even be at a level where we have to sell any Treasuries at all or very little. There's still going to be some volatility around the SLR in the days ahead, whatever form this coming announcement takes, there's going to be some volatility. And it's at those times we want to try and take advantage. Depending on the wording there, depending on the length or depending on the format of the extension, there's definitely the possibility for it to be overdone.

Dan Krieter:

Dan, why don't we move on? Let's look at the modifications made to the RRP facility because I think that's something important we have to talk about here. Specifically, the Fed has raised the counterparty limit from 30 billion currently to 80 billion per counterparty for usage of the RRP. Dan why'd they do this?

Dan Belton:

Well, we've been talking a lot about issues in the repo market recently, which can most aptly to be described as a cash collateral imbalance, where there's a lot of cash in the system chasing a declining number of Treasury bills. And that has driven repo rates to the lower end of the Fed's target range. SOFR printed at one basis point on Friday and so the Fed's RRP facility is designed to kind of soak up some of this excess cash in the front end of the market. The increasing counterparty limits is an interesting decision by the Fed. I don't see it helping very much in the near term though. RRP volume over the past six months has never been higher than I think 11 billion on one day. And so the RRP facility is clearly not the binding constraint in the repo market, maybe down the road this increased counterparty limit could help but right now I think there's other problems that the Fed would need to address before this adjustment really makes much sense. I think increasing the RRP facility rate would be one step to doing that. What do you think?

Dan Krieter:

Yeah. I think you made the important point, 11 billion and not just from one counterparty, that's 11 billion in aggregate uptake on the RRP. What the Fed did today, not likely to have much of an impact. That doesn't mean it doesn't matter though. I think that the Fed taking this step sends a pretty clear signal to the front end that I don't think the Fed's going to step in to raise repo rates. I don't think the Fed is concerned with low repo rates. I think the Fed did what they did today to try and quell some potential market fears that SOFR could turn negative because negative SOFR would have some ramifications, particularly during the LIBOR SOFR transition here and an increased emphasis this year on moving some loan side people over to SOFR and that being a little bit further behind the curve.

Dan Krieter:

Having some concern of SOFR going negative, I think that's something that the Fed would want to potentially avoid. And what they did today does that. It's a preemptive move for sure. Because like you said, the RRP is the lower bound of the Fed's target rate. And the only way that SOFR goes negative then is if you somehow reach a point where the RRP reaches capacity and there's still so much cash that then you see short rates go negative. By raising the counterparty limits, the Fed is giving the street a bunch more capacity to absorb heavy cash supply into the RRP before SOFR goes negative. It's effectively saying here, SOFR can't go negative. Or at least for now here's the Fed indicating to the market that we are watching this and they pulled this lever to say that, "We're not going to let SOFR go negative. But other than that, don't look to us for much. We're not going to be giving you RRP or IOER raises probably maybe one at a maximum."

Dan Krieter:

It's an important indication that repo rates can stay very, very low for a while here just they can't go negative. And so what does that mean for us? For swap spreads it means we should see widening influence, which we've obviously seen post Fed, a sort of combination of both what they did to the RRP and the increased expectation for SLR extension that is hitting swap spreads here.

Dan Krieter:

On the credit side what does it mean? Maybe now LIBOR really can move lower. We've been sort of printing at this 18, 19, 20 basis point range for what? Probably the whole year that I can remember. Kind of just stuck here. And maybe now this is the market saying, okay repo rates, especially with the Treasury account at the Fed now, we've come down what? 300 billion it's supposed to come down and another four to 500 billion more in the next few weeks, there's going to be a lot more reserves. Downward pressure at the short end is going to remain pretty persistent here I think for the next few months and maybe LIBOR does continue to push lower. Maybe we see LIBOR at 16, 15, 14 if the expectation is that repo can stay in the very, very low single digits here in the near term.

Dan Krieter:

I think for credit, that's probably my main takeaway until we start to see some upward pressure just from potentially SLR exemption, but more importantly, coupon supply later in the year, maybe some bill supply coming. We did see today, also the IRS extending the tax filing date, which could mean a few more bills. There could be some more collateral. That collateral will have to build in the financial system though, over time. It's not going to be a magic wand. It's going to have to build over the next few months. And so maybe you do see LIBOR come down, which could be further downward pressure on credit spreads.

Dan Krieter:

But again, to bring it back to the point we made earlier on swap spreads, this is a range bound thing now. We adjusted our view on credit a couple weeks back where we no longer saw much upside to spreads getting to our targets of 85 basis points anymore. We got to 88. 85 just became too hard with the Fed seemingly not standing in the way of higher Treasury rates. And I think that view remains unchanged. If we get some performance and credit spreads here because of what the Fed did to RRP, because of an SLR extension that we're now expecting, that uncertainty there is going to start to diminish, which should put downward pressure on credit spreads.

Dan Krieter:

I think in the very near term in the next week or so, I wouldn't be surprised at all to see credit spreads coming in from current levels. But I think from a macro level, from a high level, the main themes driving our view to be neutral on credit here are not changed by anything that happened today. And just really reinforces the view that you maybe want to sell into the strength of some of these further credit spread narrowing episodes. And maybe to sort of transition to talk a bit more about that, we can talk about the press conference in more detail from a high level, Dan. Anything you took away from the press conference that you want to start with?

Dan Belton:

I thought it was a lot of the same from Powell. Most notably, he really stressed how much longer the labor market has to go before we reach full employment. I thought it was interesting, he talked about how the unemployment rate was an insufficient statistic. He said instead he favors other indicators, including the employment to population ratio, which if you look that up, that is at its lowest level, excluding 2020 and 2021. It's currently at its lowest level since about 1983. He talked a lot about the inequality in the economy and how the pandemic had a disproportionate impact on certain groups. To me that reads as very dovish. It's nothing new from Powell, but it's really emphasizing that there's a lot of slack in the labor market and the Fed is not going to move until we see that slack tightened significantly.

Dan Belton:

He mentioned a couple times that we have to get 10 million people back to work. And presumably the Fed is going to be sitting on hold, remain accommodative until that's done. While the Fed is pretty adamant that they're not going to stand in the way of rising Treasury yields in the near term, their dovish stance with respect to monetary policy generally remains pretty steadfast I think.

Dan Krieter:

Yeah, without a doubt, the accommodation is not going anywhere. To put it in his words or in a way to see actual progress on the economy, not projected progress. They're going to wait until the economic data actually shows tangible evidence, but I don't think that represents a change from what we were expecting. The Feds are going to be here with the combination for a long time. I actually want to focus on your second point that the Fed is not going to stand in the way of Treasury yields increasing.

Dan Krieter:

And I think they made that abundantly clear, specifically during Liesman's question, who I think is at this point reliable for the best question, almost every press conference, but he gave one to Chairman Powell. It was a three part question. And he said, "Can you comment on the level of long rates currently, whether or not you expect that to have an impact on the economy?" And then third, he asked a question about other central bank jurisdiction, specifically targeting points on the curve or sectors of the curve and whether or not that was something that was toward the top or the bottom of the Fed's toolkit. And Chairman Powell gave a bit of a non-committal answer. He talked about how financial conditions remain highly accommodative at this point and that the FOMC would be concerned if that were not the case. Fed speak pretty directly translated here, saying, "Rates have gone up, nothing has broken so we're fine still. If something breaks, we might reassess, but still nothing has broken so we're fine with the rates where they are now at higher plateaus."

Dan Krieter:

And then Liesman then followed up and sort of pressed him on specifically the rate targeting thing. And I think in his followup explicitly said the words, WAM extension, twisting maybe, just talking specifically about changing the nature of the purchases to target, specifically long end rates or even hinting at rate targeting, which we've seen the BOJ and other central banks talk about doing. And I don't know what you thought, Dan, but I thought that Powell really deployed some gymnastics here to not even really say WAM extension explicitly.

Dan Krieter:

He sort of just said, again, "What we're doing is appropriate. If that needs to change, we might reassess. We can always change the composition of our purchases," blah, blah, blah, blah. But what we're doing is appropriate. Wouldn't even say if it was towards the top of the bottom of the toolkit, just I think just basically steering clear of the topic entirely to make sure that he didn't imply that WAM extension was something the market should be expecting at any point here. I actually think reading between the lines, WAM extension, it's something that we've all been sort of anticipating this year, but I think the bar to a WAM extension is continuing to rise. What was your read on that?

Dan Belton:

Yeah, he talked a lot about disorderly conditions in markets and how the Fed would react to a disorderly move in Treasuries. But he said specifically that he wouldn't characterize this recent sell off in Treasuries as a disorderly move, indicating that yeah, he is comfortable with this continued increase in Treasury yields. My read on it was more that I think it's possible we still do get a WAM extension, but Powell would rather save that bullet for when he needs it so that by not even mentioning it, like you said, he has the capability to use that if he needs to, if there is a more ugly sell off in the Treasury market, down the road, then we can start to talk about those tools. But right now this has been a prolonged, slow grind, higher in yield and that's something that they're clearly okay with.

Dan Krieter:

And something we expect will likely continue as the economic data and the high frequency data and vaccinations and herd immunity continue to meet expectations. I think that upper pressure is going to continue, which means credit spreads are just going to really struggle to make new lows here. Even with very positive fundamentals you've talked about, upgrades, things of that nature. Just from a technical perspective, rates are going to keep going up. And I think here, we should just mention very briefly that corporate supply remains extremely, extremely strong and that we've started to see some cracks in those demand metrics. Not withstanding Verizon's huge deal, which was way over subscribed and performed extremely well. Really over the past week, we've seen, you wouldn't call it anything less than good transactions, but definitely some deterioration in the numbers, right?

Dan Belton:

Yeah. I think we sort of transitioned to a different type of market here where there's no longer this grab for yield that is overwhelming all other factors with investment grade primary deals. You've seen consistently positive, but still constructive new issue concessions. And I think we should expect to see that continue in the medium term, just investors being a little bit more discerning with respect to the deals they're participating in. This continued grind to higher end yield, like you mentioned, is a headwind for credit spreads, but it should entice some more investors into the market just from an all in yield perspective once Treasuries find their footing. But I agree with you that Treasuries are likely to continue to see some upward pressure as this recovery unfolds.

Dan Krieter:

Yeah, I like your point about maybe some more interest from outright buyers. It's just going to be a push and pull I think inside of this range here. Maybe we just sort of made the top end of the range in the low triple digits on credit spreads and maybe upper eighties is the lower end of that range. But I think we're going to be in this range bound environment for a while here with Treasury rates maybe grinding higher, but fundamentals still strong. And then it's going to be what's the next move?

Dan Krieter:

And I do think that will be wider. I think the Fed will at some point start talking about reducing extraordinary monetary policy support. I think eventually Biden tax policies are going to price in you're going to see a negative impact on risk assets there. I think that will be wider but I don't think that's soon. I think this range bound, looking to add at the upper end of extremes, maybe selling when spreads go back down into in the 90 to 95 area, I think that's going to be the way to play it for now. With an eye towards the next significant move, probably being towards the upside in credit spreads.

Dan Krieter:

Elsewhere in the press conference, I did want to mention Chair Powell's response to a question he received on financial stability. It's sort of a standard question he gets every press conference at this point, but I thought his answer this time was maybe more interesting than it has been in previous editions because he actually walked through all four pillars of the Fed's framework on financial stability, including asset valuation, household and business debt, funding risk and then financial sector leverage. And he talked about each one, well sort of, he didn't really talk about any detail in financial sector leverage so he did sort of forget that one. But the other three, he talked about in detail and I was surprised by his responses.

Dan Krieter:

He said, "Asset valuation, okay, there does appear to be some elevated prices compared to history." And the adjunct he used, I think that's pretty clear at this point. He talked about household and business debt, "Household debt," he said, "wasn't bad coming in. It's gotten a little worse, but there's been some stimulus so it's not really bad." Think that's true. No real concerns I've seen or that we share on the level of household debt, but business debt, as we were highlighting coming into the pandemic as being something to watch and it has gone up dramatically since COVID-19. And he said that, "Business had a high debt load coming in, but that they have a lot of cash on balance sheet," which is true. Saying that that wasn't much of a concern. Almost implying the Fed's looking at things from a net debt perspective and that on a net debt basis, that wasn't something they were concerned about. A little surprising there, but that was his takeaway.

Dan Krieter:

And then he talked about funding risk and said that, "There doesn't really appear to be much funding risk now." But this was actually where he spent his most amount of time talking about how the Fed really wants to investigate what happened about a year ago when liquidity broke down, specifically at the short end and that in the Fed's capacity as a regulator and overseer of the market that they wanted to, when they have time, analyze what happened in liquidity at this time last year. And my takeaway from it was, I'm not saying that the Fed said this, but my takeaway from it was that the Fed will be looking to try to prevent something like that from happening again, whether that's through new rules or what have you.

Dan Krieter:

And he also did, I think it's important to mention, he specifically said, I don't remember his exact words, but it was referring to shadow banks. He said, "Banks outside the financial system," or maybe he actually said shadow banks. I don't remember. But he specifically in the same sentence, put together a breakdown on liquidity and shadow banks. Potentially there being increased regulation around shadow banks in the future. I think there's been some speculation about that already, but coming from the Fed chairman, that might be something to expect coming in the years ahead. Nothing for today, but just something to keep an eye on. I guess, from a high level on financial market stability, Dan, I was a little surprised he didn't really seem concerned at all with the first two pillars. He didn't seem to have any concerns over asset valuations or business debt. What did you think on that?

Dan Belton:

Yeah, when he talked about business debt, he mentioned the improved financing rates that companies were allowed to borrow at given Fed policies. And I think that's a fair point. And as long as rates are going to remain fairly low from historical perspective, he's probably right about that. There is an increased risk of course. And we've talked about this a lot. We've talked about this, it's one of the reasons that we might not see sustained inflation, sustainably higher Treasury rates. There's a risk to corporations who are now extremely reliant on all this debt to higher rates.

Dan Belton:

And so, while I agree with his point that business debt is not as much of a problem because of these more advantageous funding rates, it could become more of an issue down the road. And then, yeah, it was a lot more of the same with respect to asset valuations. It's hard to deny that asset valuations are elevated right now and he, to his credit, didn't try to argue against that point. And a lot of that is more of a byproduct of Fed policy, but like he has said in the past, what is the Fed supposed to do? They had to engage in these unprecedented accommodative policies, given the shock that hit the economy last March. And there's no denying that that's had a significant impact on asset prices.

Dan Krieter:

And that's really it for what I wrote down. I think anything that's at least worth talking about. Did you have anything else? We didn't talk about the SEP. I'm not much of a dot plot guy. Yeah, they pulled forward some of their dots in 2022, I don't really care. Do you think that that's something we should talk about?

Dan Belton:

Yeah, it doesn't really seem like Powell likes talking about that either. He was repeatedly asked about that and just repeatedly that these are not a forecast. And I think it's important to keep in mind that these are coming from a lot of the regional Fed presidents who are not as in tune with the board of governors in the decision making center of the FOMC. I think that's something that I don't read too much into.

Dan Krieter:

Yeah. Longterm it's fair to start wondering if the dot plot might've just been a misstep and maybe we can get rid of it because you're right, a lot of the press conferences spent talking, there's a lot of interpreting of the dot plot. That's probably not meant to be communicated by the Fed and what it could mean, how certain things make sense in conjunction with each other. And I just don't think it always does make sense. And Powell says, "Yeah, don't read into that." I'm not going to put much stock into the dot plot. I don't think it really has much bearing on what the Fed is planning to do really. And I don't think the market should take it as such. Okay, nothing else?

Dan Belton:

No, I think that pretty much covers all that I've got.

Dan Krieter:

Okay everyone, thanks for listening to Macro Horizons and we'll see you next week.

Dan Krieter:

Thanks for listening to Macro Horizons. Please visit us at bmocm.com/macrohorizons. As we aspire to keep our strategy efforts as interactive as possible. We'd love to hear what you thought of today's episode. Please email us at Daniel.belton, B-E-L-T-O-N@bmo.com. You can listen to this show and subscribe on Apple Podcasts or your favorite podcast provider. This show is supported by our team here at BMO, including the FICC macro strategy group and BMO's marketing team. This show has been edited and produced by Puddle Creative.

Speaker 2:

This podcast has been prepared with the assistance that employees of Bank of Montreal, BMO, Nesbitt Burns Incorporated and BMO Capital Markets Corporation, together BMO, who are involved in fixed income and foreign exchange sales and marketing efforts. Accordingly, it should be considered to be a product of the fixed income and foreign exchange businesses generally and not a research report that reflects the views of disinterested research analysts. Notwithstanding the foregoing, this podcast should not be construed as an offer or the solicitation of an offer to sell or to buy or subscribe for any particular product or services, including without limitation, any commodities, securities or other financial instruments. We are not soliciting any specific action based on this podcast. It is for the general information of our clients. It does not constitute a recommendation or suggestion that any investment for strategy referenced herein may be suitable for you. It does not take into account to the particular investment objectives, financial conditions or needs of individual clients.

Speaker 2:

Nothing in this podcast constitutes investment, legal, accounting or tax advice or representation that any investment or strategy is suitable or appropriate to your unique circumstances or otherwise constitutes an opinion or a recommendation to you. BMO is not providing advice regarding the value or advisability of trading in commodity interests, including futures contracts and commodity options or any other activity which would cause BMO or any of its affiliates to be considered a commodity trading advisor under the US Commodity Exchange Act. BMO is not undertaking to act as a swap advisor to you or in your best interest in you to the extent applicable, will rely solely on advice from your qualified, independent representative making hedging or trading decisions. This podcast is not to be relied upon in substitution for the exercise of independent judgment. You should conduct your own independent analysis of the matters to herein, together with your qualified independent representative if applicable.

Speaker 2:

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Dan Krieter, CFA Director, Fixed Income Strategy
Dan Belton Vice President, Fixed Income Strategy, PHD



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