Posts tagged Fixed Income
Spring has come early to the US East Coast this year, with the good citizens of Atlantic seaboard cities ditching their North Faces and donning shorts and flip-flops for outdoor activities normally kept on ice until April. Grilling, anyone? Equity investors, meanwhile, have been enjoying an even longer springtime, full of balmy breezes of hope and animal spirits. But just as a February spring can fall prey to a sudden blast of March coldness, this week has brought a few hints of discontent to the placid realm of the capital markets. Whether these are harbingers of choppy times ahead or simply random head fakes remains to be seen, but we think they are worthy of mention.
Ach, Meine Schatzie!
Fun fact: German two year Bunds go by the nickname Schatz, which is also the German word for “treasure” as well as being a cozy term of endearment for loved ones. Well, these little Teutonic treasures have been exhibiting some odd behavior in the past several days. This includes record low yields, a post-euro record negative spread against the two year US Treasury, and a sudden spike in the gap between French and German benchmark yields. The chart below shows the divergent trends for these three benchmarks in the past couple weeks.
The sudden widening of the German and French yields offers up an easy explanation: a poll released earlier in the week showed National Front candidate (and would-be Eurozone sortienne) Marine Le Pen with a lead over presumed front runner Emmanuel Macron. That was Tuesday’s news; by Wednesday François Bayrou, another independent candidate, had withdrawn and thrown his support to Macron, easing Frexit fears. Yields fell back. Got that?
The Schatz yield also kept falling, though, as the dust settled on the latest French kerfuffle. Since German government debt is one of the more popular go-to markets for risk-off trades, we need to keep an eye on those historically low yields. This would be a good time to note that other European asset classes haven’t shown much fretting. The euro sits around $1.06, off its late-December lows, and equity markets have been fairly placid of late (though major European bourses are trading sharply lower today). But currency option markets suggest a growing number of investors positioning for a sharp reversal in the euro come May.
Gold Bugs and Trump Traders Unite
Bunds are not the only risk-off haven currently in favor; a somewhat odd tango has been going on for most of this year between typically risk-averse gold bugs and the caution-to-the-wind types populating the Trump trade. The chart below shows how closely these two asset classes have correlated since the end of last year.
Now, an astute reader is likely to point out that – sure, if the Trump trade is about reflation and gold is the classic anti-inflation hedge, then why would you not expect them to trend in the same direction? Good question! Which we would answer thus: whatever substantial belief there ever was in the whole idea of a massive dose of infrastructure spending with new money, pushing up inflation, is probably captured in the phase of the rally that started immediately after the election and topped out in December. During that phase, as the chart shows, the price of gold plummeted. That would be odd if gold investors were reacting to (higher) inflationary expectations.
Much more likely is the notion that gold’s post-November pullback was simply the other side of the animal spirits; investors dumped risk-off assets in bulk while loading up on stocks, industrial metals and the like. In that light, we would see the precious metal’s gains in early 2017 more as a signal that, even as Johnny-come-lately investors continue piling into stocks to grab whatever is left of the rally, some of the earlier money is starting to hedge its gains with a sprinkling of risk-off moves, including gold.
None of this should be interpreted as any kind of hard and fast evidence that the risk asset reversal looms large in the immediate future. Market timing, as we never hesitate to point out, is a fool’s errand that only ever looks “obvious” in hindsight. An article in the Financial Times noted today that the recent succession of 10 straight “up” days in the Dow Jones Industrial Average was a feat last achieved in 1987, with the author taking pains to point to the whopping market crash that happened the same year. He waited until the end of the article to deliver the punch line: anyone who took that 10 day streak as a sign to get out at the “top” of the market forfeited the 30 percent of additional gains the Dow made after that before its 20 percent crash in October (do the math). Ours is not a call to action; rather, it is an observation that dormant risk factors may be percolating up ahead of choppier times.
Fed-watching isn’t quite the sport it was one year ago. The investing herds these days tend to be more fixated on tweets than on dot-plots. Nonetheless, the FOMC will meet again in eleven days, and what they decide to do (or not do) in January and beyond will have an impact on fixed income portfolios. The consensus wisdom is that rates are likely to rise. But direction is only one aspect of managing interest rate exposure; the other is shape – as in shape of the yield curve. Short and intermediate term rates have done anything but move in lockstep over the past several years. We think it is a good time to step back and consider the variables that may be at play in influencing the shape of the curve in the coming months.
A very odd thing happened the last time the Fed engineered a sustained policy of rate increases. The chart below shows the Fed funds target rate going back to 2000, along with the 2-year and 10-year Treasury yields.
The Greenspan Fed began raising rates in June 2004, taking the Fed funds target rate from 1.0 percent to 5.25 percent over a two year period (the green dotted line on the chart shows this ascent). Short term market rates moved accordingly; the 2-year yield started moving up ahead of the Fed, probably due to the expectations game and a sense that economic recovery was at hand. Longer term rates, though, barely moved at all. In fact, by the time the policy action topped out, the yield curve was essentially flat between 2-year and 10-year maturities.
Greenspan pronounced himself confused by this and called it a “conundrum.” His successor Ben Bernanke had done his own homework, though, and figured out what was going on. Many central banks around the world, particularly in Asia, had been burned by the currency crisis of 1997 and subsequently embarked on disciplined programs of building up their foreign exchange reserves. Meanwhile China, which had emerged relatively unscathed from the ’97 crisis, had its own reasons for stockpiling FX reserves: it was a means of keeping its domestic currency from getting too expensive while the country’s value of exports soared. What are all those FX reserves comprised of? Treasury securities, mostly. So the Greenspan conundrum was nothing more than good old fashioned supply and demand; as foreign central banks built up ever-higher mountains of reserves, the demand kept Treasury prices up and yields down. The effect was more pronounced at the intermediate and long end of the curve, which tend to be less influenced by domestic monetary policy and more influenced by other economic variables.
As the above chart shows, the expectations game with short-term rates has had some crazy moments in the past few years. Note, first of all, that the 2-year did not follow the Fed funds rate all the way down to zero as the central bank responded to the 2008 recession and market crash. The 2-year hung around the one percent level for much of the time until the second half of 2010 – the time leading into when the Fed launched its second wave of quantitative easing. The 2-year finally converged with the Fed funds (the upper band of the zero – 0.25 percent range) after the Eurozone crisis and debt ceiling debacle of summer 2011.
But the expectations game began anew in 2013 when then-Chair Bernanke mused openly about tapering the QE activity, Since that time, despite a handful of reversals, the trend in short-term rates has been resolutely higher. Market expectations ran ahead of the Fed, falling back only in 2016 when the FOMC blinked on successive occasions and held off on rate increases.
Yellen and the Tweets
While short term rates moved decisively off their 2011 and 2013 lows, intermediate rates once again behaved very differently. The 10-year yield actually set an all-time low in 2016 – yes, that was the cheapest 10-year debt has ever been in the history of the American republic. Again, the culprit appears to be supply and demand. In an age of negative interest rates, the meager two percent yield is king. Demand from institutional investors like insurance companies and pension funds, pushed out of other sovereign markets from the Eurozone to Switzerland and Japan, allocated larger chunks to intermediate and long Treasuries.
What does this mean for the remainder of 2017? A rational assessment of short-term movements, based on where rates are today and assuming the Fed goes through with at least two more rate hikes over the year, is that short-term rates might nudge up another 50 basis points or so. At the short end of the curve we think floating rate exposure remains attractive as a defense, particularly if the expectations game gets ahead of itself again.
The bigger challenge lies in those intermediate exposures. Negative rates still persist in Swiss and Japanese 10-year paper, but intermediate Bunds have trended decisively higher in recent weeks. The reflation trade that took hold right after the US election has meanwhile pushed the 10-year Treasury within striking distance of three percent. If the first month or so of the new administration gives the market cause to wrap itself even more tightly around this theme, then it may be a very painful year for fixed income portfolios. On the other hand – and we tend to see this as a more likely possibility – if the Trump trade is already overextended then we would expect to see less drama in the middle and long end of the curve, and still-healthy demand from those yield-seeking institutions.
An orderly and gradual rate increase policy was no doubt at the top of Janet Yellen’s list of New Year wishes. The overall economic environment would seem ready to cooperate with that intention. But she will have to deal with the possibility that tweets will do more to shape the curve than will dot-plots.
In this space last week we presented a case for “guarded optimism” in risk asset markets, regardless of the outcome of the presidential election. Then the Tuesday Surprise happened. It would be reasonable for one to ask us whether we are still of that cautiously optimistic view we expressed one week ago, and that will be our theme this week.
Sound and Fury
First of all, let us be crystal clear about one thing. When the subject of politics comes up in any of our weekly commentaries, our discussion is limited to how we perceive the directional impact of political events on equities and other risk asset markets. Donald Trump’s Electoral College victory has major potential implications for the U.S. and the world at many levels. Both of us have our own personal views about the outcome. But our focus here, as it is with any subject we present in these pages, is simply to share with our clients and other readers our assessment of how this development may affect their long-term investment portfolios.
As of today, our view is very little changed from where it was one week ago. Yes – futures markets plummeted through circuit-breaker levels as the results trickling in from North Carolina and Florida illuminated Trump’s path to 270. And yes – a few inclusive-sounding words by the President-elect, delivered in a relatively calm, measured tone in the wee hours of the morning, succeeded in reversing those overnight losses ahead of a Wednesday rally. That’s short-term noise, and while we could see more of that play out over the next couple weeks, we do not see as likely any sustained directional trend one way or the other proceeding from the simple fact of Trump’s victory.
Beyond the short-term sound and fury, we see three critical questions that could set the tone of markets in the first half of next year and beyond. First, will the new administration insert itself into Fed Chair Janet Yellen’s realm of monetary policy in a way that upsets central bank-dependent asset markets? Second, how will the economic priorities of Team Trump impact particular industry sectors and, by extension, the sales and earnings prospects of publicly traded companies? Third, will those same economic priorities live up to the often inflammatory, dangerous rhetoric on foreign trade that came up in the course of the campaign?
The Last Democrat
Among her other claims to fame, Janet Yellen now has the dubious distinction of being the last Democrat in Washington, D.C. with any meaningful power. The President-elect’s personal distaste for her is well-known and was featured prominently in the campaign’s closing ad messages. We think it unlikely, though, that the new president would play footsie with a possible market crash by taking concrete action in his first year to limit the Fed’s ability to independently execute monetary policy. Yellen’s term expires in January 2018, and odds are better than not that she will be replaced then by a Republican Fed head. Trump would have little to gain, and a great deal to lose, by stirring up trouble in the Eccles Building any time before then.
That is not to say that the risk of a White House – Fed confrontation does not exist as a possible 2017 surprise. In particular, it will be interesting to see how Trump and his new economic advisors react if, as expected, the Fed reactivates its rate hike program starting in December. Notoriously unpredictable as a candidate, it remains to be seen how restrained Donald Trump will be as president. We will be studying the tea leaves of formal policy speeches and off-the-cuff Twitter remarks alike in the coming weeks to get a better sense; for the time being, anyway, we would expect a more pragmatic approach to relations with the Fed at least within the next twelve months.
The Return of Fiscal Policy?
One of the first ways we expect 2017 to be unlike every one of the last eight years is that fiscal policy – i.e. actual legislative action targeting areas of economic stimulus – will be a real part of the conversation. In 2009 the Republican Congressional leadership more or less designed a tactical program around denying the Obama administration opportunities to implement economic policy. They didn’t always succeed – most notably in the 2009 stimulus package responding to the Great Recession and then in the 2010 passage of the Affordable Care Act – but by the time of Obama’s reelection in 2012 fiscal policy was by and large not a viable part of the economic equation. That has changed with the looming imminence of one-party rule. When we hear various ideas floated around – infrastructure spending, corporate tax reform, and stimulus programs for coal and other non-renewable energy sources are examples currently making the rounds – we have to assume they can actually become law and have an impact for better or worse.
One practical consequence of this is that sector picking may be back in vogue, as armies of quants tinker around with algorithms designed to follow the direction of putative fiscal policy initiatives. We already see signs of how this will play out; just since Wednesday morning, for example, the healthcare sector has been cleaved into subsectors with very distinct, uncorrelated trading patterns. Republicans on the Hill are baying for an immediate repeal of the Affordable Care Act, with little sense of what if anything is to replace it. That exposes health insurers to much uncertainty. On the other hand, expectations of an ultra-light regulatory touch are boosting the shares of drug manufacturers and biotech firms.
Trade or No Trade?
Ultimately, corporate earnings will depend on far more than U.S. fiscal policy. The IMF revised its estimates for global growth next year down in its most recent quarterly assessment. Both output and demand remain below historical norms in most developed as well as emerging markets. Weak foreign demand and a strong U.S. dollar are likely to continue to weigh on earnings and profit margins. That was going to be true regardless of who won on Tuesday night. Both campaigns took a relatively hard line against global trade; again, though, the fact that the executive and legislative branches all went Republican means that – to be blunt about it – if the new administration wants to start a trade war then it will be well within the realm of possibility to implement protectionist legislation.
Somewhat along the lines of our thinking that Trump would not likely rush into an immediate monetary policy confrontation with Janet Yellen, we think it less than probable that he would strike up a trade confrontation with China as an opening economic policy salvo. We have to imagine that somewhere in his economic transition team are voices to convince him of the unfavorable cost-benefit equation of such action.
There will be plenty of pressure from outside Washington to live up to his campaign rhetoric, however. It is not lost on anyone, least of all on traditional conservative free-traders who populate D.C. redoubts like the American Enterprise Institute and the Heritage Foundation, that the margin for Trump’s victory was delivered by voters who have largely been on the losing side of the global economy’s distribution of fortunes. The President-elect will soon enough have to confront the dilemma of pro-trade, pro-growth policy versus the strong protectionist impulses of the newly-empowered working class Republican base.
So there they are: monetary policy, fiscal stimulus and approach to trade are the three open questions at the top of our list of priorities. As we said last week, connecting the dots between the current direction of macroeconomic trends and corporate sales & earnings – i.e. the overall narrative that long predated the election – offers enough grist for at least a cautiously optimistic take on asset markets as 2017 gets underway. Whether we stand by that view as the year progresses will depend in no small part on how we see the evidence shaping up to provide answers to these three questions.
It’s just a natural continuation of conventional monetary policy, say the central bankers who have unleashed the hounds of negative interest rate policy – NIRP – into the capital markets. The Swedish Rijksbank is the latest to join the club, setting the key bank overnight repo rate at minus 0.5 percent. Even stranger than the rate itself was the accompanying announcement, part of which read thus: “Growth in the Swedish economy is high and unemployment is falling, which suggests that inflation will rise in the period ahead”.
Got that? Sweden’s economy, in fact, is growing at a clip of around 3.5 percent, or more than twice that of the Eurozone. If US GDP were growing by anything close to that rate it’s a pretty sure bet that Janet Yellen & Co. would be hiking rates with nary a second thought. What possible reason could there be for Sweden, then, to send rates below zero? “Global uncertainty” was the phrase the Rijksbank deployed in that same press release, along with a vague reference to recent inflationary weakness. “Everybody else is doing it” seems to be the underlying context, though, and that has the makings of a potentially dangerous trend.
Wonderland Not So Wonderful
We took note in this column a couple weeks back of the Bank of Japan’s joining Club NIRP. Now, as with any easy money policy, two key motivating incentives for negative rates are a weaker currency (to improve trade conditions) and higher domestic asset prices. How’s that working out for Japan so far? Consider the chart below, showing recent trend performance in the Japanese yen and the Nikkei 225.
In fact, the currency and the stock market have both done exactly the opposite of what the BoJ would have hoped. The Nikkei 225 has fallen by more than sixteen percent since the beginning of February, while the yen has strengthened by 8 percent against the dollar. Oops. The point to make here is simply this: NIRP is not, as claimed, simply an extension of the conventional easy money continuum. It is a whole new territory, an unknown land where the normal rules of finance do not necessarily apply. That NIRP is going viral around the globe is, in our opinion, cause for considerable concern.
Here Be Dragons
There are many facets to our concern about the NIRP contagion. A central one is its impact on the financial sector. The fruits of this impact are already visible in the form of a global bear market for the shares of financial institutions. Banks have to hold a certain fraction of their liquid assets in the form of central bank reserves. When the cost of holding these reserves goes up they need to make up the difference elsewhere, either in raising lending rates (counterproductive to growth) or in venturing into riskier lending areas (counterproductive to risk-adjusted capital adequacy). Again – a key objective of any easy money policy is to funnel money back into the economy via bank lending and accelerate its velocity. All the quantitative easing of the last six years has failed to accomplish this objective. It seems a great stretch to imagine that, suddenly, credit demand is going to materialize out of nowhere in response to negative rates. The banks, meanwhile, will have to figure out how to adjust their business models to remain profitable.
The reasoning behind NIRP is also flawed in terms of its capital markets objectives. Negative interest rates have spread into a widening swath of fixed income instruments, primarily (though not exclusively) government bonds. Five year German Bunds currently trade at negative yields, as does the Swiss ten year note. That’s right – if you buy a Swiss government bond and hold it to maturity you are guaranteed to lose money. What NIRP does, then, is to take low-risk assets and make them riskier – a complete perversion of standard capital market theory.
No Country for the Prudent Investor
Bear in mind that institutional investors like pension funds and insurance companies are required by their investment policy statements to hold sizable percentages of low-risk assets in their portfolios. Part of the NIRP objective is to make safer assets less attractive to stimulate purchases of riskier assets like stocks. But a prudently managed pension fund cannot simply take itself out of short term bonds and dump the money into small cap stocks. In this way, again, NIRP is counterproductive.
Finally, NIRP could potentially achieve the opposite of what it wants in terms of guiding inflation back up to those elusive 2 percent central bank targets. Think again about that ten year Swiss government bond we discussed a couple paragraphs above. Nominal bond yields are comprised of two sections: an expected real return (i.e. what the investor expects to earn from the investment after inflation); and inflationary expectations. Say for example that a certain ten year bond yields five percent and that inflation is expected to run at two percent for the next ten years. So that bond’s real return would be three percent and the inflation expectations component would be two percent. Easy math.
In light of that example, what does a yield of negative 30 basis points (about where the Swiss ten year is today) tell us about investor expectations? Only that for a rational investor to hold that security, the investor would have to believe that the most likely price trend for the next ten years would be deflation. If the average price of goods and services in the economy were to fall by one percent annually for the next ten years then it would make sense to invest in a bond, the slight negative return of which would still preserve purchasing power. Of course, deflation is exactly what financial policymakers want to avoid.
Expectations matter in explaining economic behavior and outcomes. The advanced-math models central bankers use in arriving at policy decisions have been shown to be demonstratively poor in accounting for the expectations factor. Want proof? Go back to that chart showing what the yen and the Nikkei 225 did in the aftermath of the BoJ’s NIRP decision. Expectations matter, and central banks ignore them at their – and our – peril.
Interest rates are once again the trending topic as anticipation for the Fed’s June policy meeting next week grows. Last week we considered the potential impact of a Fed rate hike on equities and the possibility of a pullback. This week we shift the focus to what the Fed action might mean for your fixed income portfolio. Back at the beginning of the year, most economists predicted that the Fed would decide to raise rates in June – meaning next week. But after a string of weak economic data the consensus was pushed back, possibly even to next year. That being said, recent data including nonfarm payrolls and this week’s retail sales have been strong. A September rate move looms large, meaning that it is important to make sure that the fixed income portion of your portfolio is positioned accordingly.
Investors say Junk Bonds are indeed “Junk”
An article in the Financial Times this week focused on outflows in high yield bond ETFs since the beginning of June, citing rising rates as a driver. This does not necessarily mean that you should get rid of your high yield exposure in anticipation of rising rates. High yield (or junk) bonds have been found in the past to be less interest rate sensitive than other investments. Rising rates can indicate an improving economy, which in turn means a better environment for companies with poor credit ratings (those companies are the ones issuing high yield bonds). For these and other reasons, junk bonds tend to trade more like equities than bonds – the Barclays US Corporate High Yield Bond Index is 74% correlated to the S&P 500 versus only a 16% correlation to the Barclays US Aggregate Bond Index over the past five years.
In fact, for much of the past year high yield prices have actually moved in the same direction as benchmark interest rates. As rates fell through the second half of last year, junk prices fell as well. When rates rose on the back of good economic news in February of this year, high yield prices performed well. Where this pattern broke decisively was just a couple weeks ago, when the 10-year yield spiked and junk bonds tanked. In other words, if recent outflows are being driven by rate perceptions, that would seem to be more of an anomaly than the “junk bonds fall when rates rise” rule suggested by the Financial Times’ article.
There are two sides to every coin, and more risks to take into account than the directions of interest rates. Call risk affects any bond with call features, and this includes the vast majority of high yield bonds. Most high yield bonds have a maturity of 10 years but are callable at 5 years. In a falling rate environment these bonds tend to get called because the borrowers can then reissue the same bond with a lower interest rate, meaning their borrowing costs fall. In a rising rate environment the opposite will happen – the bond won’t get called because it would have to be reissued at a higher duration. Investors holding callable bonds can get the worst of both worlds – lower duration when rates fall and higher (i.e. more negative price sensitivity) when rates rise. When positioning portfolios for a rising rate environment it is important not to ignore the implications of call risk.
Ever heard the disclosure “past performance is not indicative of future results”? The above chart illustrates why that regulatory disclosure is always worth keeping in mind. Even though junk bonds have historically performed more in line with equity markets than with fixed income, over the past eight months the correlation has been spottier than usual. Junk bonds mirrored equities until October, when stocks experienced a deep pullback. High yield followed stocks down, but then kept falling while the S&P 500 pulled a stunning V-shaped recovery.
Why the divergence? A considerable number of junk bond issuers are energy exploration and production companies, and the energy sector led the broader market down as oil prices were plunging. So even though the S&P 500 enjoyed a sharp recovery, investors dumped high yield bonds fearing a rise in energy-related default risk. A similar story happened back in 1999 and 2000: during the period of high volatility leading up to the implosion of the tech sector in 2000 (which also happened to be when a rate hike program was in place) junk bonds had a negative return and underperformed other asset classes.
When in Doubt, Diversify
Because it has been awhile since the last Fed policy decision to raise rates (eleven years to be exact), it is difficult to predict how the scenario will play out this time. The more recent data we have on rate hikes happened in the context of a 30 year macro bull market for bonds. If we are about to enter a secular rising rate environment (and we don’t know for sure if this is the case), the most recent comparable data we have to work of off is from 1951 – 1981 – it is safe to say that the world is vastly different now than it was back then. Quite possibly, we are entering into a whole new world of rising rates.
There are some logical assumptions we can make, though. Investments that are less interest rate sensitive (as indicated by shorter effective durations) are more likely to perform better in a rising rate environment. High yield bonds fall into this category, but as we saw above there really are no guarantees. It is more prudent to adjust your allocation accordingly in different market environments rather than to either eliminate an asset class altogether or double down on the one you think (based on past performance) likely to do best.
Floating rate debt, short-term fixed rate issues, agency & non-agency mortgage backs and asset backed securities can potentially help immunize your exposure to interest rate risk. As noted above, don’t forget about call risk. The bottom line is that when the terrain is uncharted, a well-diversified portfolio is likely to be the best way to avoid missteps.