Posts tagged Fixed Income
As 2017 draws to a close, two data points strike us as particularly noteworthy candidates for summing up the year in asset markets. The S&P 500 is up more than 20 percent in total return, and the Fed has raised interest rates three times. Investors have good cause to bemoan the exit of Janet Yellen at the end of next month, for the good professor has given us an extended seminar in how to handle interest rate policy with minimal collateral damage either in financial markets or the real economy of goods and services. Incoming Fed Chair Jerome Powell has some large shoes to fill; fortunately he, by all appearances, has been a diligent student under Yellen’s tutelage over the past several years. He will need all the benign tailwinds he can get, because the road ahead may not be quite so calm as that we leave behind heading into 2018.
Follow the Dots
This week’s 25 basis point increase in the Fed funds target range was widely anticipated by the market (again, thanks to clear and prudent forward guidance). Investors quickly skimmed past the headline announcement to see where Fed minds were regarding policy action for next year: the famous “dot-plot” showing where FOMC voting members think rates will be in the coming three years and beyond. Very little has changed since the dot-plot’s last iteration in September, with the mean expectation of three more rate hikes in 2018. The lack of upward movement on rate expectations came at the same time that the Fed raised somewhat its expectations about economic growth and labor market conditions.
Dr. Pangloss’s Market
From an investor’s standpoint the market would seem reminiscent of Dr. Pangloss in Voltaire’s “Candide” -- the best of all possible worlds, with growth supported by still-accommodative monetary policy. That pleasing state of affairs, of course, comes courtesy of inflation that refuses to budge out of its narrow range of about 1.3 to 1.8 percent, depending on which measure you prefer. Markets seem satisfied this best of all worlds will continue. Even now, Fed funds futures markets ascribe only a 20 percent or so chance of even those three rate hikes occurring next year. An unexpected surge in inflation is quite likely the most impactful variable that could upset the present state of things. It would cause a rethink in the pricing of most assets, starting with intermediate and long term bonds. Intermediate Treasuries, in particular the 10-year note, serve as a proxy for the “risk-free rate” calculations used in valuing and pricing most risk assets. Disrupt expectations for the 10-year, and you disrupt most everything else.
The Curvature of Markets
In July 2016 the 10-year yield dipped as low as 1.36 percent, which by some accounts was the lowest yield for a benchmark risk-free rate ever in the 800-plus year-history of recorded interest rates. Today, the 2-year yield -- a short term reference benchmark closely tied to monetary policy trends -- is over 1.8 percent. With today’s 10-year around 2.4 percent, the spread between short and intermediate yields is lower (flatter in yield curve-speak) than it has been any time since 2007. Intermediate yields are affected by many market variables, but inflationary expectations are prominent among them. Briefly put: if that inflationary surge were to happen, there would be plenty of upward curved space for the 10-year yield to occupy. Up go all those discount rates used to make present value computations for risk assets. All else being equal, a higher discount rate lowers the net present value of a future series of cash flows. The calm waters of 2017 would likely seem a distant memory.
All that being said, there is no hard evidence today suggesting that this kind of inflationary surge is around the corner. Other factors, such as low productivity growth and hitherto modest wage growth, continue to keep consumer prices in check. But sub-2 percent inflation in an economy where unemployment is just 4 percent runs counter to all the data and experience that have informed monetary policymakers for the past seventy years. It has been a pleasant, if confounding, feature of the Yellen years. Figuring out where it goes from here may well be incoming Chair Powell’s biggest challenge.
There has been considerable chatter over the last week or two by observers and participants in the junk bond market. Prices for HYG, the iShares ETF that tracks the iBoxx US high yield bond index, started to fall sharply at the beginning of this month and continued through midweek this week, when investors mobilized for at least a modest buy-the-dip clawback. The chart below shows HYG’s price trend for 2017 year to date.
This performance has prompted the largest weekly investment outflows from the junk bond market in three years and sparked concerns among some about a potential contagion effect into other risk asset classes. It comes at a time when various markets have wobbled a bit, from industrial metals to emerging market currencies and even, if ever so briefly, the seemingly unshakeable world of large cap US equities. Is there anything to the jitters?
Pockets of Pain
We don’t see much evidence for the makings of a contagion in the current junk bond climate. First of all, the pain seems to be more sector- and event-specific than broad-based. While junk spreads in all industry sectors have widened in the month to date, the carnage has been particularly acute in the telecom sector (where average bond prices are down more than 3 percent MTD) and to a somewhat lesser extent the broadcasting, cable/satellite and healthcare sectors. The key catalyst in telecom would appear to be the calling off of merger talks between Sprint and T-Mobile, while a string of weak earnings reports have bedeviled media and healthcare concerns. High yield investors seem particularly inclined to punish weaker-than-expected earnings.
There gets to be a point, though, when spreads widen enough to lure in yield-starved investors from the world over. We have seen that dynamic already play out twice this year. As the chart above shows, high yield prices fell sharply in late February and late July, but were able to make up much of the decline shortly thereafter. So while pundits are calling November the “worst month of 2017” for junk debt, they are somewhat facetiously using calendar year start and end points that obscure the peak-to-trough severity of those earlier drops. We still have the better part of two weeks to go before the clock runs out on November, which is plenty of time for buy-the-dip to work its charms.
Bear in mind as well that there is very little in the larger economic picture to suggest a higher risk profile for the broader speculative-grade bond market. Rating agency Moody’s expects the default rate for US corporate issues to fall in 2018, from around 3 percent now to 2.1 percent next year. An investor in high yield debt will continue receiving income from those tasty spreads above US Treasuries (currently a bit shy of a 4 percent risk premium) as long as the issuer doesn’t default – so the default rate trend is an all-important bit of data.
About Those Investment Grades
Meanwhile, conditions in the investment grade corporate debt market continue to appear stable. The chart below shows yield spreads between the 10-year US Treasury note and investment grade bonds in the Moody’s A (A1 to A3) and Baa (Baa1 to Baa3) categories. Baa3 is the lowest investment grade rating for Moody’s.
Investment grade spreads today are a bit tighter than they were at the beginning of the year, and much closer than they were at the beginning of 2016, when perceived economic problems in China were inflicting havoc on global risk asset markets. In fact, investment grade corporate yields have been remarkably flat over the course of this fall, even while the 10-year Treasury yield gained almost 40 basis points in a run-up from early September to late October.
Investors remain hungry for yield and the global macroeconomic picture remains largely benign. Recent price wobbles in certain risk asset markets notwithstanding, we do not see much in the way of red flags coming out of the stampede out of junk debt earlier this week. A spike in investment grade spreads would certainly gain our attention, but nothing we see suggests that any such spike is knocking on the door.
There’s not much interesting going on in the stock market these days, even less so than in the August “dog days” of years past. Oh sure, the Dow breaks 22,000 and local news stations go into one of their predictable round-number happy dances (as if the Dow Jones Industrial Average were anything other than a quaint relic from the 19th century). The S&P 500 (a more useful proxy for the “stock market”) lazily drifts along, sporadically setting new highs on the gentle currents of decent corporate earnings and low, but fairly stable, macroeconomic growth. Volatility, that once-fearsome stalker of equity portfolios, seems to be on the cup of fossilizing into amber or the permafrost.
On the other hand, bonds – wow! Everyone’s talking about bonds, normally the portfolio slice over which investors don’t lose sleep. More specifically, everyone’s talking about what could happen to bond prices if central banks follow through on a combination of raising rates and reducing balance sheets. Safe to say that “Raise and Reduce” focuses Wall Street’s attention in the same crystal-clear way that “Repeal and Replace” engaged the gimlet eyes of health care activists in recent weeks. For much of 2017 to date, yields on longer-dated bonds like Treasuries and investment grade corporates have remained relatively subdued while rates at the short end of the yield curve have climbed in expectations of further rate hikes. But ever since Mario Draghi mused about the pace of recovery in the Eurozone in late July, intermediate bonds (in particular Bunds and other European issues) have been channeling much of that volatility that the stock market has lost. Investors reasonably want to know if their bond portfolios are safe.
History Compared to What?
The issue at hand is whether central banks will go ahead with all these “Raise and Reduce” plans. If they were to do so, and if intermediate and long term rates were to suddenly spike as a result, then all those supposedly safe bond portfolios would be in the crosshairs. The “bond bubble” you may have heard about if you tune into the financial news channels and their bespoke pundits contemplates this scenario. At some point, the argument will wind its way back to the phrase “historically low rates” to describe how, after plumbing the lowest levels in the history of the American republic a scant twelve months ago, there is nowhere for rates to go but up, and possibly up a lot.
But what exactly are these historical averages, we would ask, and how relevant are they to the current environment? Bond yields don’t exist in a vacuum; they generally are related to the rate of growth and, particularly, the rate of inflation in an economy. In this context, historical averages are misleading. The average rate of core inflation (consumer prices excluding the volatile sectors of energy and food) from 1960 to the present was 3.8 percent, and the corresponding average rate of real GDP growth was 3.0 percent. Over the same time period, average yields on the 10-year Treasury bond were 6.2 percent, clearly far above where they have trended for most of this decade.
Past Performance Indicative of Nothing in Particular
But this 57 year “history” is hardly homogeneous. The first half of the 1960s enjoyed the tailwind of a very unusual confluence of productivity growth and growing labor participation that began after the Second World War. Those trends had petered out by the early 1970s, replaced by lackluster growth and soaring inflation – the “stagflation” era that still gives central bankers nightmares and clouds their policy thinking. Growth resumed in the 1980s with the help of both household and corporate debt, then experienced a very brief spike in productivity in the late 1990s. An uneven pace of growth in the mid-2000s collapsed with the 2007-09 recession, leading us to the current era of slow growth, tepid wages and moderate consumer prices.
The chart below shows the GDP and inflation trends over this time period. If bond yields are supposed to reflect what the collective wisdom considers a reasonable reward for deferring consumption today for return tomorrow, then what does this past history tell us about where rates might reasonably be in the weeks and months ahead?
As we have argued numerous times in these pages, the case for long-term growth much above the current trend of around 2 percent is weak: none of the catalysts – population, labor force participation or productivity – are working in the right direction. What would drive sharply higher inflation, then? And in the absence of a genuine inflation threat, what would prompt central bankers – well aware of their status as practically the only relevant economic policymakers in the world today – to take draconian action to battle imaginary dragons?
One can never rule out the potential for human error, and central bankers of course are still only human. But we do not think that a collapse in bond prices arising out of intensely hawkish central bank maneuvers is a high or even moderate probability scenario as we chart out the final leg of 2017 market trends.
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.