Quarterly Market Update
Fixed Income Outlook
A Hike in the Fed Funds Rate in 2015 of Greater than 0.50% Looks Increasingly Unlikely
It remains to be seen whether slow GDP growth in the first quarter was an anomaly, or whether the economy rebounds strongly in the second quarter as it did last year when the economy contracted 2.1% in the first quarter before expanding at a blistering 4.6% pace in the second.
The fifth-straight quarterly gain in the U.S. government bond market may be as much a function of historical trend as anything else. For four of the past five years, economic growth has dwindled in the first quarter only to rebound in subsequent quarters. Certainly, short-term interest rates will rise at some point, and the yield on Treasury bonds along with it. However, tepid U.S. economic growth and diminishing inflation are delaying the inevitable. The yield on the 10-year Treasury hovered close to the 2.0% mark for much of the quarter, climbing as high as 2.25% on stronger economic data before dropping as low as 1.64% during a flight to quality when data disappointed in late January. The yield on the 10-year Treasury ended the quarter at 1.92%.
Figure 1. The 10-year U.S. Treasury bond yield has fallen since the start of 2014, reaching some of its lowest levels in the first quarter, 2015.
No one anticipated when the Fed cut the fed funds rate to 0% in 2008 that we would stumble along in a zero rate environment for seven years. The Fed would now like to tighten interest rates, but has been constrained by a combination of factors including harsh winter weather, a west coast port strike, the collapse of oil prices, and a strengthening dollar, all of which have contributed to a slowdown in first- quarter GDP growth. Manufacturing has faded and the housing market has not recovered to the extent one would expect in the low rate environment. The bright spot in the data has been monthly payroll gains which have averaged close to 250,000 over the past several months.
Figure 2. The quarter closed with oil trading at about half of its 2014 peak. The Brent international oil benchmark averaged a price of $53.13 per barrel for the first quarter.
Although consumer confidence improved during the quarter, consumer spending remained rather anemic while the personal savings rate increased. It appears that the velocity of money concept that impacts central bank decisions to lower interest rates is also a relevant factor when it comes to the impact of lower oil prices on consumption. Just as it does little good for the Fed to lower interest rates if the reduction fails to stimulate lending, it does little good for gasoline prices to fall if the consumer does not push the savings through the economy by consuming more. Some pundits maintain that consumer confidence numbers are, to a large extent, directly correlated with and driven by gasoline prices. While an uptick in consumer confidence may sound bullish for the economy, it could actually be a benign indicator if it simply reflects consumers’ happiness over lower gasoline prices. Just because consumers are happy about lower gasoline prices does not mean they will spend the windfall. However, the longer gasoline prices remain low, the more likely consumers are to begin spending the extra cash.
The market continues to push the timing of the first rate hike further into the future, and the further out the hike is pushed, the more resilient the bond market becomes. After January and February’s strong employment numbers, 239,000 and 295,000 jobs added respectively, market expectations were for a June tightening. However, because of weaker economic data of late, the market has now priced-in a 10% chance of a June tightening, a 35% chance of a September tightening, and a 75% chance of a December tightening.
In the minutes of the last FOMC meeting, committee members revised their forecasts for the fed funds rate over the next three years. The forecasts are plotted as dots on a graph, and the resulting “dot plot” is the Fed’s best estimate of the future path of short-term interest rates. While the Fed kept the long-term target fed funds rate at 3.75%, it lowered the path to that rate over the next three years. This revision was yet another factor that kept bond yields down and prices up in the first quarter.
Yield Differential Drives Buyers into Treasuries
Another headwind delaying the first rate hike has been low interest rates in Europe. The ECB began its QE program on March 9 after the U.S. exited its QE program in October 2014. Twenty of the 25 countries in the Eurozone now have lower yields on their sovereign debt than the yields available on U.S. Treasuries. In Germany, you have to go to an eight-year maturity in order to get a positive yield on sovereign debt! The 10-year German bund now yields a paltry 0.18%. Japan has also engaged in QE, and yields there are also below those available in the U.S.
When a bond carries a negative coupon, the investor is not repaid the entire par amount of the bond at maturity. Similarly, the ECB began paying a negative rate on bank deposits in June 2014. For example, a deposit of $1,000 is carried on the books below $1,000, or at an amount equivalent to the negative yield. The negative rate effectively acts like a service charge on money deposited at the bank.
Figure 3. While the Fed has kept the long-term target fed funds rate at 3.75%, it has lowered the path to that rate over the next three years.
Low rates in Europe and around the world have pushed foreign investors into U.S. Treasuries which, despite their historically low yield, are actually attractive on a relative basis to foreign investors. In the most recent auctions of 3, 10, and 30-year Treasury securities, over 50% of the bonds sold were bought by indirect bidders, which include foreign central banks. Because U.S. interest rates are much higher and the U.S. dollar is strong, central banks benefit not only by earning more interest than they could domestically, but also by the fact that the rising dollar helps cushion any capital loss they would suffer as the result of rising rates in the U.S.
Corporate Bonds Flirt with Negative Yields
Corporate bond issuance in the first quarter was $450 billion, a 10% increase over the same period last year. The increased volume is being driven primarily by merger and acquisition activity and by corporations seeking to refinance existing bonds or add debt while rates are at historic lows. Low interest rates make mergers and acquisitions all the more attractive because the cost of financing the acquisition is so much lower. In one example, Actavis is buying fellow drug maker Allergan for $66 billion and paying for the acquisition in part with a $21 billion bond offering, the second largest corporate bond offering in history, behind the $49 billion Verizon deal in 2013.
Demand for corporate bonds has remained strong despite low yields and heavy supply. Indeed, corporate bond deals on average have been four to five times oversubscribed. Such strong subscription has led to deals being ultimately priced at yields that are 10 to 20 basis points below the “whisper yield” where investors initially expected the bonds to be priced. Investors are requiring very little “spread” or risk premium in exchange for assuming the greater default risk of corporate bonds versus Treasury bonds. Credit spreads formed a u-shaped pattern in the first quarter, falling throughout January before stabilizing in February. Spreads gradually widened in March, but not quite back to where they began the quarter.
For a time there was speculation that corporate debt might even come with a negative coupon. Apple sold a bond deal in Europe in February that was denominated in Swiss francs. That deal featured a 10-year maturity and a coupon rate of only 0.375%, priced at par! Apple is essentially getting free money for 10 years.
Figure 4. Low rates in developed countries, particularly Europe, have pushed foreign investors into U.S. Treasuries which, despite their historically low yield, are actually attractive on a relative basis.
Municipals Attract Crossover Buyers
Municipal bonds traded in the same direction as Treasuries in the quarter, but in a lower volatility range. Supply was heavy as refundings boosted the new issue calendar, accounting for 70% of all new issuance year-to-date compared to 47% for the same period last year.
Demand for munis remains strong. The Municipal/Treasury (M/T) yield ratio is very attractive, especially in the 10-year space where the ratio sits north of 100% as evidenced by AAA- rated municipal bonds yielding more than comparable maturity Treasuries on an absolute basis. Attractive M/T ratios tend to attract more non- traditional, crossover buyers who would normally only buy taxable bonds. The federal tax structure, with its 39% top bracket and 3.8% Obamacare tax, has also created a great deal of demand for tax-free income despite low yields.
Figure 5. Investors are requiring very little “spread” or risk premium in exchange for assuming the greater default risk of corporate bonds versus Treasury bonds, even at longer maturities.
The stronger payroll data necessary for the Fed to make a decision on the fed funds rate will not be available in time for the June FOMC meeting, making the possibility of a June tightening a long shot.
We anticipate that the yield on the 10-year Treasury will trade in a range of 2.25% to 2.50% at the end of the year, but the outlook is highly dependent upon GDP growth. It remains to be seen whether first quarter weakness was an anomaly and whether the economy rebounds as strongly in the second quarter as it did last year when the economy contracted 2.1% in the first quarter, but expanded at a blistering 4.6% in the second. If first quarter GDP comes in at say 1% or below, even if subsequent quarters post an average annualized growth rate of 3.5%, GDP in 2015 will still come in under 3.0%, making it difficult for the Fed to execute much more than a 50 basis point hike in interest rates before the year end.
There are a number of cross currents at play in the economy. The Fed will probably need to see more payroll data in order to determine how those cross currents impact growth. The payroll data necessary for the Fed to make a decision will not be available in time for the June FOMC meeting, making the possibility of a June tightening a long shot. We know that the energy sector will lose jobs as oil workers are laid off. What is not yet determinable is how much the strong dollar hurts exports and subsequently manufacturing, and therefore how employment in that sector will hold up. On the other hand, if lower gasoline prices finally boost consumer spending, then the consumer sector will positively impact economic growth and payrolls.
While the Fed would like to proceed with hiking rates, it cannot ignore the impact QE in Europe and other places is having on the U.S. dollar. Fed rate hikes will likely increase dollar strength and create more headwinds for U.S. companies deriving significant revenue from exports. In light of where interest rates are overseas, there is definitely damage to be done to U.S. companies, and therefore to employment, by raising rates too much or too early.
With regard to the corporate bond market, there is little reason for credit spreads to widen as we are headed into a quiet period until supply increases in August. However, if the economic data rebounds in the second quarter enough to justify a rate hike by the Fed, then we will likely see increased supply as companies continue the rush to secure financing before rates move higher. That increased supply could lead to modestly wider credit spreads on corporate bonds.
Demand for tax exempt bonds should remain strong because municipals, particularly at the long end of the curve, are somewhat inexpensive relative to Treasuries. Even if interest rates do begin to rise, the increase in yields on municipal bonds can be expected to lag the timing and amount of increase in taxable bond yields. That said, a barrage of new issue supply combined with a rising rate trend and increased inflation could result in a buyers strike whereby muni investors delay purchases in expectation of being able to buy bonds later at a lower prices. Such a scenario seems unlikely at the moment.
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