Quarterly Market Update
Fixed Income Outlook
Practicality May Drive Next Fed Rate Hike
October is historically the most volatile month of the year, and it could be even more so this year as investors engage in trading activity they might not otherwise undertake, attempting to get out of the way of the upcoming election.
A safe haven rally ignited by the U.K.’s vote in late June to exit the European Union pushed the yield on the 10-year U.S. Treasury to a record low of 1.32% on July 6. However, the tumultuous response dissipated as it became apparent that neither European or U.K. economic growth was going over the cliff. August was the calmest month for bonds since the 1960’s; the yield on the 10-year Treasury closed outside of the 1.50%’s only twice. Although volatility picked up in September after markets became increasingly nervous about central bank policy, the yield on the benchmark Treasury remained range bound between 1.50 to 1.75%.
Generally speaking, rates declined in the third quarter. The yield curve flattened as yields on the short end increased more than those on the long end. The yield on the 10-year Treasury was at 1.75% the day before Brexit, fell to an intraday low of 1.32% following the vote, and ended the quarter at 1.60%.
Corporate Bonds Outperform
Supported by the continuing yield grab and more stable oil prices, high yield bonds were the best performing domestic fixed income sector in the third quarter, followed by corporate investment grade bonds. Corporate spreads tightened at the end of August and then gradually widened. Generally speaking, the financial sector widened more than the industrial sector. However credit spreads across sectors ended the quarter tighter than where they began, thanks largely to the fact that the Brexit vote does not appear likely to have a material negative impact on U.S. corporate earnings, at least not in the near term.
It was a fairly active quarter for issuance as around $450 billion in new corporate bonds came to market. For the year, new issuance is expected to be above $1.3 trillion and is on pace to beat last year’s record of $1.5 trillion. New issuance in October will be particularly strong as businesses attempt to complete their financing needs in advance of the election and December FOMC meeting.
New regulation for money market mutual funds played a role in credit spread widening on the short end of the yield curve. New regulations require money market funds that maintain a stable $1 NAV to invest only in government securities. The NAV is required to float if the money market fund holds any commercial paper or other non-government security. Floating NAVs in cash deposit accounts do not work well for most institutions or individuals. Therefore, credit spreads subsequently widened materially as demand diminished for non-government securities maturing in one-year or less.
Municipal Bond Market Reaches 51 Consecutive Weeks of Positive Inflow
Tax-free money market funds were similarly impacted by the new money market rules. Where one-year municipals had been trading at yields ranging from 55 to 65 basis points for weaker names, yields increased to 75 to 90 basis points by quarter end. Those yields are materially greater than 100% of the yield available on Treasury Bills of around 60 basis points.
The municipal yield curve ended the quarter higher while flattening at the same time. The spread between two-year and 10-year municipal bonds ended at 69 basis points, the flattest the muni yield curve has been in three years. Unfortunately, credit spreads on municipal bonds are now quite tight and generating incremental return through credit spread compression is expected to be more difficult going forward.
Year-to-date municipal bond supply is $334 billion compared to $319 billion this time last year, and issuance is on pace to exceed $400 billion. New issuance in the first quarter was very slow, but the pace picked up in the third quarter when a number of deals were brought to address infrastructure needs. Heavy supply has been offset by steady demand – cash flows into tax-exempt bond funds have been positive for 51 consecutive weeks! The relative value of ten-year municipal bonds remains between 90% and 94% of 10-year Treasuries, where it has been trading for the past six months.
The low interest rate environment has been harmful to some, including financial institutions, insurance companies, senior citizens, and savers. That might be the reason the Fed finally hikes rates – out of a practical sense of helping a few economic and demographic sectors in hopes that improvement there stimulates broader growth.
October is historically the most volatile month of the year, and it could be even more so this year as investors engage in trading activity they might not otherwise undertake, attempting to get out of the way of the upcoming election. The fourth quarter could also be pretty volatile post-election with markets adjusting to a new president and new Congress. For the bond market, the makeup of Congress is more important than who is President. The bond market does not like one party governments which can push their agenda through without a great deal of checks and balances. We anticipate that the yield on the 10-year Treasury will end the year between 1.50 and 2.00%.
Although not exactly hung in a classic Catch 22, the Fed has at least become more sensitive to the impact of its policies on the equity market. The Fed is well aware that rate hikes typically have a negative impact on the stock market as well as the bond market. The “wealth effect” of a rising stock market has been one of the few legs on which global economic growth has had to stand. An equity market selloff induced by a Fed rate hike could easily reverse the wealth effect and cause economic growth to slow, thwarting the Fed’s intention of heading off would-be inflation without harming growth.
Even with massive Fed stimulus on the heels of an epic recession not seen since the Great Depression, post-recession GDP growth has not even reached 3% for a single calendar year. Such a weak bounce after recession is unprecedented. Historically, the deeper the recession, the greater the economic rebound that follows. However, this time around, the bounce has disappointed despite massive monetary stimulus, quantitative easing, yield curve manipulation, and a $4 trillion balance sheet. It appears that monetary policy is close to its limits in terms of impacting what is proving to be an efficient economy.
Calls for a fiscal response to weak growth are becoming more widespread and frequent. In previous cycles, recovery from recessions has been aided by both fiscal and monetary stimulus. This time around, the aid has come almost entirely from the Fed’s monetary actions. If Congress and the President were able to pass legislation that includes significant fiscal stimulus, and do it in a way that would not balloon the federal budget deficit (a tall order), then perhaps the economy could finally emerge out of its grinding malaise while corporate earnings also rise to a level more consistent with current stock prices.
Regardless of the slow economy, the low interest rate environment is hurting some, including financial institutions, insurance companies, senior citizens, and savers. That might be the reason the Fed finally hikes rates– out of a practical sense of helping a few economic and demographic sectors in hopes that improvement there stimulates broader growth. That said, we still anticipate a very weak-handed hike of only 25 basis points in December and that hike is still subject to payroll gains remaining solid, respectable retail sales, and ISM manufacturing and service indices above 50 between now and the December FOMC meeting. Longer term, the consensus expectation is for the fed funds rate to reach 1% by the end of 2017.
Last year, the rate hike in December dramatically increased market volatility, but the upcoming hike has been so well-telegraphed that we do not anticipate the same degree of volatility unless the economy gains significant momentum between now and the December meeting. If the situation plays out the way it did around the December 2015 rate hike, then the Fed will tighten on December 12, the market will go dormant around December 15, and the true impact of the rate hike will not be felt until January.
Corporate Bonds Set to Continue Outperformance
Corporate bonds should continue to outperform Treasuries simply because of their incremental yield spread versus Treasuries. Unless there is some unexpected unwind of the European banking system, we anticipate fairly stable corporate bond performance, and perhaps even relative outperformance, if the third quarter earnings season is supportive of credit spreads.
We expect the impact on the short-end of the credit curve from recent money market regulation changes to run its course and for investors to eventually buy short-maturity credits for the additional yield available. One area where the regulation could affect the bond market is with those companies that have typically borrowed in the commercial paper market. Demand for their paper has diminished to the extent that the companies may be forced to either raise the rate they pay on commercial paper to a point that attracts money or change their debt structure and go further out on the yield curve to borrow. As a result of the latter, we could see some additional supply come into the corporate bond market.
Municipal Bond Outlook Continues to be Strong
In municipals, we continue to see heavy supply as issuers take advantage of low rates before the Fed meeting. Any back-up in tax-free yields will be welcomed by the market as demand remains quite strong.
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