Quarterly Market Update
Fixed Income Outlook
Solid Justification for Interest Rate Hike Critical to Market Reaction
The situation in China may have tempered the recent flight-to- safety rally in the U.S. Treasury Market.
Despite the possibility of a fed funds rate hike in September, the U.S. Treasury market rallied in the third quarter, although not as much as one might have expected given the sharp selloff that occurred in the equity market. Demand for U.S. Treasury bonds jumped in August, driving yields to a two-month low after the People’s Bank of China (PBOC) surprisingly announced plans to devalue the Chinese Yuan, sparking chaos in the equity markets and a flight-to-safety in Treasuries. After having loosely pegged the Yuan to the U.S. dollar for many years, the PBOC’s devaluation on August 11 came as a surprise to the financial markets, sparking concerns that growth in China was weaker than thought, and the Fed might, consequently, be forced to postpone plans to raise interest rates.
In their effort to devalue the Yuan, the Chinese sold approximately $100 billion in U.S. Treasuries during a two-week period. At approximately $17 trillion, the U.S. Treasury market is the largest and most liquid government securities market in the world and China is its largest creditor, owning about 7.6% or $1.3 trillion of U.S. government securities. Given the size of their holdings, China has significant influence on the U.S. Treasury market, and China’s recent large-scale sale of U.S. Treasury securities may have indeed tempered the flight-to-safety rally, offsetting the safe-haven buying of investors running from the equity market. The yield on the 10-year U.S. Treasury only fell to a low of 2.0% before ending the quarter at 2.03%.
Figure 1. The yield on the 10-year U.S. Treasury trended down in the third quarter, pushing prices higher.
Corporate Bond Credit Spreads Widen for Second Year in a Row
Investment grade corporate bond issuance reached a record $1.2 trillion for the year-to-date despite the fact that a number of new offerings were postponed in the third quarter due to equity market volatility. The flight to safety in the Treasury market combined with the selloff in the equity market led to considerable credit spread widening in the corporate bond market in August. The difference or “credit spread” between ultra-safe Treasury securities and investment grade bonds is now on pace to increase for the second year in a row for the first time since the financial crisis began in 2007.
Such a trend has historically been a harbinger of economic problems. When investors are less confident about companies’ business prospects, they demand a higher yield relative to Treasuries. Currently, investors are concerned that economic weakness overseas could potentially spill over into the U.S. Indeed, BBB-rated and high-yield credit spreads are at their widest levels since mid-2012. Debt issued by commodity companies, particularly in the energy sector, and debt issued by certain companies in the industrial sector, like Volkswagen, has been sharply punished. Energy debt makes up the largest share of the high-yield debt (i.e., junk bond) market and when energy is in the tank the impact bleeds over to the entire junk bond market. Also, high yield bonds are somewhat hostage to equity market performance because as one moves down the credit quality curve, lower quality bonds perform more and more like equities in terms of volatility and sensitivity to economic conditions. Other factors contributed to credit spread widening in the third quarter. Strong investor demand over the past few years has pushed credit spreads to inordinately tight levels that are proving to be unsustainable. Additionally, broker/dealer unwillingness to inventory bonds could mean additional spread widening in a broad bond market selloff, especially given ETF redemptions. Credit spreads on A-rated and higher investment-grade bonds reached their widest at the end of August, bottomed around the first part of September, and have stabilized since then.
Figure 2. U.S. Treasury returns have beaten other domestic fixed income asset class returns for the third quarter and the year-to-date.
Municipals Take Their Cues from the Treasury Market
The municipal bond market took its cues from the Treasury market in the third quarter. The yield on the 10-year AAA General Obligation Bond began the quarter at 2.32% and ended at 2.03%, after starting the year at 2.01%.
While attractive on a relative basis, municipal bonds are near their lowest yields of the year. Municipal bond issuance has been moderate but higher than in 2014. Despite the increase, supply has struggled to meet the heavy demand for municipal bonds seen over the past couple of months. Regardless, the ratio of AAA-rated municipal yields to Treasury yields remains around 100%, creating strong demand for municipal bonds, even among crossover buyers who recognize good relative value versus other fixed income asset classes. States facing pension funding deficits have seen credit spreads on their debt widen or contract abruptly based on the headline of the day, but municipal credit spreads have otherwise been fairly constant.
The argument being made is that a fed funds rate of zero is an emergency rate, but the economy is no longer in an emergency situation
Level of Fed Funds Rate Remains Data Dependent
We anticipate that the yield on the 10-year Treasury will end the year at around 2.40%. While the Fed had enough cover from the data back in June to raise rates, that cover has pretty much disappeared – politically and internationally, particularly given the PBOC’s surprise devaluation of the Yuan. Tepid global growth, low inflation, and a strong dollar are making the Fed’s job difficult. While the Fed rate hike decision remains data dependent, we still expect an interest rate hike within the next three months. The argument being made is that a fed funds rate of zero is an emergency rate, but the economy is no longer in an emergency situation. As time passes, the pressure only builds to increase rates, but a solid justification for the hikes will be critical to market reaction.
Should economic conditions reach utopic levels of 5% unemployment, 2% inflation, and 2.5% GDP growth, the Fed’s job will be complete. The economy is on target to meet the payroll objective and is close to reaching the GDP growth rate objective, but there is considerable work to be done to get the inflation rate up to 2.0%. Some strategists believe that the non-accelerating inflation rate of unemployment (NAIRU) is now 4.5%, rather than the previously projected 5%. If true, then the unemployment rate may need to drop all the way to 4.5% before wage inflation increases enough to get overall inflation up to the 2% target. As has been the case for the last two years, bond investors remain in “wait and see” mode. The future path of Treasury yields will be a function of Fed movements and safe haven buying, if any. Also, by managing its currency, there is the potential for China to liquidate more U.S. Treasury securities which may prop-up rates. Some pundits believe that the rash of Chinese selling is not yet fully priced into U.S. Treasury securities and that a fairly large liquidation over the next months could change the market outlook.
Heightened Bond Illiquidity could Push Corporate Credit Spreads Wider
Certainly, the outlook for investment-grade corporate bonds will be influenced by conditions in China. Commodity and energy related corporate bonds have been hit the hardest, and there must necessarily be improvement there to see broader credit spread tightening in the corporate bond space. In addition, two factors could raise yields and widen credit spreads over the remainder of 2015. First, November and December are seasonally the strongest months of the year for equities which typically means interest rates move higher as growth/inflation fears intensify. The second factor is heightened bond liquidity risk. Regulatory changes have caused banks to decrease their corporate bond inventories as those inventories must be supported by high levels of capital in order to pass Fed stress tests. It is estimated that wholesale banking balance sheets that support traded markets have contracted 20% since 2010, and are expected to shrink by another 10% to 15% over the next two years due to tighter regulatory requirements. As the final two weeks of the year approach, dealers will likely be reluctant to add bonds to their inventory, creating a thinly traded market where credit spreads are biased to widen.
Pace of Municipal Supply Should Continue to Increase
We anticipate a pickup in municipal bond supply in October and November, but the market will pretty much shut down in December as broker/dealers empty inventories and new issuance disappears. Other than that, the municipal bond market will continue to take its cues from the Treasury market.
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Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), Bloomberg 7-10 Year U.S. Treasury Index (USG4TR), Morningstar U.S. Agency Bond TR Index (MSBIUATR), Municipal Bond Buyer 40 Index (BBMIRNEW), Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).