Week ending October 17, 2014
A weekly newsletter
providing a synopsis of the latest market and economic
news and releases and a recap
of the securities markets. Find commentary for a wide range of
sectors: US equities, US Treasury, corporate, mortgage,
municipal and high-yield bonds,
global bonds and currencies, and emerging-market bonds.
|1 Yr Ago
|MSCI EM Index
|US$ / Euro
|US$ / British
|Yen / US$
as of 7:30 a.m. PDT
to Date (12/31/13 -10/17/14)
Jones Industrial Avg
|DJ STOXX Europe
|MSCI EM Index
to Date (12/31/13 -10/16/14)
High Yield Index
Morgan EMBI Global Diversified
||(UK) CPI YoY
||Inflation declined across the index in the UK, but a decline in fuel prices drove the dive. More important, prices increased at a slower pace than the Bank of England's expectations. Core CPI rose only 1.5% since last year
||(EC) Industrial Production WDA YoY
||Industrial production fell dramatically in August, dropping -1.8% since July. Weakness in capital goods and manufacturing production drove the decline
||(US) NFIB Small Business Optimism
||Small business sentiment fell due mostly to strong correlation with gas prices and the stock market. Expectations for the future were unchanged on the month
||(UK) ILO Unemployment Rate 3Mths
||Headline unemployment dropped 20 basis points on the month, as more full time employees registered in the data
||(US) Retail Sales Advance MoM
||Sales disappointed on the month, and even core retail sales (ex. motor vehicles and gas) fell -0.2. Non-store retailers saw sales decline -1.1%
||(US) Industrial Production MoM
||Strong gains in electric utilities output (4.5% MoM) and mining (1.8% MoM) drove annualized quarterly gains above 3%
||(US) Housing Starts
||Housing starts rose 6.3% on the month, in a return to strength. Building permits also rose 1.5% since the last month
||(US) Univ. of Michigan Confidence
||Consumer sentiment improved in October as consumers' economic outlook rose and their appraisal of current economic conditions held steady
Through the first half of 2014, many traders and strategists in the US rates market were convinced: the Fed was behind the curve. One Wall Street strategist was particularly adamant and summed up sentiment nicely: "The more rates markets believe in the lower neutral fed funds story the more it will be wrong. Because [sic] the longer rates stay too low the more it will boost the economy and hence inflation, and if inflation goes up faster then the Fed will have to hike faster and overshoot the neutral fed funds rate to keep inflation under control."
At the time such thinking might have seemed appropriate. The unemployment rate was falling fast (down nearly 1% in 2014). Growth began to rebound in the second quarter. Next, it was assumed, inflation would accelerate. The Fed itself forecasted a slow return to 2%. Certain low prices were "temporary." But inflation has hardly moved. We attribute at least some of the recent move in rates markets to a reassessment of this dominant story. The new conclusion: low inflation means later rate hikes. And the low inflation environment goes well beyond US shores. Core measures of inflation are +0.3% in Europe, 1.2% in the UK, 1.3% in Japan, 1.6% in China and 1.5% in the US. Low inflation means later rate hikes.
Evidence for the re-think comes from the Eurodollar futures market. In this market, investors trade contracts which price the future interest rate on 3-month dollar deposits outside of the United States. As the most inclusive short-term market for dollars, the Eurodollar market is one of the most liquid in the world. Because of its popularity, Eurodollar futures offer investors a view on the market's vision of the path of future short-term interest rates.
Below is a chart which plots the various Eurodollar futures contracts over a long time horizon. What we see is that in the past month, market participants have substantially revised down their expectations for the level of short-term interest rates. One month ago, the market envisioned the short rates at roughly 1.05% at the end of 2015 (that is roughly three 25 basis point interest rate hikes from current levels). Now, futures contracts clear at a rate of just 0.70% for overnight dollar deposits.
The re-pricing has profound consequences for the entire Treasury yield curve and for fixed-income securities in general. One needs only observe price action in bond markets in the past week to discover the chaos wrought by speculation over Fed policy. More specifically, though, if inflation continues to run below the FOMC's 2% target then interest rate hikes come later. If front end rates are lower and inflation remains subdued, we shouldn't expect to see interest rates out the yield curve move much either.
So what's the Fed to do? One approach: prolong QE. We don't like this because a) there is scant empirical evidence QE actually works in generating inflation (in our view and as evidenced by the absence of inflation despite 5 years of QE) and b) even the theoretical evidence is shaky (in the view of the world's foremost monetary policy theorist, Michael Woodford). Instead it is more likely that the Fed could push out market expectations of the first rate hike.
The US rates market finished a highly volatile week closely tracking risk market sentiment. On two separate trading sessions, the 10-year note broke below 2.00% for the first time since May 2013 as continued global risk-off fears drove the flight to quality bid. The price of the current 30-year note moved in a 7 point swing over the shortened holiday week but retraced most of the move to finish the session.
The market again pushed out its expected timing of the first rate hike though a number of Fed officials have pointed to June 2015 as appropriate timing. CME futures volume exceeded all-time records on Wednesday surpassing the US debt downgrade, Taper Tantrum and the Flash crash while open interest decreased on continued short covering. Given the drastic moves, liquidity remains thin with dealers unwilling to take additional risk on their balance sheets.
The U.S. Equity Market fell for the fourth consecutive week as weaker global economic growth concerns and fears of an Ebola outbreak set off a volatile week of trading. Negative investor sentiment has persisted in the broad equity market since the middle of September with the potential bottoming on Wednesday. At one point, the S&P 500 index erased all of the year-to-date gains after falling almost 10% from its year-to-date highs. The S&P 500 index closed the week down a manageable 0.6%, while the Dow Jones Industrial Average fell 1%. The NASDAQ Composite bucked the trend and closed up 0.2% for the week. Despite the spike in intra-day volatility, the higher beta small-cap stocks outperformed large-cap stocks. In terms of style, large-cap growth stocks outperformed large-cap value stocks. The best performing sectors were industrials and utilities, which were the only two sectors up for the week. The worst performing sectors were info tech and health care.
A full week of corporate earnings after 53 companies from the S&P 500 index reported quarterly results this week. So far, quarterly results have been better than expected with 76% of the companies topping earnings estimates. In fund flow news, Lipper reported that U.S. based equity mutual funds saw their third weekly redemption out of the last four weeks after investors withdrew $1.51 billion for the week.
Investment grade primary issuance did not come close to meeting expectations this week with a meager $6 billion pricing. Expectations were for $15-$20 billion of supply, but with the recent volatility in equities, companies in earnings "blackout" and dramatic swings in treasuries, most issuers were content to sit on the sidelines.
Lower risk appetite along with recent equity and rate volatility could cause issuers looking to tap the market to consider a more generous new issue concession in order to attract investors, which in turn, could cause secondary spreads to move wider. One notable deal this week came from JPM who brought a $2 billion 5-year. Initial price talk was at +100 area, had nearly three billion in the book and eventually priced at +100/5-year, which was roughly a 15 basis point new issue concession. It is currently trading at +94.
Investment grade corporate spreads were noticeably wider on the week with most of the widening happening the first two trading days, only to snap back marginally on Friday. The VIX index was up 13% on Wednesday to a year-to-date high of 26.25, now back down to 20.73, but still higher than the year-to-date average of 13.83. The Corporate Index Option-Adjusted Spread (OAS) finished the week at +120, eight wider on the week, but remains tighter than actual levels. Senior financials +5-7, sub financials +7-10, Metals/Mining +10-15, Media +5-7, Industrials +3-5, Tech and Healthcare +5-7.
In wild trading sessions, mortgages lagged Treasuries but recovered most of the underperformance by the end of the week. Plummeting oil prices, a roller-coaster ride in equities, and the Ebola crisis raised convexity fears as volatility spiked. Fortunately, mortgage secondary yields did not stay below 3.0% long enough to entice lenders to lower mortgage rates offered to borrowers.
Within the asset class, the market bifurcated as production coupon kept pace with Treasuries in the rally whereas higher, premium coupons trailed their hedges as market participants revised up their prepayment forecasts. The mortgage-Treasury spread on FNMA 3% 30-year mortgages closed flat at 71 basis points. In contrast, FNMA 4.5% 30-year mortgages widened 12 basis points.
In the programs, Ginnie Mae mortgages suffered from a lack of relative buying compared to their conventional, Fannie Mae and Freddie Mac, cousins. The price spread between GNMA and FNMA 3% mortgages fell from 1.75% to 1.62% points. In commercial MBS, a quiet supply week and little spread change as many investors watched the action in rates/credit from the sidelines. 10-year AAA-rated conduit bonds remain in the mid 80s versus swaps.
In this holiday shortened week, we did not see many shy away from new issuance as it was business as usual with plenty of supply across the different sectors. Prime Auto was represented by Volkswagen, auto leasing by Ally, and Dealer Floorplan by GE. CNH brought an equipment deal while Navient brought a private student loan deal. There were also a few esoteric deals in the market with a Hilton timeshare and a small green funding projects deal. All the deals were able to get done and priced, despite the four day week. It did feel like a few deals went slower than usual and some modest price widening occurred where needed.
Treasury rates rallied significantly in the first two trading days of this holiday shortened week. The story in the municipal market during this rally has been underperformance in the short 3-5 year part of the curve. For months we have highlighted the historically tight relationship between 3-5 year municipal and Treasury rates and the likelihood of a correction.
While we had originally leaned towards a basis widening for this correction, this underperformance has achieved the same outcome. Since October 1, 3 and 5 year Muni/Treasury ratios have gone from 62% and 69%, to 83% and 79%, respectively. This correction has narrowed the relative value trade into corporates that we've been taking advantage of recently. Some opportunities continue to exist but they will be concentrated in lower credit/wider spread corporate sectors.
This week's new issue calendar is approximately $6.6 billion, led by $1.1 billion New York Dormitory Authority Sales Tax Bonds and $765 million State of Washington General Obligation bonds. New issue deals were eagerly anticipated by investors as significant municipal cash remains on the sidelines. Most issues were re-priced lower in yield by almost ten basis points from five years and longer, with minimal drops by market participants resulting in modest allotments from underwriters. Municipal bid wanted activity was somewhat muted this week adding to the downward trend in yield levels. Mutual funds simply cannot replace calls and redemptions with limited new issue supply as fund flows remain mostly positive, totaling over $13 billion year-to-date. All-in-all, the municipal bond market appears poised to continue its trend to higher prices as limited municipal supply meets strong investor demand.
The high-yield market traded lower for the first few day of this week as softness in equities and worries over slower economic growth pushed the market lower. Thursday and Friday marked an abrupt reversal in investor sentiment as buyers flooded into the market and drove prices sharply higher. Flows in high-yield have been mixed as AMG reported an inflow of $1.28 billion last week, and a $549 million outflow this week. Trading in high-yield has been relatively orderly as compared to the dramatic price swings in equities as accounts focus on shedding out of favor credits and adding more desired positions at lower price levels. Secondary volumes continue to be robust with a predominance of activity in newer issues and larger capital structures.
Aside from a $500 million ten-year note brought by Nova Chemical Corporation, there was no new issuance this week. The market continues to absorb the $53 billion in new debt that has priced over the past five weeks. The recent spates of new issues had some pushback from buyers and were priced at relatively attractive terms for investors and this has helped these issues to better weather the market weakness. The forward calendar for new issue is almost bare as issuers wait for a more receptive audience. Expectations are for a quiet calendar for the balance of 2014 and a break in the recent flurry of new debt is anticipated to be beneficial to the performance of the high-yield asset class.
Global Bonds and Currencies
Major non-US sovereign bond markets ended almost unchanged after a very volatile week that was dominated by renewed worries about weak global economic growth and deflationary pressures in the Euro-zone. The week started with a US holiday and a downgrade of France's credit rating outlook to negative by S&P. Investors' risk aversion rose significantly mid-week and 10-year yields in major sovereign bond markets dropped 20-25 basis points on worsening economic data and record low Euro-zone inflation expectations figures. However, investor sentiment improved at the end of the week after the European Central Bank (ECB) announced its intention to begin its planned purchases of private-sector debt instruments, including covered bonds and asset-backed securities, within days. Ten-year Bund yields ended the week down about 3 basis points, while 10-year Gilt yields ended flat.
In peripheral Europe, sovereign government bond spreads over German Bunds were wider on fears of renewed recession in the region. Spanish government bond yields were also pushed higher by an unsuccessful bond auction, while Greek sovereign bonds came under significant pressure on suggestions the Greek government is considering an early exit from its IMF bail-out program.
In currency markets, the US dollar ended flat to weaker against the major crosses as investors assessed that some poor US retail sales data would discourage the Federal Reserve from raising interest rates any time soon. The greenback was lower against the Euro and the yen, which benefitted from safe-haven flows. The USD was also lower against the AUD in response to data showed Chinese imports rose in September. However the dollar was flat against sterling, which fell following comments by the Bank of England's Chief Economist warning that early monetary tightening may stifle the recovery.
Emerging market dollar-pay spreads widened to 330 basis points over US Treasuries, driven largely by the sharp decline in Treasury yields, while local yields rose to 6.56%. Emerging market currency performance was mixed against the US dollar; the Brazilian real (-3.0%) and Russian ruble (-1.8%) depreciated, while the Hungarian forint (+0.6%), and Romanian leu (+0.5%) gained.
Markets focused on sliding oil prices with Brent down 25% from the mid-2014 peak. Inflation prints across Asia showed steady deceleration in price pressure owing to softening oil and commodity prices. India reported September CPI at 6.5% year-over-year (y/y) significantly below consensus expectations of 7.2%. While base effects played a part, the lower inflation print was also attributed to lower food prices as well as declining crude. Similarly, Chinese inflation fell to 1.6% y/y, also supported by slowing food and commodity prices. The People's Bank of China (PBoC) lowered the 14 day repo by 10 basis points to shore up the domestic economy. A benign inflation outlook could create the space for further broad based easing by the PBoC through the rest of 2014.
The Central Bank of Chile (BCCh) lowered the policy rate by 25 basis points to 3.0% in line with market expectations. The minutes indicated that the BCCh has turned more bearish on global growth, particularly expressing concerns over lower commodity prices.
Emerging market debt funds saw outflows of $0.2 billion, slightly skewed towards hard currency funds.
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||(US) Existing Home Sales
||(US) CPI YoY
||(US) CPI Ex Food and Energy YoY
||(UK) Retail Sales Ex Auto YoY
||(UK) Retail Sales Incl. Auto YoY
||(US) Initial Jobless Claims
||(US) Markit US Manufacturing PMI
||(EC) Consumer Confidence
||(US) Leading Index
||(UK) GDP YoY
||(US) New Home Sales
||(US) New Home Sales MoM