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Market Commentary

Ken Leech
Chief Investment Officer

In the Book of Life, the answers aren’t in the back. ~Charles M. Shultz (1922–2000), American Cartoonist

Executive Summary

  • Bond markets have gyrated between pessimism and optimism this year. Currently markets are optimistic and October saw a substantial rally in spread sectors.
  • We have maintained a cautious optimism throughout the year, changing tactical positions to adjust to variations brought on by investors’ mood swings.
  • October’s bounce-back was gratifying, but the low and declining global inflation rate suggests it would be wise to keep an eye on downside risks and utilize appropriate macro strategies.
  • In terms of Fed policy, Fed Chair Janet Yellen has emphasized that investors should be more focused on the path and trajectory of the rate-hiking cycle rather than the specific liftoff date.
  • There have been some interesting developments in the interest rate swap market, where LIBOR swaps are currently yielding less than Treasuries over all maturities ranging from 3 years to 30 years. As a value investor, it is very hard to pass up relative value opportunities that we believe will win if held to term.

This mid-quarterly note comes in three parts. First, we discuss this year’s market developments and our positioning. Second, we discuss upcoming Federal Reserve (Fed) policy. Last, we have a brief overview of the interest rate swap market.

Market Developments

Fixed-income markets have gyrated wildly this year, constantly shifting from pessimism to optimism and back. Early in the year, plunging oil prices and fears of European recession pushed German bund rates to near 0%, while 10-year US Treasury yields hit 1.6%. Then optimism returned with the spring, as growth sentiment about the US and Europe improved, oil prices stabilized in the $60s, stock prices rebounded and so did bond yields. During the summer, expectations of global growth dropped sharply, driven by fears of a pronounced slowdown in China, and knock-on fears for the emerging market (EM) sector as a whole. All this led to the most brutal performance for spread sectors since the euro crisis of 2011.

Exhibit 1
Excess Returns by Sector (In Basis Points)
Source: Barclays. As of 30 Sep 15.

Presently, optimism has returned, and October saw a substantial bounce-back in spread sectors. We think this optimism is predicated on the belief that global monetary policymakers are headed in the right direction. With the US showing stronger growth than other regions, a policy mix of relative tightening here opposite easing in Europe, China and Japan seems right. While global economic data have not really strengthened, there has been enough stability in the news that fears of a global recession have receded.

Our cautious optimism hasn’t changed much over the course of the year, and we have changed our tactical positions to “fade” the market variations brought on by investors’ mood swings. In our last note, we discussed our recent positioning, which was to take advantage of the widening in yield spreads for spread sectors, particularly investment-grade corporates. October’s spread sector rally has been gratifying, but we can’t yet sound the “all clear.” The contrast in the storyline between decent US growth and a still-fragile global recovery means risk markets will be susceptible to periodic pullbacks, even while we find the pricing for risk markets to be attractive. Moreover, the low and declining global inflation rate and accumulating EM weakness suggest that it will be prudent to keep an eye on downside risks and utilize appropriate macro strategies.

Fed Policy

We strongly believe the Fed has been determined to raise the funds rate off the zero “emergency” level and that it will finally move in December. The Fed stayed its hand when international markets were clobbered over the summer, but it has been very clear that the decision on tightening in December would be based on US economic developments. Additionally, it has lowered its estimates of trend growth to where even the current slow growth environment is sufficient to spur higher short rates. Add on October’s surprisingly strong nonfarm payroll release and only a quick and meaningful falloff in the economic data could keep the Fed from moving.

One argument posited by market observers is that when the Fed finally raised the funds rate, uncertainty would decline. The problem with this point is that while the uncertainty of the liftoff date is removed—the guessing game then morphs into how far and how fast the hiking will eventually go. Once you enter a rate-hiking cycle, experience suggests uncertainty levels will not diminish (although the 2004–2006 experience is a possible counterexample to this tendency).

The point that Fed Chair Janet Yellen has personally tried to make is that investors should be more focused on the path and trajectory to the rate-hiking cycle rather than on the specific liftoff date. She has been very clear in conveying the message that the path of rate hikes will be shallow by comparison with other cycles. We fully expect this to be the case. The Fed wants to end emergency policy by lifting rates above zero, but it does not want to jeopardize the recovery by unduly slowing growth or tightening financial conditions. Starting with December, Exhibit 2 compares previous hiking cycles with a path of rates with 25 basis points (bps) of hikes each quarter, which would by far be the shallowest path.

Exhibit 2
US Fed Rate Hiking Cycles (Point Change Since First Hike)
Source: Federal Reserve, Bloomberg. As of 30 Sep 15.

The Fed has presented a growth forecast of roughly 2.3%–2.4% for the next 2 years, with core personal consumption expenditures (PCE) deflator inflation moving up from 1.4% to 1.7% next year. While such a path provides a much lower bar for growth than the Fed had set in previous years, we believe even this forecast may once again prove too optimistic, as Fed forecasts have been over the last 4 years. Still, we also think the Fed will stay on a once-a-quarter hiking regime until the data clearly fall below its forecast. This year, despite a very weak first quarter, the Fed waited until April to announce a delay of its hiking plans. This suggests to us that two hikes are likely. After that, data dependency, the nature of global events and financial conditions should all keep Fed uncertainty in the ongoing market conversation.

Right now, the market is pricing in roughly a 1% fed funds rate for early 2017. This assumes the Fed hikes rates in 4 of the next 6 quarters. If our forecast comes to fruition, the path of Fed tightening would be slower. However, there is not enough cushion in market pricing to make us bet aggressively on this position. As already stated, Fed growth expectations have dropped so much that even a slowing from this year’s growth rates might not be much of a below-forecast shock.

Swap Spreads

Exhibit 3 displays the yield curve for LIBOR swap spreads versus Treasuries. There was a time in the not too distant past when Treasury bonds were the lowest yielding US fixed-income securities. Currently, LIBOR swaps yield less than Treasuries over all maturities ranging from 3 years through 30 years. This anomaly has generated much market discussion: How could this happen? How long might it last? Is it going to become a quasi-permanent condition? There is a confluence of several strong forces that help explain how we have come to this point. Call us heroic, but we think the Treasury will someday be able to borrow at a lower rate than private entities of lesser credit worthiness!

Exhibit 3
Yield Curves: US Treasuries Versus US Swaps
Source: Bloomberg. As of 10 Nov 15.

The three main factors said to be driving inverted swap spreads are:

  1. A regulatory environment that makes it more onerous for banks to hold Treasuries and more expensive for leveraged investors to use Treasury repo to finance positions, leading these actors to the derivatives market to express their positions,
  2. Central bank selling of Treasuries in order to raise cash to support their currencies, and
  3. Corporations swapping their new issuance back to floating rates in order to protect against downside economic risks.

These factors offer a powerful explanation of how swap spreads have come to be inverted, but they don’t imply that swap spreads will stay inverted. The argument for further inversion is that these “technicals” are so strong that spreads will get much more inverted before they normalize. However, as a value investor, it is very hard to pass up relative value opportunities that should win if held to term. Buying an intermediate Treasury and paying fixed LIBOR while picking up 20 bps in yield may not be the most exciting trade in the world, but it must work. More importantly and directly, it may work a lot sooner than many think.

The banks and levered communities are not meaningfully blocked from this trade. There may be a desire to stay uninvolved through the year-end balance sheet process, but then the gloves could come off. Central banks may not be the continuous suppliers of Treasuries that they have been recently. The dollar’s trend is not guaranteed to always rise and current account surpluses given the currency depreciation already seen are helping many countries to replenish reserves.

This brings us to the corporate treasurers who issue long bonds, then receive fixed LIBOR (at 40 bps below Treasuries) to hedge back to a floating-rate liability that now trades over today’s negligible short-term interest rate. What does this really accomplish? True, it provides a short-term interest cost that is low. Also, this is a derivative position that can be liquidly unwound. But think of this from the standpoint of a long-term investor. Basically, this locks the corporation into a yield spread that is not only the widest since 2011 but adds another 40 bps. An easier way to think of this might be its investment opposite. At our firm, we buy long corporate bonds believing spreads are attractively valued. We want to protect ourselves from the interest-rate risk, so we hedge, either by selling Treasuries, or in this case selling (paying fixed LIBOR) swaps. We do not worry about rising interest rates, we worry about wider corporate bond spreads. An entity with the opposite position loses if interest rates rise and corporate spreads narrow. These would be conditions one might expect in a recovering economy.

Historically, LIBOR and swap spreads perform very poorly in periods of Fed tightening. This time may be different. Maybe the Fed doesn’t really mean it and no tightening is coming. Perhaps the new reverse repo facility won’t be effective and LIBOR can’t be moved sufficiently higher.

Then again, a bedrock principle of finance that lower credit demands a higher risk premium could prevail. When the Fed first introduced “emergency” monetary policy in late 2008, ultra-high LIBOR collapsed. Perhaps when the Fed starts to exit, ultra-low LIBOR will also reverse.

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