Cavanal Hill Fixed Income Insights 1 st Quarter, 2018

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1 Cavanal Hill Fixed Income Insights 1 st Quarter, 2018 Michael Maurer, CFA Senior Fixed Income Portfolio Manager Russell Knox, CFA Fixed Income Portfolio Manager Rich Williams Senior Tax Free Fixed Income Portfolio Manager Mike Kitchen, CTP, CFA Senior Cash Management Portfolio Manager NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 03/18 1

2 What Keeps Us Up At Night? The tax cut in the 4 th quarter and subsequent budget deal has introduced a significant amount of potential stimulus to the economy, which is why inflation expectations have risen in the past couple months. This may force the Fed to tighten more than they would like to. Add to this the increased Treasury supply to finance this stimulus and it may lead to increased volatility in the fixed income markets along with the possibility of short circuiting the expansion. Dollar weakness. Though the market has continued to price in an increasing number of Fed rate hikes, the dollar has failed to rally. The significant appreciation since the middle of 2014 has been a headwind to inflation. The weakness over the last year has done a lot to reduce that headwind. NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 03/18 2

3 What Keeps Us Up At Night? During the record issuance in December, muni dealers took down large positions in the primary market as they anticipated the market to rally in However, that strategy was foiled as rates rose in conjunction with the upward move in Treasury yields. The lack of new supply in 2018 has allowed dealers to hold on to their bonds rather than cut prices, so the market has been at a standstill as buyers hold out for more attractive levels. What will break the standoff and which direction will it go? Perhaps an infrastructure deal gets announced and new issuance helps reprice the market? New regulatory initiatives which further decrease the supply of short-term debt, causing yields to decline further as investors scramble for scarce assets. NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 03/18 3

4 Key Rates 12/31/17 3/31/18 1 Month Bps Change 3 Month Bps Change 1 Year Bps Change 2 Year Treasury Note 1.89% 2.27% Year Treasury Note 2.41% 2.74% Year TIPS 0.42% 0.71% Year MMD AAA 1.32% 1.68% Year MMD AAA 2.10% 2.48% Fed Funds Rate % % Month LIBOR 1.69% 2.30% yr Mortgage Rate 3.85% 4.28% NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 03/18 4

5 Fed Dot Plot Three rate hikes still expected in However, expected rates moved higher for 2019 and Terminal rate expected to be around 3.25% in However, market path for Fed Funds rate (represented by green line) is much lower. % Longer Term FOMC Dots Median Fed Funds Futures - Latest Value OIS - Latest Value NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 03/18 5

6 Markets Expecting Further Rate Hikes Current market expectations (End of March, 2018) indicate: ~80% probability of at least 1 rate hike at the June meeting of the Federal Reserve (left chart), ~20% probability of at least 2 hikes in the next two months, increasing to ~60% after 6 months (middle chart), ~37% chance of 3 hikes within eight months (right chart) The following charts show market expectations for one or more rate hikes to be announced at upcoming meetings of the Federal Reserve. Each line shows market expectations for a given observation date The path of each line shows the probability of a rate hike (or more for the right two charts) within a given number of months The red line represents the market expectations as of March 22, 2018 The market currently is pricing in less hikes than it was at the beginning of March (before the most recent hike). AT LEAST 1 HIKE AT LEAST 2 HIKES AT LEAST 3 HIKES Apr % Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Nov-17 Mar-18 PROBABILITY OF HIKE 80% 60% 40% 20% Mar-18 0% MONTHS UNTIL EXPECTED HIKE MONTHS UNTIL EXPECTED 2ND HIKE MONTHS UNTIL EXPECTED 3RD HIKE NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 03/18 6

7 Taxable Fixed Income NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 03/18 7

8 Treasury Yield Curves 10 Year Historical Chart All interest rates rose in the 1 st quarter. However, the yield curve continues to compress as short rates rose more sharply than longer term rates. 6 Rate History 5 4 Percenet % Year Note 5 Year Note 10 Year Note 30 Year Bond NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 03/18 8

9 10 Year Treasury Yield Minus 2 Year Treasury Yield After a brief blip higher in early 2018, the curve has flattened back to near its 10yr lows. We believe longer term inflation expectations will remain contained and as the market continues to price in additional rate hikes, the curve will flatten further 3.5 2Y10Y Slope Percent % NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 03/18 9

10 High Yield Credit Default Swap Spreads Credit default swap spreads dropped to a 10 year low in early 2018, but have since risen back into the +325 range. The lack of volatility over the past 2 years is one of the main reasons for compressed spreads. We expect increased volatility will lead to mildly wider spreads as we move through Market CDS North America 5 Year High Yield Index Bbs Points NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 03/18 10

11 Core Inflation Remains Low The January reading of core PCE (the Fed s preferred measure) was the 69 th consecutive year-over-year print below the Fed s 2% target. We should see some upward pressure on these measures as we use weak 2017 comparisons. 3.25% 2.75% 2.25% 1.75% 1.25% 0.75% 0.25% Core PCE YoY Core CPI YoY NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 03/18 11

12 Expected Inflation Breakeven inflation rate over next 10 years versus nominal Treasuries. Expected inflation has ticked up some recently, but still remains barely above 2%. As long as this remains contained, longer term rates are unlikely to break out significantly 3.0 US Breakeven Inflation 10 Year Percent % NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 03/18 12

13 Inflation Expectations Remain Low Inflation expectations measures are off of their recent lows, but remain well below their longer-term averages. There is a lot of correlation with oil prices (particularly with the 10yr TIP breakeven) & the rebound in oil over the last 2 years has helped pressure these expectations higher % $ % $ % 2.500% 2.000% 1.500% 1.000% 0.500% $120 $100 $80 $60 $ % $ % 10 yr TIP breakeven (LHS) 5yr 5yr Forward CPI Swap (LHS) WTI (RHS) $- NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 03/18 13

14 Wage Growth Remains Low Wage growth has been strengthening over the past 18 months, but the absolute level remains relatively low, and certainly not indicative of a 4.1% unemployment rate. 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Weekly Earnings Production & Non-supervisory Workers YoY Employment Cost Index YoY & bls.gov NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 03/18 14

15 Housing Affordability Wage growth hasn t kept pace with home price gains. Median home sales price / Income is now at the same level as at the peak of the housing bubble. The recent increases in mortgage rates have added more expense to an already expensive housing market. $350, $300, $250, $200, $150, $100, $50, $- 0.0 Median Household Income (LHS) Median Home Sale Price (LHS) Home Price / Income (RHS) Source: Federal Reserve NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 03/18 15

16 Municipals NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 03/18 16

17 Muni Ownership The chart below shows muni ownership while the majority of munis are owned by households and mutual funds, the important aspect of this information is the amount owned by banks and insurance companies. Last year s tax reform lowered the corporate tax rate from 35% to 21%, so market participants are closely monitoring the response from corporate buyers. There has been limited selling in the secondary market in 2018, but that could accelerate in the coming months. Billions % of Total Household % Mutual funds and ETFs % Banks and credit unions % Rest of the world % Other % Insurance Companies % TOTAL % Household Mutual funds and ETFs Banks and credit unions Rest of the world Other Insurance Companies NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE Source: Federal Reserve (as of 9/30/17) NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 03/18 17

18 Municipal Supply The chart below shows the 30-day visible muni supply (in millions), which reached a level not seen since 2005 in December as issuers rushed into the market in response to the tax reform bills. While December ended up being the biggest supply month in history, the issuance dropped precipitously at the outset of 2018 and has yet to rebound (down about 28% year-to date). Most participants expected supply to decline due to the tax-exempt status being taken away from advance refunding deals, but it remains to be seen if issuers will return to the market as the year progresses. 35, , , , , , , NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 03/18 18

19 Cash Deployment in Short Munis One way to measure where cash is being deployed in the muni market is to track the yield ratio of munis to comparable Treasurys. As evidenced by the graph below, it appears that so far in 2018 cash is being deployed in the short end of the muni market rather than the intermediate part of the curve. The yield ratios on the 2-year and 10-year munis have diverged since the beginning of the year, indicating a strong demand for short munis. 95.0% 90.0% 85.0% 80.0% 75.0% 70.0% 65.0% 2-Year Muni/Tsy Ratio 10-Year Muni/Tsy Ratio NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 09/17 NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 03/18 19

20 Money Markets NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 03/18 20

21 Libor-Overnight Index Swap (OIS) Spread at Elevated Levels The 3 month US Libor-OIS spread has widened to a level not seen since the Eurozone crisis in Elevated supply of U.S. Treasuries, corporate buildup of supply in anticipation of repatriation, money market fund positioning in front of an anticipated mid-march FOMC move, and the Fed s balance sheet unwind have combined to elevate this spread. Unlike in years past, this isn t indicative of problems in the banking sector. However, we will continue to watch this closely, as a sustained elevated level would be more worrisome. % M Libor - Overnight Index Swap Spread NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 03/18 21

22 Short Term Treasury Bills vs Agency Discount Notes Treasury bill yields outperform agency discount note yields from three months to one year out the short term credit curve. While a bit unusual, we would expect agency discount notes to move toward Treasury yields. % D 1W 15D 3W 1M 45D 2M 3M 4M 5M 6M 1Y MM48 USD T-BILLS CURVE Last Mid YTM MM47 USD DISCOUNT NOTES CURVE Last Mid YTM NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 03/18 22

23 DISCLOSURES Cavanal Hill Investment Management, Inc. ("Cavanal Hill") is an SEC registered investment adviser and a wholly-owned subsidiary of BOKF, NA, a wholly-owned subsidiary of BOK Financial Corporation, a financial holding company ("BOKF"). SEC registration does not imply a certain level of skill or training. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. The opinions expressed herein reflect the judgment of the author at this date and are subject to change without notice and are not a complete analysis of any sector, industry or security. Cavanal Hill Distributors, Inc., member FINRA, is the distributor for Cavanal Hill Mutual Funds. Cavanal Hill Distributors, Inc. is also a wholly-owned subsidiary of BOKF, NA and an affiliate of Cavanal Hill Investment Management, Inc. This report is not to be considered a recommendation of Cavanal Hill s investment management services, any particular security, strategy or investment product, nor is it intended to provide personal investment advice. It does not take into account any specific investment objectives, financial situations, or particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities, other investment or investment strategies discussed in this report and should understand that statements regarding future prospects may not be realized. The information provided in this presentation is for informational purposes only and is not an offer to sell or a solicitation of an offer to buy any securities in any jurisdiction. Investors should note that income from such securities or other investments, if any, may fluctuate and that price or value of such securities and investments may rise or fall. Investments are not insured by the FDIC and are not guaranteed by Cavanal Hill or any bank, including any banking affiliates of Cavanal Hill. Investments are subject to risks, including the possible loss of the principal amount invested. Past performance does not guarantee future results. This document contains forward-looking statements that are based on management's beliefs, assumptions, current expectations, estimates, and projections, the securities and credit markets and the economy in general. Words such as "anticipates," "believes," "estimates," "expects," "forecasts," "plans," "projects," variations of such words and similar expressions are intended to identify such forward-looking statements. Management judgments relating to and discussion of the value and potential future value or performance of any security, group of securities, type of security or market segment involve judgments as to expected events and are inherently forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what is expressed, implied, or forecasted in such forward-looking statements. The potential realization of these forward-looking statements is subject to a number of limitations and risks. Cavanal Hill does not undertake any obligation to update, amend, or clarify forward-looking statements, whether as a result of new information, future events or otherwise. This report may not be reproduced, redistributed, retransmitted or disclosed, or referred to in any publication, in whole or in part, or in any form or manner, without the express written consent of Cavanal Hill. Any unauthorized use or disclosure is prohibited. Receipt and review of this research report constitutes your agreement not to redistribute, retransmit, or disclose to others the contents, opinions, conclusion, or information contained in this report. For questions about this report, please contact Mike Maurer at (918) or Rich Williams at (972) NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 03/18 23