Cavanal Hill Fixed Income Insights. First Quarter 2017

Transcription

1 Cavanal Hill Fixed Income Insights First Quarter 2017 April 3,

2 What Keeps Us Up at Night? Corporate bond spreads are near record tight levels versus Treasuries. There is little room left for improvement, but significant downside if risk appetite declines. Despite recent upward pressure, inflation expectations remain well contained. The pace of potential Fed Funds rate hikes remains similar to the beginning of the year. Including the rate hike on March 15, we expect 3 hikes this year, followed by 2-3 more in Should the Fed decide to reduce the size of their balance sheet, later in 2017, they will strive to make the reduction using asset maturities and paydowns on mortgage backed securities, avoiding outright sales of securities. This is still likely to put pressure on credit spreads in all products was a record year for municipal issuance. However, refinancing was a big driver and that portion of supply will most likely decline this year. After strong inflows for most of 2016, municipal bond funds saw sizeable outflows at the end of the year as rates rose. Historically, the impact from tax reform on the municipal market has been minimal, but market participants will be closely monitoring this reform cycle. 2

3 Key Rates 12/31/16 3/31/17 1 Month Bps Change 3 Month Bps Change 1 Year Bps Change 2 Year Treasury Note 1.19% 1.37% Year Treasury Note 2.45% 2.42% Year TIPS 0.48% 0.45% Year MMD AAA 1.18% 1.09% Year MMD AAA 2.38% 2.37% Fed Funds Rate % % Month LIBOR 1.00% 1.15% yr Mortgage Rate 4.06% 4.02% Source: Bloomberg 3

4 Treasury Yield Curves 10 Year Historical Chart Short Term rates rising faster than Long Term rates from very depressed levels in middle of Short rates likely to remain under higher pressure than low rates as the Fed continues to hike the target Fed Funds rate. % 5 2 Year Note 5 Year Note 10 Year Note 30 Year Note /28/08 3/28/09 3/28/10 3/28/11 3/28/12 3/28/13 3/28/14 3/28/15 3/28/16 Source: Bloomberg 4

5 10 Year Treasury Yield Minus 2 Year Treasury Yield Long term trend is toward a flatter yield curve. It should flatten further as rate hikes pressure yields on the short end of the curve. Bps /28/2008 3/28/2009 3/28/2010 3/28/2011 3/28/2012 3/28/2013 3/28/2014 3/28/2015 3/28/2016 Source: Bloomberg 5

6 3/1/87 11/1/87 7/1/88 3/1/89 11/1/89 7/1/90 3/1/91 11/1/91 7/1/92 3/1/93 11/1/93 7/1/94 3/1/95 11/1/95 7/1/96 3/1/97 11/1/97 7/1/98 3/1/99 11/1/99 7/1/00 3/1/01 11/1/01 7/1/02 3/1/03 11/1/03 7/1/04 3/1/05 11/1/05 7/1/06 3/1/07 11/1/07 7/1/08 3/1/09 11/1/09 7/1/10 3/1/11 11/1/11 7/1/12 3/1/13 11/1/13 7/1/14 3/1/15 11/1/15 7/1/16 Concerns Over Inflation Are Likely Misplaced Core inflation measures have ticked higher over the last year and a half. However, underlying conditions are insufficient to sustain the move higher. % Core CPI YoY Core PCE YoY Source: Bloomberg 6

7 3/1/97 8/1/97 1/1/98 6/1/98 11/1/98 4/1/99 9/1/99 2/1/00 7/1/00 12/1/00 5/1/01 10/1/01 3/1/02 8/1/02 1/1/03 6/1/03 11/1/03 4/1/04 9/1/04 2/1/05 7/1/05 12/1/05 5/1/06 10/1/06 3/1/07 8/1/07 1/1/08 6/1/08 11/1/08 4/1/09 9/1/09 2/1/10 7/1/10 12/1/10 5/1/11 10/1/11 3/1/12 8/1/12 1/1/13 6/1/13 11/1/13 4/1/14 9/1/14 2/1/15 7/1/15 12/1/15 5/1/16 10/1/16 Concerns Over Inflation Are Likely Misplaced (cont d) Capacity Utilization is low and remains in its long-term downtrend % Source: Bloomberg 7

8 3/1/97 9/1/97 3/1/98 9/1/98 3/1/99 9/1/99 3/1/00 9/1/00 3/1/01 9/1/01 3/1/02 9/1/02 3/1/03 9/1/03 3/1/04 9/1/04 3/1/05 9/1/05 3/1/06 9/1/06 3/1/07 9/1/07 3/1/08 9/1/08 3/1/09 9/1/09 3/1/10 9/1/10 3/1/11 9/1/11 3/1/12 9/1/12 3/1/13 9/1/13 3/1/14 9/1/14 3/1/15 9/1/15 3/1/16 9/1/16 Concerns Over Inflation Are Likely Misplaced (cont d) The recent strength in the US Dollar (DXY) is a headwind to inflation as the purchasing power of US consumers increases Index Level Source: Bloomberg 8

9 1/31/97 6/30/97 11/30/97 4/30/98 9/30/98 2/28/99 7/31/99 12/31/99 5/31/00 10/31/00 3/31/01 8/31/01 1/31/02 6/30/02 11/30/02 4/30/03 9/30/03 2/29/04 7/31/04 12/31/04 5/31/05 10/31/05 3/31/06 8/31/06 1/31/07 6/30/07 11/30/07 4/30/08 9/30/08 2/28/09 7/31/09 12/31/09 5/31/10 10/31/10 3/31/11 8/31/11 1/31/12 6/30/12 11/30/12 4/30/13 9/30/13 2/28/14 7/31/14 12/31/14 5/31/15 10/31/15 3/31/16 8/31/16 1/31/17 Concerns Over Inflation Are Likely Misplaced (cont d) Much attention is paid to the average hourly earnings figure which has shown an uptick over the last two years. However, this measure is skewed by the denominator in the calculation (average weekly hours) and is therefore a poor indicator of inflationary pressures. It is unlikely that we are at or near full employment with wage growth this low. 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% More reliable indicators show wage growth remains anemic YoY Wage Growth (Production & Non-Supervisory) Employment Cost Index YoY Growth Source: Bloomberg and Bureau of Labor Statistics 9

10 Concerns Over Inflation Are Likely Misplaced (cont d) If the rise in core inflation is sustainable, it has yet to show up in measures of longer-term inflation expectations % Source: Bloomberg 10

11 Millions Market Value of Corporate Debt Debt growth has been explosive since the financial crisis (up roughly 150% since 2008). Many companies locked in low rates over the past few years. When forced to either refinance at higher rates or repay the debt, it is likely to put significant pressure on their balance sheets, raising funding costs. $ Recent decline in market value due to rising interest rates Source: Bloomberg 11

12 High Yield Credit Default Swap Spreads Credit default swap spreads fall near record lows. Spreads tend to have a hard time staying below +350 Bps for a prolonged period of time. After a brief period, there are sharp rebounds to higher spreads. Leaving little room left for additional excess return from high yield corporate bonds. Bps Source: Bloomberg 12

13 Credit Downgrades Net Negative Credit downgrades continue to outpace upgrades. Since 2008, the average credit quality of corporates has declined every year. The -15% decline for 2016 is equivalent to the average credit quality declining by 15% of one notch. 20.0% 10.0% 0.0% -10.0% -20.0% -30.0% -40.0% -50.0% -60.0% Source: Moody s 13

14 High Yield Covenant Quality Has Been Very Low For Several Years Low yields around the world are driving this phenomenon Sustained decline in debt covenant protections High yield covenant quality was ok after the financial crisis Investors, starved for yield, began allowing companies to waive covenants in returns for better yields Source: Moody s Stable, at a low level Source: Moody s The top chart shows the deterioration started roughly 5 years ago Many of these bonds will start coming due beginning later this year Recovery rates (percent of 100 repaid after default) for companies likely to suffer as reduced protection allows for further depletion of assets before default 14

15 High Yield Default Rates Energy defaults were 50% of the 2016 default rate. Excluding energy, default rates remain very low. Rising interest rates could lead to significantly higher defaults over the next few years as companies are forced to refinance at higher rates % 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% Source: Moody s 15

16 Muni Short Rates The SIFMA Index, which is an average of yields on variable rate, tax-exempt demand notes, moved dramatically higher in 2016, as tax-exempt money market funds prepared for latest round of SEC reforms, which took effect in October; SIFMA spread relative to the 1-year muni maturity has returned to a more normal relationship of late. % Source: Bloomberg and Municipal Market Data 16

17 Muni 10-Year Yield After a dramatic 75 basis point move higher in November, muni yields subsequently found their footing and have settled into a fairly tight trading range so far in % Source: Municipal Market Data 17

18 Muni Yield Curve In addition to shifting upward, the muni yield curve has also steepened; for example, the spread between the 2-year and 10-year has widened from 77 basis points to 137 basis points since 6/30/16. This is likely due to investors shifting their focus to the short end of the muni market in anticipation of a rising rate environment. % Source: Municipal Market Data 18

19 Muni/Treasury Ratio Muni yields were very attractive relative to Treasurys in the weeks following the election; in 2017, muni yields in the 2- and 5-year maturity range have become rich, while the 10-year remains cheap. Investors are likely buying in the short end of the curve in anticipation of the Federal Reserve raising rates in the coming months. Source: Bloomberg and Municipal Market Data 19

20 Muni Bond Fund Flows Muni bond funds typically see outflows when rates move dramatically higher and last two months of 2016 were no different. Flows have stabilized at the outset of 2017, but market participants will be monitoring the situation closely if rates begin to move higher. % $10, $5, $ $5, $10, $15, /1/16 10/1/16 11/1/16 12/1/16 1/1/17 2/1/17 Muni Bond Fund Flows (millions) (Right Scale) Muni 10-Year (Left Scale) -$20,000 Source: Municipal Market Data and ICI 20

21 Fed Dot Plots Mostly unchanged from December. Still anticipating 2-3 rate hikes per year in 2017 and Longer term, the Fed Funds rate is expected to rise to 3%. % Longer Term FOMC Dots Median OIS - As of Meeting Date OIS - Latest Value Source: Federal Reserve and Bloomberg 21

22 Commercial Paper Rates Commercial paper levels began to reflect the possibility of higher levels last year 22

23 3 Month Treasury Bill Rates Jump After trending higher for some time, three month Treasury Bill levels are reflecting the likelihood of higher rates 23

24 Money Market Funds Positioned for Higher Rates Relatively short weighted average maturities (WAM s), along with the relatively long weighted average lives (WAL s) of money market funds reflect positioning to capture higher interest rate levels by both keeping average maturities short and by keeping a fairly high concentration of floating rate notes (which is captured by the WAL calculation) Prime Institutional 10/31/ /30/ /31/2016 1/31/2017 2/28/2017 WAM WAL Government Institutional WAM WAL Treasury Institutional WAM WAL Source: Crane Data 24

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