Cavanal Hill Fixed Income Insights 4 th Quarter, 2017

Transcription

1 Cavanal Hill Fixed Income Insights 4 th Quarter, 2017 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 12/17 1

2 What Keeps Us Up At Night? The Fed has begun to run off its balance sheet. However, the pace is currently very slow at just $10 billion per month. This is expected to increase to $20 billion per month in Q The increase in supply will likely be easily absorbed early on, but as the size of the monthly runoff increases, the market may have more trouble digesting it. It is difficult to discern how much of the potential impact from the Republican tax plan is priced into the fixed income market. It will be important to note the bond market s ultimate perception of the impacts to longer-term growth and inflation upon passage of the tax plan. However, with the passage likelihood increasing, the Treasury market s reaction has been muted. NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 2

3 What Keeps Us Up At Night? Tax Reform! Will the reduction in the corporate tax rate make Munis less attractive to investors and lead to a decline in demand? Will the tax exempt status be taken away from private activity bonds and/or advanced-refunding bonds and lead to a decline in supply? The Fed has raised rates from 0%, creating a buffer to be able to lower rates to combat an economic slowdown or recession. However, this still leaves the Fed little wiggle room if a macro economic or geopolitical shock were to shake the markets and the economy. NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 3

4 Key Rates 9/30/17 12/31/17 1 Month Bps Change 3 Month Bps Change 1 Year Bps Change 2 Year Treasury Note 1.48% 1.89% Year Treasury Note 2.32% 2.41% Year TIPS 0.48% 0.42% Year MMD AAA 1.02% 1.32% Year MMD AAA 2.09% 2.10% Fed Funds Rate % % Month LIBOR 1.33% 1.69% yr Mortgage Rate 3.82% 3.85% Source: Bloomberg NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 4

5 Fed Dot Plot Mostly unchanged from last quarter. Terminal rate still expected to be around 3% in However, market path for Fed Funds rate (represented by green line) is much lower Longer Term Source: Bloomberg FOMC Dots Median Fed Funds Futures - Latest Value OIS - Latest Value NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 5

6 Real GDP Quarterly GDP has become less volatile over time, though the long term trend in GDP has slowed from 4+% in the 1950s to roughly 2% today /1/1954 3/1/1956 6/1/1957 9/1/ /1/1959 3/1/1961 6/1/1962 9/1/ /1/1964 3/1/1966 6/1/1967 9/1/ /1/1969 3/1/1971 6/1/1972 9/1/ /1/1974 3/1/1976 6/1/1977 9/1/ /1/1979 3/1/1981 6/1/1982 9/1/ /1/1984 3/1/1986 6/1/1987 9/1/ /1/1989 3/1/1991 6/1/1992 9/1/ /1/1994 3/1/1996 6/1/1997 9/1/ /1/1999 3/1/2001 6/1/2002 9/1/ /1/2004 3/1/2006 6/1/2007 9/1/ /1/2009 3/1/2011 6/1/2012 9/1/ /1/2014 3/1/2016 6/1/2017 GDP Annualized % Quarterly GDP 5Y Moving Average Source: Bloomberg NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 6

7 Modified Duration Impact of Low Rate Environment Low rates have a material impact on the duration of investment securities. Longer Maturity = Higher Duration (All Else Equal) Lower Rates = Higher Duration (All Else Equal) The chart to the right shows that a 350 basis point reduction in rates has approximately the same impact on duration as a nearly 2 year maturity extension. NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 7

8 Taxable Fixed Income NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 8

9 Treasury Yield Curves 10 Year Historical Chart Short-term rates rose sharply in the 4 th quarter, while longer-term rates have remained relatively stable. 6 Rate History 5 4 Percenet % Year Note 5 Year Note 10 Year Note 30 Year Bond Source: Bloomberg NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 9

10 10 Year Treasury Yield Minus 2 Year Treasury Yield The curve continues to flatten, and has accelerated in the past few months. The curve is the flattest it has been since late Percent % Source: Bloomberg NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 10

11 Expected Inflation Breakeven inflation rate over next 10 years versus nominal Treasuries. Expected inflation over the next 10 years has remained remarkably stable over the past 4 years, mostly fluctuating between 1.5% and 2%. This explains much of the reason why longer term rates have been unable to rise very much Percent % Source: Bloomberg NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 11

12 Central Bank Balance Sheets Liquidity continues to be poured into the markets, even after the Fed stopped buying at the end of Both the BOJ and ECB have now exceeded the Fed s balance sheet in size. 20,000 Global Total of Central Bank Assets (Bils $) 15,000 10,000 5,000 0 '06 '07 '08 '09 '10 '11 '12 '13 '14 '15 '16 '17 Source: Strategas Research Partners Fed ECB BOJ PBOC SNB BOE NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 12

13 Mortgage Yields Versus Treasuries Credit spreads in agency MBS have declined significantly in the past year as investors desperately search for yield Agency Mortgage Treasury 5Y /1/2008 3/1/2009 6/1/2009 9/1/ /1/2009 3/1/2010 6/1/2010 9/1/ /1/2010 3/1/2011 6/1/2011 9/1/ /1/2011 3/1/2012 6/1/2012 9/1/ /1/2012 3/1/2013 6/1/2013 9/1/ /1/2013 3/1/2014 6/1/2014 9/1/ /1/2014 3/1/2015 6/1/2015 9/1/ /1/2015 3/1/2016 6/1/2016 9/1/ /1/2016 3/1/2017 6/1/2017 9/1/2017 Rate (%) Treasury 5Y Mortgage Spread Source: Bloomberg NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 13

14 High Yield Credit Default Swap Spreads Credit default swap spreads are tightly bound near 325 basis points. Spread volatility is very low, even versus previous low spread periods. While excess spread/yield can be captured in the near term, a small move higher in interest rates would easily wipe out that yield advantage. 700 Market CDS North America 5 Year High Yield Index Percent % Source: Bloomberg NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 14

15 Rate Hikes Have Had Little Impact on the Long End On December 16, 2015 the Federal Reserve raised the Fed Funds target rate for the first time since Since then they have raised the target rate four more times for a total of 125 basis points. Since that first rate hike, 10yr yields are higher by 8 basis points while 30yr yields are down 26 basis points. 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% Fed Funds Target Rate - Upper Bound 10yr Treasury yield 30yr Treasury yield Source: Bloomberg NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 15

16 Yield Curve & Recessions A flat yield curve (as measured by the spread between the 10yr and 2yr Treasuries) has historically been a good predictor of recession. A flattening yield curve often coincides with a rate hike cycle, and that trend continued in 2017 as the Fed hiked a total of 75 bps and 10s 2s declined by 69 bps. Marginally reducing the size of the Fed s balance sheet is another form of monetary tightening and may lead to more flattening of the curve. 4,500,000 1,800 1, ,000,000 3,500,000 3,000,000 2,500,000 2,000,000 1,500,000 1,000, ,000 (200) - 12/1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/2017 Fed Funds and 2s-10s Rate Spread (in basis points) Federal Reserve Assets (dollars, millions) Federal Reserve Total Assets Recession 10yr - 2yr Treasury Spread Fed Funds Target Rate (Upper Bound) Source: Bloomberg & NBER NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 16

17 Finally, Some Yield It s been nearly 10 years since we ve been able to get these kinds of yields on the short end. With a 62 basis point rise in yields since the beginning of the year, 2-year notes are at their highest yields in nearly a decade. 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% 12/31/2007 3/31/2008 6/30/2008 9/30/ /31/2008 3/31/2009 6/30/2009 9/30/ /31/2009 3/31/2010 6/30/2010 9/30/ /31/2010 3/31/2011 6/30/2011 9/30/ /31/2011 3/31/2012 6/30/2012 9/30/ /31/2012 3/31/2013 6/30/2013 9/30/ /31/2013 3/31/2014 6/30/2014 9/30/ /31/2014 3/31/2015 6/30/2015 9/30/ /31/2015 3/31/2016 6/30/2016 9/30/ /31/2016 3/31/2017 6/30/2017 9/30/2017 2yr Treasury Yield Source: Bloomberg NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 17

18 Municipals NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 18

19 Muni Short Rates The SIFMA Index, which is an average of variable rate demand notes, has increased 100 basis points over the course of the last two years. Yields on 1-year munis have also been on the rise, reaching levels not seen in several years Source: Bloomberg SIFMA 1-Year Muni NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 19

20 Municipal Supply The first half of the 4 th quarter was fairly typical from an issuance standpoint for the muni market; however, the situation changed dramatically when the tax reform bills were announced in November. While the corporate and individual tax rates came as no surprise, the muni market was not expecting the potential for the tax-exemption to be taken away from private activity bonds and advanced-refunding bonds. As a result, issuers rushed their deals into the market in order to get them done in December will go down as one of the largest issuance months in the history of the muni market. The chart below shows the 30-day visible muni supply (in millions), which reached a level not seen since , , , , , , , Source: Bloomberg NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 20

21 Muni Market Yield Roller Coaster As mentioned on the previous slide, the muni market was caught off guard when the tax reform bills proposed that the tax-exempt status of private activity bonds and advanced-refunding bonds would be taken away. The subsequent weeks have seen a great deal of volatility in the market, particularly in the long end of the curve; yields have moved up due to a near record amount of monthly supply in December, but market participants have driven rates lower by purchasing bonds due to the concerns over a potential precipitous decline in supply for The chart below shows the yield on a 30-year AAA muni according to Municipal Market Data, which experienced a decline of nearly 40 basis points from November 29 th to December 6 th. 2.90% 2.85% 2.80% 2.75% 2.70% 2.65% 2.60% 2.55% 2.50% 2.45% 2.40% Source: Municipal Market Data NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 09/17 NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 21

22 Money Markets NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 22

23 Money Market Yields The spread between T Bills and Discount notes remains tight Source: Bloomberg NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 23

24 Corporations Building Cash The pace at which organizations have accumulated cash and short-term investments over the past quarter shot to its highest level since January 2011 Source: Association For Financial Professionals NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 24

25 Money Fund s AUM Growth Higher corporate cash balances can translate into higher money market fund asset balances 2,820 2,800 Annual Money Fund Assets '11 '17 ($B) 2,780 2,760 2,740 2,720 2,700 2,680 2,660 2,640 2, Source: ICI, Crane Data. NOT FDIC INSURED I NO BANK GUARANTEE I MAY LOSE VALUE 12/17 25

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