Fixed income market update June 2018 BMO Fixed Income 1001 Brickell Bay Dr. Suite 2100 Miami, Florida 33131 bmogam.com/usfixedincome
Fixed income market update Fixed Income Sectors Total Returns For the month ended May 31, 2018, the Bloomberg Barclays U.S. Aggregate Bond Index returned 0.71%. Year to date, the index has returned -1.50%. U.S. Treasuries returned 0.90% during the month as the yield on the 10-year U.S. Treasury declined to 2.87% at the end of May from 2.95% at the end of April. For the month, long Treasuries (+2.12%) outperformed intermediate Treasuries (+0.65%.) Mortgage-backed securities (MBS) returned 0.70% during the month, underperforming duration-matched Treasuries by 5 basis points. The option adjusted spread (OAS) of the Bloomberg Barclays U.S. Mortgage Index remained unchanged, ending the month at 28 basis points. (%) (bps) 1.5 0.5-0.5-1.5-2.5-3.5 40 20 0-20 -40-60 -80-100 -120-140 0.90 1.02 0.71 0.61 0.64 0.61 0.41 0.55 0.80 0.49 0.70 0.83 0.50-1.10-1.50-0.49-0.02-0.10-1.21-1.00-2.53 Treas. U.S. Agg. Agencies ABS CMBS MBS Credit 1-Mo 3-Mo YTD (05/31/2018) Source: BBG Barclays Fixed Income Sectors Excess Returns 7 7 14 3 7-2 -3-1 -5-1 -15-21 -27-38 -40-45 -107-123 U.S. Agg. Agencies ABS CMBS MBS Credit 1-Mo 3-Mo YTD (05/31/2018) Source: BBG Barclays 2
Fixed income market update (continued) Subsector and Quality Total Returns Credit securities returned 0.50% for the month, underperforming Treasuries by 45 basis points on a duration-adjusted basis. The OAS of the Bloomberg Barclays U.S. Credit Index ended the period at 109 bps, 7 basis points wider than at the end of April. For the month, long credit (+0.46%) underperformed intermediate credit (+0.52%) by 102 basis points on a duration-adjusted basis. For the month, on a duration-adjusted basis, financials delivered -40 basis points of excess returns, outperforming industrials, non-corporates and utilities by 6, 6 and 15 basis points, respectively. AAA rated securities delivered -3 basis points of excess return for the month, outperforming AA, A and BBB rated securities by 15, 36 and 61 basis points of excess return, respectively. High yield delivered -65 basis points of excess return for the month. (bps) (%) 1.0 0.0-1.0-2.0-3.0-4.0 50 0-50 -100-150 -200 0.58-0.08-2.74 0.69 0.14-3.21 0.42-0.33-2.53 0.35 0.09-1.67 0.67 0.60-1.00 0.70 0.52 0.59 0.35 0.01-1.62-0.03-0.46-0.03-0.24-2.84-2.80 Industrial Utility Financial Non-Corp Aaa Aa A Baa HY Source: BBG Barclays 1-Mo 3-Mo YTD (05/31/2018) Subsector and Quality Excess Returns -3-17 -18-17 -46-40 -39-46 -38-55 -54-54 -83-110 -120-121 -135-133 -150-133 -121-164 39-64 -65-59 -119 Industrial Utility Financial Non-Corp Aaa Aa A Baa HY Source: BBG Barclays 1-Mo 3-Mo YTD (05/31/2018) 3
Economic update Percentage (%) For the first quarter of 2018, U.S. gross domestic product (GDP) grew 2.2%, modestly below expectations of 2.3%. Of note, corporate profits pretax fell 0.6%, but rose 5.9% on an after-tax basis largely due to the new tax rules passed in December. Business investment increased from the first estimate, growing 6.5% versus the prior 4.7%. Consensus for the second quarter GDP growth is about 3.1%. 6 5 4 3 2 1 0-1 -2-3 Consumer Price Index (YoY) Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Jan 14 Jul 14 Jan 15 Jul 15 Jan 16 Jul 16 Jan 17 Jul 17 Jan 18 Percentage (%) 6 4 2 0-2 -4-6 -8-10 Gross Domestic Product (GDP) Mar 07 Sep 07 Mar 08 Sep 08 Mar 09 Sep 09 Mar 10 Sep 10 Mar 11 Sep 11 Mar 12 Sep 12 Mar 13 Sep 13 Mar 14 Sep 14 Mar 15 Sep 15 Mar 16 Sep 16 Mar 17 Sep 17 Mar 18 Source: Bureau of Economic Analysis The Consumer Price Index (CPI) increased 0.2% in April and rose 2.5% for the trailing year, the largest increase since the beginning of 2017. Core CPI, which excludes the impact of energy and food, rose by 0.1% for the month and 2.1% for the trailing year, the same as March. Core personal consumption expenditures (PCE), the Fed s preferred inflation gauge, rose 0.2% in April and 1.8% for the trailing year. CPI YOY Index Source: Bureau of Labor Statistics 4
Economic update (continued) Announced June 1, May non-farm payrolls increased by 223,000, exceeding market expectations of 190,000 new jobs. Revisions to the prior two months added 15,000 jobs. The unemployment rate fell 0.1% to 3.8%; that level is tied with April 2000 as the lowest level since 1969. Wages rose 0.3% for the month and 2.7% for the trailing year; Labor force participation decreased to 62.7% in May from 62.8% in April, while the underemployment rate fell 0.2% to 7.6%. 1300 1250 1200 1150 1100 1050 1000 950 900 850 800 Bloomberg Dollar Spot Index Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Jan 14 Jul 14 Jan 15 Jul 15 Jan 16 Jul 16 Jan 17 Jul 17 Jan 18 Thousands (000) 600 400 200 0-200 -400-600 -800-1000 Nonfarm Payrolls MOM (net) Jan 07 Jul 07 Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Jan 14 Jul 14 Jan 15 Jul 15 Jan 16 Jul 16 Jan 17 Jul 17 Jan 18 Source: Bureau of Labor Statistics After declining for most of the last year and a half, the dollar rallied beginning in April and continued into May. The Bloomberg dollar index, which measures the dollar against a basket of 10 global currencies, rose over 2% for the month and approximately 8% since the lows of the year. The dollar also rose over 3% against the Euro partly fueled by the increasing Italian political tensions and its implications for the Eurozone. Source: Bloomberg 5
Economic and market perspective Political developments in Italy triggered broader market concerns in late May. Populists parties won Italian elections in March, but after forming a government their candidate for finance minister was vetoed by Italy s president in May. As a result, the populist coalition appeared to withdraw from forming a government, setting up the need for new elections. Market concerns center on the potential results of those future elections, with many expecting the populist parties to benefit from the perception that the E.U. is having too large an influence in Italian politics. The prospect of a larger victory for the populist parties raised market concerns about an Italian departure from the Eurozone, however as the month ended the populist parties appeared to reach a compromise to form a government. Treasury secretary Steve Mnuchin said in mid-may that theu.s.andchinawere puttingthetradewaronhold, reflecting what had already seemed like waning tensions in the ongoing tariff spat between the two countries. The Trump administration is seeking a $200 billion reduction in the U.S. trade deficit with China. Though both sides claimed progress in trade negotiations, at the end of May the Trump administration said its plan to implement tariffs were moving forward with a final list of tariffs being released mid-june and going into effect shortly thereafter. Also at the end of the month, Commerce Secretary Wilbur Ross announced that waivers for E.U., Canada and Mexico would not be renewed and steel and aluminum imports would be subject to tariffs effective at month end. The E.U. is widely expected to issue retaliatory measures. 6
Economic and market perspective (cont.) While external vulnerabilities of emerging market sovereigns are generally thought to have declined, the impacts of higher U.S. rates and an appreciating dollar had impacts on emerging markets during the month. Major emerging market countries such as Argentina and Turkey experienced significant currency depreciation in May. Argentina is negotiating a bailout package with the International Monetary Fund (IMF) expected to be in the range of $30 billion. Managing Director of the IMF, Christine Lagarde, stated that the package will protect growth, job creation, and social cohesion in contrast to the Argentinian perception of the negative impacts of the last IMF package. President Trump announced the United States withdrawal from the Iran deal (Joint Comprehensive Plan of Action) on May 9. The withdrawal frees the U.S. to re-impose sanctions on Iran, which President Trump announced will occur near-term. Combined with dollar strength and continued global growth, the U.S. exit from the Iran deal helped oil rise as much as 5% intra-month, exceeding $70 a barrel for the first time November 2014. However, by the end of the month Eurozone turmoil and expectations that a June OPEC meeting could result in increased production led to oil giving up its monthly gains. 7
Outlook and conclusions At the May 1-2 meeting of Federal Open Market Committee, the FOMC left the Fed Funds rate unchanged at 1.5-1.75% in line with market expectations. The Fed statement included the view that inflation on a 12-month basis is expected to run near the Committee's symmetric 2 percent objective over the medium term and that economic conditions will warrant further gradual increases in the Fed Funds rate. Minutes from the May 1-2 meeting were released on May 23. In the minutes, the Fed repeatedly referred to the 2% inflation target as symmetric and indicated that the FOMC would be comfortable with a temporary period with inflation above the 2% target. The minutes also indicated that it would likely soon be appropriate for the Committee to take another step in removing policy accommodation, which has been broadly interpreted as suggesting a June rate hike. Themarketisprojectinganearcertaintyofaratehikeat the Fed s June 12-13 meeting and approximately a 70% chance of an additional hike at the September 25-26 meeting. Also in May, the Fed proposed loosening certain aspects of the Volker Rule with the goal of replacing overly complex and inefficient requirements with a more streamlined set of requirements. In our view, May neatly captured the vacillation of bond markets between positive economic data driving rates higher and geopolitical risks and policy concerns pulling them lower. This tug-of-war was seen as the 10-year Treasury yield rose to its highest yields since 2011 mid-month before rates declined back below 3% by the end of the month. Whether emanating from Italian populism and fears of impact to the Eurozone or uncertainties around international trade policy, U.S. fixed income and Treasuries, in particular, remain a safe haven asset. At the same time, credit spread widening given these increasing tensions has allowed spreads to return closer to historical median levels, but set against a strong fundamental economic backdrop, the combination of which offers better prospects for investors in the space. 8
Fixed income returns as of May 31, 2018 Index Returns as of May 31, 2018 Total Return (%) Excess Return (%) Month-to-Date Year-to- Date Month-to-Date Year-to- Date U.S. Aggregate 0.71-1.50-0.15-0.40 U.S. Treasury 0.90-1.10 - - Intermediate 0.65-0.68 - - Long 2.12-3.17 - - TIPS 0.43-0.42 - - Agencies 0.64-0.49 0.07 0.07 U.S. MBS 0.70-1.00-0.05-0.27 U.S. Credit 0.50-2.53-0.45-1.07 Intermediate 0.52-1.30-0.14-0.47 Long 0.46-5.26-1.16-2.39 Industrial 0.58-2.74-0.46-1.10 Utility 0.69-3.21-0.55-1.20 Financial 0.42-2.53-0.40-1.33 Non-Corporate 0.35-1.67-0.46-0.54 Aaa 0.67-1.00-0.03-0.17 Aa 0.70-1.62-0.18-0.38 A 0.59-2.84-0.39-1.33 Baa 0.35-2.80-0.64-1.19 High Yield -0.03-0.24-0.65 0.39 Floating Rate Notes 0.16 0.99-0.02 0.33 Source: Bloomberg Barclays 9
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