November 11, 2021
Twists and turns: Central banks and the yield curve begin to react to persistent inflation
November 11, 2021
Twists and turns: Central banks and the yield curve begin to react to persistent inflation
November 11, 2021
Higher than expected inflation has caught the attention of global central banks and bond markets. With developed and emerging market economies beginning to tighten monetary policy, short-term rates have increased, helping to drive yield curves flatter. Technical factors played a role as well, and we believe the back end of the curve could move higher as the economy continues to expand and the Powell Fed remains dovish and focused on full employment. We reiterate our preference for credit over duration in fixed income portfolios.
Since mid-September, the 2-year Treasury yield more than doubled to 50 basis points (bps), as markets aggressively pulled forward rate hike expectations ahead of a highly anticipated November FOMC meeting. Headline CPI inflation above 6% has the market beginning to believe the Fed will be forced to raise rates sooner than expected. While the Fed acknowledged the “substantial further progress” required to begin tapering QE bond purchases, Chair Powell pushed back against market expectations for multiple interest rate hikes in 2022. Powell has consistently noted a higher bar for raising interest rates while trying to divorce the start of tapering from the start of tightening. During the press conference, he suggested it won’t be until next summer before we can truly discern the long- term inflation trends from Covid and supply chain issues. The implication is the Fed has redefined transitory inflation and is still willing to let inflation temporarily run hot as they believe many of the supply chain issues are Covid related and will get sorted out next year. This should support a steeper curve, while running the risk they may have to tighten more abruptly in the future.
The market continues to challenge the Fed in the front of the curve as the inflation data remains persistent at the highest levels seen in 30 years. However, yields in the back end of the Treasury curve have barely moved and seem to be ignoring inflation. 10-year Treasury bond yields have been in a range of 1.25%- 1.75% since the end of the first quarter. We think some of the reasons the long end has been well-behaved have been technical in nature. Large pension fund inflows, foreign buying and unwinds of levered hedge fund carry and curve trades have all produced buying out on the curve.
Rebounding economic data could support higher interest rates as Delta cases have slowed in the U.S. and the economy has continued adding jobs. The Citi U.S. Economic Surprise Index (Display 1), measuring economic data relative to expectations, has again returned to positive territory. October’s strong monthly job gains included upward revisions to prior months. After initial estimates of 6-7% GDP growth, we saw soft economic data drag down 3rd quarter GDP to 2% as the Delta variant spread this summer. Since Labor Day, Covid cases in the U.S. have been cut in half and vaccines for children and more effective therapeutics are currently hitting the market. After disappointing in the 3rd quarter on Delta variant supply chain woes, we expect GDP to bounce back in the 4th quarter and remain above trend in 2022. The average 2022 GDP target is 4% according to Bloomberg, with Morgan Stanley economists calling for 4.6% in 2022 and 3% in 2023.
Source: Bloomberg as of October 31, 2021.
The summer also produced a strange cocktail of technical factors supporting Treasuries that could abate later this year. Tax season was pushed out from April until June. The debt ceiling debate caused the Treasury General Account to run down, reducing the supply of T-Bills. And the Fed is now tapering purchases of Treasuries and Mortgage-Backed Securities (MBS) by 15 billion per month. As the debt ceiling is resolved and infrastructure bills make their way through Congress, net supply could shift from a tailwind to a headwind for Treasuries.
For investors searching for yield and income, we still prefer an overweight to credit and default risk while remaining underweight duration risk. This trade has worked well in 2021 and continues to benefit from strong corporate and municipal fundamentals. Investors can also look for opportunities in extending from money market funds to short-duration bond funds that have started to reflect future rate hikes and higher yields. While yield curves may steepen, excess global liquidity and persistent demand from pension funds and foreign buyers should keep a lid on long end yields.
The technical bid to the long end of the market cannot be ignored, despite growth and inflationary pressures in the economy. As equity markets rally (S&P 500 +25% YTD), pension funds are becoming fully funded and can defease their liabilities by purchasing high quality long duration bonds. The demographic trend of retiring baby boomers favors fixed income allocations as well. Weekly bond fund and ETF fixed income in flows have remained robust. For foreign investors, U.S. rates remain a bargain relative to the negative sovereign yields seen throughout Japan and Europe. With $12 trillion in negative-yielding securities globally,1 and the world awash in central bank and government liquidity, high quality U.S. fixed income assets should continue to see demand.
In sum, even though we anticipate higher trend growth and inflation data leading to higher long-term interest rates, we think higher yields will still be met with many buyers which should limit the ceiling for long-term yields.
For investors, a key debate surrounds Powell’s ability to remain patient as politically unpopular inflation continues into 2022. With above trend inflation data continuing to roll in, markets could again attempt to test the Fed’s resolve. The next update will be the FOMC meeting on December 15th when the committee releases its latest Summary of Economic Projections and dot-plot. This will be the opportunity for the hawkish wing of the committee to demonstrate the extent of their divergence with Powell, and it should be closely scrutinized by market participants for signs of a potential shift.
Municipals: “Future Hindsight”
“Hindsight is 20/20” is the simple acknowledgement that prior actions may have been different had future outcomes been known at the time. While this seems incredibly obvious, it speaks to last summer’s press that implied that bond purchases made years ago now look great today. Indeed, articles such as these tend to appear whenever municipal bonds are perceived to be fully valued…or even overvalued. They also dovetail with our longstanding opinion that during such frothy periods “the best thing about munis is already owning them.” The real question is how to attain this “future hindsight.”
While the path and trajectory of U.S. interest rates remains an open question, fueled by each data release and periodic FOMC rhetoric, the municipal bond market does offer clues as to how it may outperform or underperform within the broader context of the trajectory of U.S. Treasury (UST) yields during certain seasons. Indeed, the tax-exempt muni market is frequently impacted by powerful factors, referred to as “technicals,” that can acutely alter the balance of supply and demand in the municipal bond market. In fact, our runner-up title to this section was “It’s Technical.” Let’s examine.
With the summer season in the rearview mirror, many students are back to school, workers back in the office, investors appear to be reengaged, and municipal bond issuers (states, counties and local municipalities) have been back in the market issuing bonds.
While most bond market participants rightfully have an intense interest in economic data, Fed rhetoric regarding the timing of “liftoff” (a raising of interest rates) and the related response in UST yields, municipal money managers and muni pundits have an additional interest in shifting technical factors that routinely appear in a seasonal fashion.
With an impressive ten months already in the books and a YTD Bloomberg total return that made it the envy of fixed income, the tax-exempt muni market cruised through the summer flush with cash, but with few bonds to satisfy that demand, only to encounter the fall headwinds of rising UST yields, weaker demand and greater supply. The total return for the Bloomberg Municipal Bond Index was +1.12% on November 22. Admittedly, a one percent gain does not appear compelling, but compared to YTD negative total returns for U.S. Treasuries (-2.93%), securitized (-1.26%) and investment grade corporate (-1.73%) Bloomberg indices, it’s relatively impressive.
That said, the tax-exempt muni sands shifted in both September and October to the benefit of prospective buyers. After three months of outsized demand from bond redemptions and constrained new issue supply due to light summer issuance, these technical factors, which often dictate the degree to which the muni market will outperform or underperform corresponding maturity USTs, reversed in September and October. This shift endured into early-November.
Driving the fall price weakness is a positive net supply of bonds, weaker (sub- $500mm) mutual fund inflows and the formidable headwind of weaker USTs. In fact, June, July and August represented the three largest months of bond redemptions (maturities, coupons and calls) hitting bondholder accounts this year … and September was the smallest! After the residual monies from the summer reinvestment demand were deployed, there was little left in the pipeline. Specifically, total redemptions declined from approximately $47 billion in August to just over $22 billion for September, and remain at reduced levels through November, as illustrated in Display 2.
Source: ICE Data, as of September 30, 2021.
Meanwhile, new issuance supply typically increases during the fall months of October and November. This combination of increasing supply and decreasing reinvestment demand marked a reversal of the recent market-favorable technicals and spelled opportunity for those patiently awaiting a better buying environment…especially given recently higher benchmark yields. Display 3 illustrates average muni issuance, by month, over the last 20 years.
Source: The Bond Buyer, as of September 30, 2021
What we watch for… and what we are seeing
Like most fixed income investors, we are keeping a close eye on economic data, specifically the monthly payroll situation reports, as well as rhetoric and data from the FOMC regarding the timing of an eventual “lift-off” following the proposed end of tapering in June of 2022. On the tax-exempt municipal front, we are seeing a relatively consistent rise in new issue supply, as well as more attractive munirelative value ratios versus corresponding maturity USTs (75% on 11/09 versus an average of 67% year-to-date for the 10-year benchmark).
There are a number of muni-specific or muni-impactful “known unknowns” in play today: a possible cap adjustment on state and local property tax deductions (SALT); the potential advance refunding capability using tax exempts for municipal issuers; the possibility of a return of a Build America Bonds-style taxable muni program. Yet despite these market uncertainties we remain optimistic about the tax-exempt muni asset class due to what we believe will be a continued environment of robust demand and constrained supply. There is also the real possibility of higher upper-bracket income tax rates, which may provide a strong tailwind for individual investor demand.
What about rising rates?
Our upbeat outlook notwithstanding, we do acknowledge that rates are expected to rise in the coming months (and beyond), given Morgan Stanley’s forecast of 1.80% for the 10-year UST by year-end, and 2% for the end of 2Q 2022. Additionally, the street consensus also has rates rising, though less dramatically, with year-end forecasts for the 10-year UST that average 1.69% according to Bloomberg (as of 11.09.21). As of this writing the 10-year UST stands at approximately 1.65% (Bloomberg).
That said, we find it helpful to discuss the prospect of rising muni yields using the Morgan Stanley forecasts as benchmarks to apply various muni-relative value scenarios, which enables us to provide potential paths for muni yields (Display 4 below). For context, although the 40-year average for 10-year AAA muni-to-UST relative value ratios is approximately 84%, the year-to-date average has been just 67%, within a range of 55% to 81%. Display 4 shows muni paths for 65%, 75% and 84%, but our base case is that 65% or lower will prevail by year-end.
Sources: Bloomberg, Morgan Stanley as of October 18, 2021. Forecasts/estimates are based on current market conditions, subject to change, and may not necessarily come to pass.
What to do?
One of the most difficult decisions fixed income investors encounter is whether to purchase bonds when rates have risen and/or appear set to continue rising. That said, the scenario that has unfolded over the last two months presents just such a dilemma for prospective buyers. While our forecast chart may help to keep the potential yield rise and corresponding price decline in context, it may also be helpful to bear in mind some of the basic tenets of highquality muni investing, which include the preservation of principal and the maximization of tax-free income. With this in mind, purchasing tax exempts during what appear to be opportune, yet uncomfortable, times can (or may not) lead to a favorable “future hindsight” experience, along with the related media coverage, at some undetermined point in the future. In the interim, bondholders can enjoy “clipping their coupons” along the way while they wait. Stay tuned!
Despite a mid-summer move lower in bond yields, credit spreads and interest rates ended the third quarter close to where they started. Corporate credit markets have remained calm, with spreads near their tightest levels of the year, despite the recent increase in interest rate volatility.
Source: Bloomberg, as of October 31, 2021, based on ICE BofA US Corporate Index option-adjusted spread. The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See Disclosure section for index definitions.
We continue to favor credit risk over interest rate risk, which has worked well for investors this year. Year to date, credit-sensitive assets such as high yield (4.53%), bank loans (4.65%) and preferreds (2.21%) have outperformed the broad Investment Grade (IG) indices such as the Bloomberg Aggregate, which was down 1.55% through quarter end.2
We believe the corporate bond market benefits from four key pillars of support: monetary policy, fiscal policy, improving fundamentals and strong technicals. The strong technicals have been apparent through the consistent weekly fund inflows into credit funds and ETFs. This trend continued in the third quarter as investors continued to look toward the corporate credit markets for yield in a low-yield environment. The IG market saw a marked increase in supply in September and October to $145 billion and $115 billion, respectively, which was digested with minimal friction. As yields have started migrating higher, anecdotal evidence points to increased pension fund and foreign buying of corporate credit, especially in the long end of the yield curve.
The fundamental case for credit continues as corporations report strong earnings and de-lever their balance sheets. Corporate defaults and credit rating downgrades remain low. We did witness some credit deterioration in the Chinese property space recently, but we believe that U.S. financial exposure to this sector is rather limited. The biggest risk we see with credit markets is that valuations are expensive on a historical basis and we could see some volatility as fiscal and monetary support begin to fade. We think that fundamentals and technicals in the IG market will stay supportive in the near term and we would suggest investors remain overweight credit and default risk and underweight duration in their fixed income allocations.
Given valuations in the credit market, we believe it’s very important to be selective and to look at credits from a bottom-up perspective. As we head into earnings season, we will be watching for signs of margin compression as some companies face supply chain bottlenecks, wage inflation and other input costs that cannot be passed on. We have also seen some companies report margin issues as commodity and labor input costs remain elevated. We are overweight financials in our corporate portfolios as we believe this sector is largely immune from some of the supply chain and input cost issues that are affecting companies in sectors such as chemicals, industrials and consumer products. For the most part, multi-national investment grade companies have been able to manage the supply disruptions.
Financials corporate bond spreads have lagged the tightening in other sectors. We believe supply-related technical pressure has caused financial spreads to lag and some of this supply should start to ease up in the 4th quarter. From a fundamental standpoint, bank and finance company earnings have been strong while balance sheet capitalization and credit quality remain solid.
From an interest rate standpoint, the potential for a more hawkish Fed policy led us to be cautious on duration throughout the summer. However, front end yields have recently started to rise. Inflation pressures in the U.S. and abroad have pulled forward market expectations of interest rate hikes as central banks begin to remove the extraordinary liquidity programs implemented at the onset of the Covid crisis.
As bond markets start to price in additional rate hikes, we will look to start covering our duration short. Investors can now pick up attractive incremental yield by extending out of money markets into short-duration solutions.
Source: Bloomberg, as of October 31, 2021. $25 par represented by ICE BofA Core Plus Fixed Rate Preferred Securities Index, $1000 par by ICE BofA US Investment Grade Institutional Capital Securities Index.
The index performance is provided for illustrative purposes only and is not meant to depict the performance of a specific investment. Past performance is no guarantee of future results. See Disclosure section for index definitions.
During the third quarter, the ICE BofAML Fixed Rate Preferred index returned 22bps as interest rates were close to unchanged and credit spreads widened marginally at the end of September. The 2.21% return through the end of the 3rd quarter exceeds that of investment grade bond indices, with ICE BofAML U.S. Corporate Index down 1.12% and the Bloomberg Aggregate down 1.55%. Despite the continued performance, the asset class appears attractive relative to others in credit, especially on an after-tax basis.
October featured the start of corporate earnings season and a wave of preferred new issues from financial institutions. YTD supply is tracking over 20% higher than 2020, and approximately double that of 2019. Refinancing high coupon securities remains the dominant theme, but issuers are also building capital in response to asset growth and regulatory changes, and still others are choosing to refinance LIBOR-based securities.
Aside from some weakness in July and October, the market has absorbed the new supply well. Fund flows remain a steady source of support. Preferred ETFs averaged $200 million in weekly inflows during the summer, and despite a week of outflows to begin October, continued to benefit from weekly inflows through the end of the month.3 The largest ETF in the space now commands a market cap of $20 billion.4
Beyond serving as a catalyst for new supply, corporate earnings underscored the fundamental strength from some of October’s issuers. Supply can be motivated by any number of factors from refinancing, to changing capital requirements, to acquisition financing, or simply organic growth. In the case of a regional that priced two deals in the month, loan growth topped 19% compared with an industry average of 1%. For a capital markets focused money center, their new issue was after 20% YTD growth in risk-weighted assets.
These institutions are growing their balance sheets in response to attractive market conditions, and despite the supply headwinds, investors are getting compensated to finance that growth.
In more detail on 3rd quarter results, property and casualty insurers had higher catastrophe losses, led by Hurricane Ida. Auto underwriting was an underperformer, in a reversal from Covid trends, as drivers returned to roadways and the inflated costs of labor and parts decreased profitability. Fundamentals appear stronger outside of auto where commercial lines are enjoying a strong pricing environment. Life insurers continue to experience elevated mortality rates, though positive results from investment portfolios provided some offset.
For the banks, management teams began to make good on their forecasts for loan growth. Paycheck Protection Program (PPP) loans continue to run off, weighing on loan balances for some regional banks, but excluding this impact, the largest banks delivered loan growth in the quarter of 1%. Credit cards may have turned the corner as well. A weak spot for loan growth during Covid, card balances grew across the industry over 3% in the quarter, while charge-offs remained at or near historic lows.
Investment banking had another banner quarter driven by heavy deal volume and an active underwriting environment. M&A advisory had a record quarter for some banks while equity sales and trading remained robust as FICC revenues moderated towards historical trends. Capital levels declined across the group as institutions returned capital to shareholders through buybacks and balance sheets grew. Excess deposits remain elevated for banks, and if rates continue to rise, banks could improve net interest income by deploying the excess into securities. Despite hopeful commentary from management teams regarding revisions to the Supplementary Leverage Ratio, we are not anticipating regulatory changes in the near term.
In portfolios, we continue to favor more credit sensitive areas of the market, as well as bonds with stronger structures, meaning less sensitivity to extension risk. With new issue coupons dipping below 4% in some cases, lower coupon securities can exhibit greater interest rate sensitivity as the yield curve steepens. We have a bias to own fixed-to-floating rate and shorter call, high coupon securities, known as “cushion paper,” to help mitigate this risk.
There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this portfolio. Please be aware that this portfolio may be subject to certain additional risks.
Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interestrate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Municipal securities are subject to early redemption risk and sensitive to tax, legislative and political changes. Taxability Risk. Changes in tax laws or adverse determinations by the Internal Revenue Service (“IRS”) may make the income from some municipal obligations taxable. By investing in investment company securities, the portfolio is subject to the underlying risks of that investment company’s portfolio securities. In addition to the Portfolio’s fees and expenses, the Portfolio generally would bear its share of the investment company’s fees and expenses. Preferred securities are subject to interest rate risk and generally decreases in value if interest rates rise and increase in value if interest rates fall. High yield securities (“junk bonds”) are lower rated securities that may have a higher degree of credit and liquidity risk.