Nicholas Zaiko, CIMA®
Investment Consultant
Bridgebay Financial, Inc.
US Federal Reserve
On December 16, 2015 the Federal Reserve raised the Fed Funds rate
target range to 0.25% - 0.50%. The low
interest rate environment has been in place for several years at the 0.0% -
0.25% range.
Fed policymakers concluded the benefits of the zero interest rate
policy were being outweighed by the costs, specifically the misallocation of
capital into riskier and higher-yielding sectors.
The FOMC stated that the pace of rate increases will be gradual and
monetary policy will remain highly accommodative. Expectations are that there will be 3 – 4
additional rate hikes in 2016.
Given the turmoil in the markets so far in January 2016, fewer rate
hikes may actually occur, but the Fed is still indicating 3 to 4 rate hikes.
Fed funds futures contracts show that traders expect the central bank to raise
rates at least twice in 2016, and are reducing bets on a third hike by
December, 2016.
At the September 17, 2015 FOMC meeting, the Fed had cited global
financial and economic developments that could impact and restrain US economic
growth and keep inflation low. This may
delay further hikes.
Reverse Repo Program (Fed RRP)
The Fed raised the overall cap on the overnight Fed New York (Fed NY)
RRP to $2 trillion from $300 billion. The Fed NY RRP is an important policy
tool for managing the fed funds rate floor, now 0.25%, and meeting money market
fund demand. Without sufficient RRP
there would be potential disruptions in repo, securities lending, T-bills and
other funding operations. The sizeable increase in RRP provided funding market
stability.
FOMC Forecast for Fed Funds
The FOMC’s forecasted average Fed Funds rate for 2016 is 1.375%. The forecast average for 2017 was reduced to
2.375% and 2018’s forecast average was revised to 3.25%. The longer run average remains unchanged at
3.5%.
Employment
The US economy created around 292,000 net new jobs in December or
257,000 private payroll jobs, exceeding the 252,000 increase in November that
was stronger than previously estimated.
The unemployment rate held at a seven-year low of 5%. Some analysts, however, noted that many of
the December jobs were part-time delivering no wage growth.
China
Investors focused on volatility in Chinese markets after the country
sought to quell losses in equities and stabilize its currency. Fresh concern
that China’s slowdown will hamper global growth has emerged again. Policy makers are struggling to revive an
economy that’s the world’s biggest user of resources. China Securities Regulatory
Commission announced the suspension of a new stock circuit- breaker that forced
local exchanges to shut for the second day in the first week of January. The
move added to worry that policy makers are struggling with how to contain the
months-long turmoil in its financial markets.
Global Growth
The World Bank cut its global economic growth forecast for 2016, saying
the weak performance of major emerging market economies will hamper activity
overall, as will anemic showings from developed countries such as the United
States.
In the U.S., economic growth should increase slightly, from an
estimated 2.5% in 2015 to 2.6% in 2016, with rising employment, wage growth and
consumer spending countered by lagging capital investment and manufacturing.
Oil and High Yield bonds
Oil prices fell to 12-year low for a fourth day last week, lurching
again to 12-year lows as new financial market turmoil in China brought a $32
per barrel price for the commodity.
Recently, oil’s close below $30 a barrel heightened fears of
disinflation fueling concern that junk-rated energy producers won’t be able to
stay solvent. A collapse in commodity
prices has been the main driver for high-yield’s setback since September and
there may be some defaults in energy-related credits.
Junk Bond Selloff
The high yield market sell-off was sparked by declining oil prices and
concerns about energy and commodity companies. The closure of a Third Avenue
bond mutual fund sparked a wider sell-off in the credit market. Several high yield bond ETFs were hit with
major redemptions as a result of the junk bond selloff.
Inflation
Headline consumer prices remained flat in November, in line with
consensus expectations, pulled lower by declining oil and food prices. Headline
inflation is now up 0.5% from November 2014, while the energy index is down
14.7% in the same time. Core CPI inflation increased to 2.0% year over year
growth and improved by 0.1% month over month.
With the drag from energy prices expected to fade in early 2016,
headline inflation should also move closer to the Fed's 2.0% mandate in the
medium term.
Manufacturing
In October, the Institute for Supply Management (ISM) reported that the
U.S. manufacturing sector fell to 50.1, slightly above 50, the level between
expansion/contraction. This is a sign
that the strong US Dollar and tepid overseas demand is weighing on
manufacturers.
Corporates
corporate issuance returned to the market in January with over $19
billion in supply. For 2016, economists
are expecting corporate issuance to exceed $1.1 trillion, which would be
in-line with 2015’s supply.
While investors cope with the turbulence sparked by China, another
source of consternation is looming as the corporate earnings season
begins. Investors will begin to contend
with another expected decline in corporate earnings.
During the quarter, investment-grade corporate bonds underperformed
Treasuries and agencies amid the risk-off environment and credit spreads
widened. Treasury prices were volatile
on speculation that China will continue to sell U.S. debt to raise cash to
defend its currency and support its stock market. Corporate profits are expected to slow due to
falling energy prices and a high U.S. dollar.
During 2015, investment grade corporates issuance was 17% higher than
2014 with $1.33 trillion in new supply.
US corporate issuance in 2016 is expected to be as high as the acquiring
companies in M&A deals continue to issue investment grade debt.
Credit Quality
Recently there has been a noticeable deterioration in credit quality as
newly announced M&A transactions are leading to high corporate debt
issuance by the acquiring companies.
These companies in turn are being downgraded by the ratings agencies
although the overall credit quality is expected to improve over the next 18
months. Issuance related to the M&A
activity is especially pronounced in the below investment grade bond market.
U.S. corporate defaults hit a four-year high for below investment grade
bonds that increased from 2.1% to 2.5% in 3Q2015. Investment grade bonds have also seen a
downward trend in credit ratings.
Interest Rates
Market sentiment has become cautious with heightened market volatility
rising over the last 3 months. The rate
hike by the Fed was basically priced into the market. The shorter-end of the yield curve has seen
spread widening in anticipation of the Fed action. During the quarter, the yield curve continued
to flatten in December as rates on the 2-yr and 5-yr both climbed 12 bps for
the period. The yield on the 10-yr rose 6 bps during the month, while the 30-yr
rose 4 bps.
Negative market sentiment is not being driven by the Fed, but by the
collapse of oil and commodity prices. The
OPEC meeting in mid-December did not resolve the supply glut.
Banks that are lending to the energy sector or holding leveraged loans
on their books may also have some credit problems on their books. If lending to the weak high yield oil sector
is stopped, some of those issuers may have liquidity problems.
Higher quality, energy-related names may come under short-term pressure
and their bonds will have spread widening.
Australian banks and some Canadian banks may be impacted if they have
substantial loans to the energy and commodity-related industries.
Third Avenue Focused Credit Fund froze redemptions and Stone Lion
Capital Partners LP, a distressed-debt specialist, stopped redemptions on its
credit hedge funds due to falling commodity and junk-bond prices in December.
Although the portfolio is all investment grade, our cautious view is
that we may be entering into a period of credit spread widening, and
overreaction by the ratings agencies, being quick to downgrade credits. The pace of credit downgrades has been accelerating
over the last few months.
U.S. short-term and long-term rates are rising in contrast with other
countries where rates are falling. The
USD is expected to continue strengthening against other currencies.
Liquidity
Liquidity in the US bond market has changed dramatically from the
period before the financial crisis.
Historically, broker-dealers carried securities inventories on their
balance sheets and were willing to make markets in securities and take market
risk. The change in making markets, and
the record corporate issuances and low interest rate environment have made it
difficult for broker-dealers to make markets and inventory securities. Fixed income trading has become less liquid.
Fixed income investors face longer holding periods than they would have
considered in the past. Lower turnover
strategies have a lower impact on transaction costs on portfolio especially
when there are changes in market liquidity.
Trading now requires a more deliberate approach to minimize transaction
costs. Conversely, there are attractive
prices for buyers when there are forced sellers in the market.
The liquidity in fixed income markets has changed across all sectors
including Treasuries. The ability to
trade in large blocks has changed. Primary
dealers that purchase directly from the Fed have been buying fewer Treasures
and volume has fallen. The size of the
Treasury market has doubled since 2008.
US and foreign investors have purchased a higher percentage of
Treasuries sold by the Fed than the dealer community.
