The Fed shocked markets yesterday, sending Treasury yields spiking. Interestingly, the surprise was not about the Fed’s decision to unwind its balance sheet, but rather the path of interest rates. Against all expectations, the Fed said it planned to hike in December. The comments came after months of anxiety over weak US inflation. The implication of the statements is that the Fed appears to have abandoned its long-held approach of being “data dependent”.
FINSUM: Yellen has always maintained the Fed would respond to economic data for its decision-making, but in this last meeting they seem to have completely abandoned that approach. That should lower investors’ confidence in predicting Fed moves.
The Fed will hold a potentially monumental briefing today. Fed chief Yellen may announce that the central bank intends to reduce its balance after undertaking several years of bond purchases. A decision on interest rates is also on the line. According to investment bank Jefferies, which issues bold forecasts for what the Fed will do, it is likely the Fed will keep interest rates unchanged, but announce that it will stop reinvesting interest income in new assets. This will work as a de facto shrinking of the central bank’s balance sheet.
FINSUM: We do not have any particularly sharp insight into what the Fed will do (and we don’t think anyone really does), but we do believe that a shrinking of the balance won’t cause the bond market losses that many fear.
Everyone on Wall Street is worried that if the ECB ends QE and the Fed begins reducing its balance that government bond yields will spike and the bond market will see big losses. However, there is another argument out there that would prove those fears completely wrong. That is the idea that QE was really only ever a signaling mechanism, a promise that inflation and the economy would move higher, which sparked a boom in shares. If that promise is removed, especially now when the market is worried about the state of the economy, it may do the exact opposite of expectations and send yields tumbling as people will flee to safer havens.
FINSUM: There are two things to weigh here—the increase in supply from the Fed selling assets, and the signaling impact of losing the Fed’s promise. We think Treasuries may see gains when the Fed starts reducing its balance sheet.
It used to be that companies issued bonds and asset managers bought them. The situation has changed, making companies the new top dog in the market. Because of their huge un-patriated cash piles, companies are buying up each other’s debt in huge volumes. American multi-nationals now own over $400 bn of US corporate bonds, amounting to near 5% of the total market. The buying is part of a move away from the money market accounts corporates used to rely on. In total, US corporates have over $2 tn in cash and securities.
FINSUM: This is an interesting level of interconnectedness that few talk about. It makes one wonders about vulnerabilities in the event of a crisis.
Anyone looking for signs of what is to come in markets need to look no further than Treasuries yesterday. On the back of fears over North Korea, a dovish Fed, and the monstrous hurricane bearing down on Florida, the yield on ten-year Treasuries dropped a whopping 10 bp yesterday. Gold also jumped on the same fears. The Fed made new dovish comments about inflation, which bolstered worries about the slowing pace of interest rate hikes. Financial shares dropped 2.2% yesterday.
FINSUM: The North Korea situation is really looming over markets right now, as are concerns over the implications of Fed dovishness. However, earnings and the economy still look strong, which should protect against big losses.
The high yield bond market still has some good opportunities, but because valuations are so stretched, the key to success may be defensive positioning. Spreads are very low (400 bp over Treasuries), but not at historic lows (e.g. less than 300bp in 2007). On the positive side, credit quality has improved, but this has brought coupons down and raised interest rate risk accordingly. Some bonds to look at are Netflix, Carlson Wagonlit Travel, and McClaren Automotive.
FINSUM: There are a lot of risks out there for the high yield market. One of the more comforting aspects is that average duration of high yield bonds is only 4 years, so a slow rate rise would not wound the market too much.