(New York)
Investors beware, the muni bond market has gone through some dramatic moves over the last year, and the market looks like it might be headed for a downturn. Changes to the US’ tax policy have caused massive inflows to muni bonds as investors try to minimize their taxes. This has caused yields to plunge and spreads to Treasuries to widen. The average ten-year muni yield is now just 1.965% versus 2.6% in 10-year Treasuries, the widest gap since at least 2009. Munis in high tax states have plunged even further, with a recent California issuance having a yield of just 1.73%. One portfolio manager warns investors that they need to be responsive, saying “The best place for investors to be is shorter duration, higher-quality credit, so when opportunities present themselves, they have the flexibility to take them … You can’t really set it and forget it”.
FINSUM: This is a hard situation to call. On the one hand, the rapid fall in yields is worrying and the market seems overbought, but on the other hand, you have somewhat artificial demand being created by the government, which makes the behavior less risky and more sustainable in our view.
(San Francisco)
One of the core tenants of US central banking is being shunned by Jay Powell’s Fed. Former central bank leadership had always taken the approach that tight labor markets posed a serious threat for higher inflation. However, Powell is stepping away from that view. Labor markets remain tight, with unemployment very low and strong job creation consistent. Yet, the Fed has completely stepped off the gas pedal on rate hikes, a position that runs counter to previous approaches.
FINSUM: At least in this cycle, the relationship between labor markets and inflation seems to be thoroughly broken. The reality is that no one can give a great answer as to why, but Powell’s policy nonetheless sticks to the idea that the link is severed.
(New York)
The bond market took on a very strong position about the Fed in its recent rally—that rate cuts were likely this year in order to stimulate the economy. However, upon the release of the most recent Fed minutes, that view appears to be quite clearly wrong. The Fed minutes show no indication at all of cuts to come this year. Instead, those at the Fed merely indicate that hikes are likely to be put on hold for the rest of the year.
FINSUM: We don’t think there is much of a chance the Fed will cut this year. Recent economic data has been a little better, which means they seem much more likely to stand pat than to cut.
(New York)
A rising tide lifts all boats right? Well it also means credit scores get lifted alongside the economy. Goldman Sachs thinks this is a problem. The bank is arguing that credit scores have been artificially inflated by FICO, a dangerous development that could have implications for all sorts of lending. Goldman thinks that current FICO scores are not an accurate reflection of consumers’ ability to pay in an economic downturn, meaning there is much more credit risk sloshing around in the economy than is currently priced into the market.
FINSUM: The big risk here is really at the lower end of the lending spectrum. There are 15 million less consumers with scores of 660 or below than there were before the last Crisis. Therefore, the risk of borrowers in that area is probably being underappreciated.
(New York)
There is a LOT going on in fixed income markets right now, and for the most part, those developments are confusing. Treasury bonds had a huge rally, and then a little pull back, on worries about the economy. But at the same time, the riskiest bonds—high yield—have been doing very well even though they are the most likely to suffer in a recession. So where should investors have their money in fixed income? Long-dated municipal bonds might be one good idea. Advisors will be well aware of their tax exempt status, but what is interesting right now is that they appear a relative discount. 30-year munis have yields over 3%, well above Treasuries, making them look like a relative steal.
FINSUM: These seem like a good buy right now, especially with the rate outlook being so dovish.
(Washington)
US core retail prices came in soft in new data this week. The US core consumer price index, which excludes food and energy, rose 0.1% from the previous month and 2% from a year earlier in March. The readings both underperformed expectations, but are not considered indicative of a recession or any real economic trouble.
FINSUM: This data reinforces the idea that we are in a goldilocks moment with the economy. Let’s see if that continues. If it does, it sets up a nice environment for asset price growth.
(New York)
Investors have been very worried about the yield curve’s recent inversion, and with good reason—an inversion is the most reliable indicator of a forthcoming recession. That said, there are two important factors to note. The first, of which most readers will be aware, is that it takes an average of 18 months for a recession to arrive once the curve inverts. However, the second factor, which is less well understood, is that the specific pairing of yield curves that are inverted also makes a difference. The media and market have been totally focused on how the 3-month and ten-year yield has inverted, but the best indicator historically has been the two-year and ten-year, which is still 18 basis points or so shy of an inversion.
FINSUM: The signal from the 2- and 10-year pairing has been a much better indicator. Accordingly, the inversion the market has been obsessing about may be less relevant.
(New York)
What is the biggest short-term risk to markets? Is it a recession, China trade relations, and EU meltdown? None of the above. Rather, it is the upside risk of better economic data. A short burst of good US economic data, and the resulting comments from the Fed, could send US bond markets into a tailspin after the huge rallies of the last several weeks. The market for long-term Treasuries looks overbought, which means a reversal in economic data could bring a lot of volatility which could even whiplash equities.
FINSUM: At this point, a round of good economic data, and a stray hawkish comment from the Fed, would deeply wound bonds and hurt equities too (because everyone would again grow fearful of hikes).
(New York)
Do you remember those glory years between the taper tantrum and the end of 2017? The time when inflation was low, but not totally weak, growth was solid but not great, and the Fed decided to do nothing and say little? That was the time when the market surged. Well, those days may be here again as the economic signals right now, and the Fed’s language, are starting to look like they are returning to the post-Crisis “new normal” of moderate growth and inflation, but not enough to bring on a policy response.
FINSUM: Our own view is that we are not headed for recession, but rather a return to the pre-tax cut rate of growth and inflation. This is a solid setup for markets as it produces a dependable environment and a good atmosphere for corporate earnings growth.
(New York)
We don’t want to say that we told you so, but we have been broadcasting that bond markets had overreacted to the Fed’s change of tune. This week, bond investors have started to correct themselves as yields on the ten-year have jumped considerably on better economic news. With that in mind, limiting rate risk on bond holdings has taken on renewed importance. Accordingly, where better to be that in short-term, less rate-sensitive, bond funds. For options here, take a look at the Vanguard Short-Term Bond ETF (BSV), yielding 2.8%, and the PIMCO Enhance Short Maturity Active ETF (MINT), yielding almost 3%.
FINSUM: We think there could be some significant yield volatility in the next few months, and therefore feel it is best to stay rate hedged/defensive.
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(New York)
The yield curve is the center of attention right now. The short end is yielding more than the long end, everything feels upside down. So how to play it? Yields on long-term bonds have fallen so steeply that it seems foolish to think they will continue to do so. Inflation is still around and the Fed still has a goal to get the country to 2%, which means yields seems more likely to rise than fall (unless you think a recession is imminent). Accordingly, there are two ways to play this curve. The first is to use a “bullet” strategy by buying only intermediate term bonds, which tend to do well when the yield curve steepens, especially if short-term rates actually fall. For this approach, check out the iPath U.S. Treasury Steepener ETN (STPP). The other option is to remain agnostic as to direction, buying something like the iShares Core U.S. Aggregate Bond fund (AGG).
FINSUM: Our own view is that we are not headed into an immediate recession, and thus the long end of the curve looks overbought.
(New York)
The general understanding of markets is that bond investors are signaling that there is going to be a recession. Treasury yields have tumbled, and the Treasury yield curve has inverted, both signs of a coming downturn. However, the corporate bond market is sending a different signal, and it is worth paying attention to. The big sign of economic worry in the corporate bond markets is widening spreads between investment grade bonds and junk, but that is exactly the opposite of what is happening. The market is sanguine, and showing little of the concern that Treasury markets are. “Corporate spreads are extraordinarily narrow”, says Dan Fuss, vice chairman of Loomis Sayles.
FINSUM: This is a very good sign in our opinion. While it could turn out to be wrong, we do think this signals that Treasury investors may simply be overreacting.
(New York)
For the last year all the fear in bond markets was about inflation and how the Fed would handle it. Were we going to be hiked into a recession? Now all of that has shifted and fixed income gurus are concerned over an entirely different beast—recession. In many ways the fears of recession have become so strong that they are intimidating the market as a whole, making the term “bond vigilante” more than appropriate here.
FINSUM: The speed with which the bond market has reversed since December is pretty alarming. We do wonder if this inversion might be a false signal.
(New York)
The professor who first identified yield curve inversions has written an article explaining what the development really means. First identified in 1986, a yield curve inversion is considered the most widely accurate indicator of recession. Since it was first identified and back tested, it has accurately predicted a further 3 out of 3 recessions. This is a point its “discoverer” Campbell Harvey hammers home in his article. He explains that an inversion is usually followed by a recession within 12-18 months. The yield curve has not been inverted since before the Crisis, but just did so on Friday.
FINSUM: One of the important points Harvey makes is that in order for the inversion to really indicate a recession, it needs to remain in place for at least three months. We are only at one day.