May 2015 – Monthly Commentary

Economic activity continued to accelerate in May, as the weather finally stabilized and recession concerns abated. Despite the improvement, the bond market was mixed, with credit spreads generally wider, especially in the municipal bond market. The continued acceleration in economic activity was underscored by the robust jobs report released on June 5th. Hours after the release of the report, New York Fed President Bill Dudley commented that the Fed is likely to raise interest rates this year, resulting in selling across all maturities of the yield curve.

Aside from employment, there’s no better gauge of economic activity than automobiles and homes. When people are getting jobs, raises, and feeling optimistic about their economic future, they buy cars and homes, and last month they bought a lot of them. During the month, consumers purchased new cars at a 17.7 million annualized rate, exceeding expectations by more than one million vehicles and registering the highest monthly sales level in ten years. Coincidentally, the average age of the cars on the road reached a record 11.4 years, portending that the sales rate should stay high as those older cars are replaced. Similarly, housing starts jumped by 20.2% compared to the prior month, and 9.2% compared to the year earlier period. After the brief hiatus in March, the U.S. economy is again adding in excess of 200,000 jobs a month, which should put us back in the virtuous circle that we’ve been experiencing for the last several years.

While the U.S. bond market continued to experience heightened volatility, the real action lately has been in Europe where local bond markets suffered steep losses. Hedge Funds had been on a buying spree since the European Central Bank announced that it would buy Euro area government bonds in the secondary market. The stated goal was to drive down interest rates and encourage investors to move into riskier debt, which they hoped would stimulate economic activity. The ECB is following the same money printing exercise that the U.S. Federal Reserve and Japanese Central Bank have pursued. The only difference is that the ECB has vowed to buy debt even if it had a negative yield to maturity, effectively paying debtor governments for the privilege of borrowing from them. With that pledge, yields plunged below 0% for many European nations as traders speculated that ECB would drive yield levels ever lower. Days after the program was announced, one trader was quoted as saying that -0.05% offered good value because the price would go higher still as the ECB bought. That would have been correct, unless investors concluded that ultra low rates aren’t worth the risk, which is exactly what happened last month. Yield curves across Europe entered into a “bear steepener,” which is to say that prices sold off across the maturity spectrum with the price of longer maturities falling faster than shorter maturities. For example, the German 10-year note which yielded 0.15% at the end of April, rose to 0.86% in early June, resulting in a 7% drop in price. The price action in the 30-year bond was even worse, falling more than 20% as the yield shot up from 0.62% to 1.50%. Adding to the confusion, ECB Chairman Mario Draghi announced mid-month that the ECB would front-end load their open market purchases this summer citing the lack of liquidity and wish to avoid subjecting the market to heightened volatility during the August holiday season. However, we wonder if by announcing the change in their buying schedule to avoid volatility, they aren’t ensuring it. Opportunistic traders, knowing that the ECB won’t be buying as volume falls in August may be tempted to sell aggressively. Once again, it seems that markets would be better served if Central Banks didn’t “tinker” with policy.