February 2014 – Monthly Commentary

February 2014

Unlike the wild swings witnessed in January, capital markets were relatively calm in February with the yield of the 10-year and 30-year Treasury securities effectively unchanged for the month.  Similarly, equities reversed the selloff suffered in January and early February, ultimately posting a year to date total return of 0.94% through the end of the month.

On February 19th, the Federal Reserve released the minutes of the January Federal Open Market Committee meeting, the first Chaired by Janet Yellen.  While the Fed had repeatedly communicated that there would be continuity in monetary policy as the Chairmanship was passed from Bernanke to Yellen, the minutes reflected otherwise.  Attention had been focused on whether or not the committee would continue to reduce the pace of quantitative easing.  As we wrote last month, the economy has been sputtering through a weather-related slowdown and there was some speculation that the Fed would suspend the pace of tapering in an effort to offset the slowdown.  For the record, we did not share that opinion.  In reducing the pace of quantitative easing, the Fed is only doing less emergency easing; in no way are they tightening policy.  Surprisingly, the discussion among the policy makers was more hawkish than we had expected.  What caught our eye was the statement “downside risks to the forecast were thought to have diminished, but the risks were tilted a little to the downside because with target Fed Funds at its lower bound, the economy was not well balanced to withstand future adverse shocks.”  In other words, the Fed realizes that they don’t have much “dry powder” stimulus should an unanticipated shock disrupt economic growth.  This has been a worry of ours for some time.  When questioned about that risk, Fed policy makers have said that increased quantitative easing would mitigate such a risk.  Nevertheless, they’ve been reluctant to admit that they no longer have interest rate management as a policy tool.  Apparently the discussion delved far deeper into the question of interest rate normalcy.  The minutes indicated that three of the Regional Presidents of the Federal Reserve were in favor of raising the Fed Funds rate “relatively soon” and specified that by targeting this summer.  That’s certainly a departure from keeping rates low for an extended period of time.  The shift in discussion could become more pronounced when Stanley Fischer, the Vice-Chairman nominee joins the Fed.  Fischer has advocated a more reactionary monetary policy both while at the Bank of Israel and in comments since leaving that post.  Under his supervision, the Bank of Israel was the first Central Bank to raise rates following the financial crisis.  Recently, there has been a divide between several of the more hawkish bank Presidents and the decidedly more dovish Fed Governors.  Should Mr. Fischer advocate a more balanced approach to monetary policy, the message from the Fed could soon be one of restraint.

Interestingly, despite the Fed comments, investor appetite for risk has increased.  Since the beginning of the year, the spread of investment grade corporate and municipal debt has narrowed versus U.S. Treasury notes of similar maturities.  Similarly, the S&P 500 has rallied nearly 7% to 1859, a new record high since closing at 1741 on the first trading day of February 2014.  One would assume that the members of the FOMC are watching the heightened risk appetite and factoring it into their thoughts on interest rate policy, which is what prompted the change in discussion at the last meeting.

January 2014 – Monthly Commentary

January 2014

The capital markets have vacillated wildly during the first six weeks of 2014.   Investors dumped equities in January in what appeared to be a calendar-related attempt to lock in the outsized gains of 2013.  As the selling swelled, so did the price of U.S. Treasury bonds.  For the month, the yield-to-maturity of the 10-year Treasury note fell to 2.64% from the 3.02% year-end closing yield, reversing a portion of the sharp selloff experienced is the fourth quarter.

Driving capital markets has been the sudden and unexpected weakening in job growth for December and January.  As we closed the year, average monthly job growth as measured by the non-farm business survey registered approximately 197,000, which is certainly more robust than the 80,000 monthly average witnessed for December and January.  However, a quick inspection of the full labor report indicated that the excessive cold and inclement weather experienced across the country kept a lid on labor growth.  The report was “muddied” further by the less referenced Household survey which reported a drop in the unemployment rate to 6.6% from 6.7%.  While economist had been expecting a drop in the rate due to an influx of people leaving the workforce, the BLS reported that the reverse occurred.  During January the work force actually expanded by 523,000 people while those employed increased by 638,000 people, hence the fall in the unemployment rate.

As equity losses mounted, the media increasingly referenced the adage “as goes January, so goes the year,” suggesting that equity price weakness could continue, exacerbating investor anxiety.  However, all was made right by newly sworn-in Federal Reserve Chair Janet Yellen’s testimony before Congress.  In it, she made clear that she intended to continue with management of the open market operations in the same manner as her predecessor.  With that proclamation, and propelled by a ferocious short-covering rally, the S&P is once again trading above 1800 and just below the previous record close.

Ironically, through both the selloff and subsequent rally, credit spreads have continued to narrow.  Credit spreads typically have an inverse relationship to interest rates, widening as rates fall and narrowing as rates rise; at least as rates initially move.  Considering the primary driver of interest rates, namely the state of economic health and the forecast for inflation, the correlation makes sense.  The relationship has broken down this year because the economic weakness is attributable to the extremely cold, snowy and icy weather.  Assuming that weather related weakness will be temporary and recaptured once weather returns to normal, investors have been willing to allocate money to the higher yielding corporate and municipal bond sectors even as rates fall.  The narrowing in spread has been beneficial to the fund, adding to performance in January.  Looking forward, we expect that the recent spread compression will hold and that interest rates will likely stay at current levels until the impact of foul weather passes.  That’s not likely to be evident until at least early April, when March economic data will be released.   In the meantime, we will continue to collect coupon income and maintain our hedges.

December 2013 – Monthly Commentary

With an acknowledgment that economic activity has consistently strengthened since the third quarter, Fed Chairman Bernanke announced at the December Federal Open Market Committee (FOMC) meeting that the Federal Reserve would begin to reduce emergency quantitative easing commencing in January.  Moreover, he said the FOMC expects quantitative easing to be fully concluded by the end of 2014.  While we are cheered to see the Fed retreat from what we deem to be irresponsible monetary policy, we see the measure as only a small step in the right direction.  While not apparent to those unfamiliar with the mechanics of the money markets, that marketplace is not operating as smoothly as it should and that’s directly attributable to QE.  Banks have not been able to lend and invest the $85 billion of freshly printed cash the Fed generates every month.  As a result, cash is flooding into the money market resulting in a shortage of Treasury Bills and money market instruments.  In the last week of 2013, the shortage became so acute that Treasury Bills were trading above their par maturity price, resulting in a negative yield for buyers.  On the 31st of December, the Federal Reserve satisfied the Bill shortage with their Fixed Interest Rate Reverse Repo facility, which is their de facto deposit facility.  The facility is open to 139 counterparties including 94 mutual funds, the various government-sponsored enterprises, 21 primary dealers and the largest commercial banks.  The amount “deposited” at the Fed was an astounding $197.8 billion.  While it’s not unusual for interest rates to vacillate wildly at year-end as supply and demand for excess cash comes into equilibrium, such an amount is extraordinary.  Transaction volume in the facility remained elevated well into the New Year, with $60 billion trading on January 13th.  That represents an enormous amount of excess liquidity, and likely a consideration in the FOMC’s decision to reduce the pace of QE.  As an aside, the Fixed Rate Reverse Repo is an arcane policy tool that, while not new, has been increasingly mentioned in the media.  We suspect that as the Federal Reserve ultimately moves to raise interest rates, the Fixed Rate Reverse Repo will be a more closely watched measure.

Since the announcement, rhetoric from the various Fed Presidents and Governors has taken a decidedly hawkish tone.  As we’ve speculated for some time, the change in Fed policy will occur in incremental steps, carried out through public debate via the media.  Since the taper announcement, that debate has intensified and the collective voice of the Fed has changed from nearly unanimous dovishness to a more conciliatory tone in which the majority are in agreement that less aggressive stimulus is desirable.  The most glaring change is evident in the “jaw-dropping” statement made by New York Fed President, and easy money advocate, Bill Dudley.  In a speech delivered to the American Economics Association on January 4th, he remarked that “We don’t understand fully how large-scale asset purchase programs work to ease financial conditions…”.  After nearly $4 trillion dollars of money printing and interest rate manipulation one of the most ardent advocates of quantitative easing declares that he’s not sure he understands how the program works.  That certainly doesn’t engender confidence in our Central Bank!

Despite the pledge to taper, investors continue to believe that the first rate hike is still far off, as is evident in the muted movement in short term interest rates compared to longer maturities.  As we’ve described on numerous occasions, a pillar of the Halyard investment thesis is that short term interest rate options are too cheap and will rise in price as the Fed moves to normalize interest rates.  We continue to deem the position as offering a highly attractive reward/risk payoff and expect that as economic activity continues to grow at a robust pace, traders will begin to discount the Fed pledge to hold rates low and will push short-term interest rates higher.

November 2013 – Monthly Commentary

November 2013

The barrage of better than expected economic data witnessed in October continued through November and into the early days of December. With the improvement in growth, investor confidence has risen markedly from the doom and gloom days of the government shutdown.  Reflecting the improved confidence, bond prices fell off and equity markets rallied.  .

As we anticipated at summers end, investors have reversed their aversion to credit and have been buying the various sectors despite the downward price action of government debt.  In addition to a heightened risk appetite, positive news on municipal finance also contributed to the improvement in credit.  Specifically, the State of Illinois, after decades of fiscal mismanagement passed legislation designed to bolster their woefully underfunded state pension plan.  While the governor has said he will sign the bill into law when it arrives at his desk, union officials representing future retirees said they intend to fight the agreement in court.  They claim the action violates the Illinois constitution which states that the pension “shall not be diminished or impaired.”  The unions may be fighting an uphill battle in proving diminishment or impairment.  To improve the funding of the pension, the proposal would reduce the annual cost of living adjustment and increase the retirement age for workers hired on a go-forward basis; arguably, neither impairs the current value of the fund.  Following the announcement, 30-year Illinois bonds rallied and have continue to improve in secondary trading.  Given that positive outcome, we expect other municipalities to follow suit to bolster their pension obligation, thereby improving their credit profile.  We continue to see the municipal bond market as the most undervalued sector of the bond market.

As mentioned in the first paragraph, economic activity continues to accelerate, with housing and job growth leading the way.  Following strong job growth in October, economists were surprised with the continued strength witnessed in the November report.  In addition to the second consecutive 200,000 job gain, labor force participation increased and the unemployment rate fell to 7.0% from 7.3%.  The 7% unemployment rate is especially important since the Fed said at the June press conference that they expected to have concluded secondary market purchases when unemployment rate fell to that level.  That puts the Federal Reserve and their maintenance of emergency easy-money policy in an awkward position.  As we described last month, the Fed does not like to change policy in December due to diminished volume and the accompanying risk of outsized volatility.  Just hours after the release of the employment report Wall Street economists were handicapping the odds of a taper announcement at the December 18th FOMC meeting at 50/50.  With that date only a week away and coming with just eight trading days left in the year, Chairman Bernanke certainly must be regretting his decision to postpone the taper announcement back in September.  Despite the challenge of the calendar, equity investors took the news of better than expected employment as good news for earnings and rallied the market sharply.

The favorable unemployment news came one day after Q3 GDP was revised from 2.8% to an “eye-popping” 3.6%.  Much of the revision was attributable to an increase in inventories, which could potentially weigh on Q4 GDP if those goods are simply being restocked.  However, if those goods were produced in anticipation of heightened sales, that could portend a strong economic outturn.

October 2013 – Monthly Commentary

Investors were clearly pleased with the end of the government shutdown, as the various “risk on” trades performed well in October.  Fixed income returns were driven entirely by a demand for credit, as the Treasury market was mostly unchanged for the period.

As the government returned to work late last month, investors debated what impact the political squabble would have on the economy.  Conventional wisdom was that the work stoppage and the collateral damage done to government-related business had weakened consumer and business confidence; especially since the squabble is likely to resume as the year comes to an end.  Reflecting that, many Wall Street economists have lowered their Q4 GDP forecasts to below 2%.  Surprisingly, the economic data released since the shutdown has been almost uniformly positive.  Weekly claims for unemployment insurance continue to fall and the manufacturing sector, as measured by the purchasing manager indices, has accelerated.  Most surprising has been the unexpected increase in Q3 GDP and the big jump in hiring as portrayed in the October jobs report.  The GDP report was boosted by an inventory buildup, which jibes with the jump in manufacturing and is widely seen as being a drag on future GDP growth.  However, due to unseasonably warm weather, the utility expenditure component of the report was down 0.3%, which is arguably beneficial for future expenditure and partial offsets the inventory effect.  Money saved on utilities becomes available for discretionary spending.  Unlike the “good news, bad news” GDP report, the non-farm payroll report was an unqualified positive.  Economists had been expecting an anemic gain of 120,000 new workers.  With more than 200,000 jobs added in October and an additional 60,000 in the August and September revisions was welcome good news.

Against that backdrop and with the fiscal uncertainty continuing to linger, investors were left to again debate the timing of the Fed’s taper plans.  On this matter, no clear consensus has emerged as comments from members of the committee continue to send conflicting signals.  Last week Atlanta Fed President Lockhard suggested that action could come as soon as December.  Given Chairman’s Bernanke’s penchant for preparing the market well in advance of any change, we think that’s unlikely.    The Fed has historically been loath to change policy in December when markets are materially less liquid and a policy change could have an outsized effect on asset prices.

While economists debated the timing of the policy change, corporations took advantage of the marginal fall in interest rates to issue debt.  During the month, 106 investment grade deals totaling $108 billion came to market.  That comes on the back of the $145 billion debt issued in September.  Of that $108 billion, nearly a third was issued by financial institutions, more than half was issued by “A” or lower rated issuers, and the maturity breakout was evenly split between three-, five-, and ten-year notes.  Despite the onslaught of new debt, investor appetite was voracious as evident in the narrowing in Barclays Credit Index from 137 to 126 basis points in the course of the month.  Despite than narrowing of the credit spread, we continue to see attractive value in the credit markets.

September 2013 – Monthly Commentary

While the news media has been commemorating the 5 year anniversary of the financial crisis, investors continue to vacillate between risk-on/risk-off strategies on a daily basis.  September was especially so, driven by a barrage of “you gotta be kidding me” news headlines.

 

To recap, Verizon announced and within 48 hours completed the largest corporate bond deal ever; nervous investors grappled with the impact of the Federal Reserve’s impeding change to monetary policy; Democrats and Republicans continued to disagree on the future of “Obamacare,” budget funding, and raising the debt ceiling; terrorist tragedies shattered the lives of innocent people at the Navy Yard office building in Washington D.C. and a mall in Kenya; Federal Reserve Chairman Bernanke shocked the capital market by reversing course and continuing the current program of quantitative easing; several members of the Federal Open Market Committee, namely Dallas Fed President Fisher, publicly blasted the reverse as being irresponsible; and finally, despite expectations to the contrary, Federal Offices are closed at the time of this writing due to Washington’s inability to agree on budget funding.

 

Given the lengthy list of market moving events, the bond market was remarkably stable for the period.  The most economically surprising event was Chairman Bernanke’s announcement that the Federal Reserve was not yet prepared to slow the quantitative easing program.  Since the idea of tapering the program was initiated in May, members of the Open Market Committee have consistently signaled that the program would begin to wind down at the September FOMC meeting.  Taking the cue from those pronouncements, investor consensus was nearly unanimous that the taper would occur in September and that the amount would total between $10 and 15 Billion.  While the stock market reacted negatively when the plans were first announced in May, equities had stabilized at levels just below where indices traded prior to the announcement.  One would think that with the message well communicated and capital markets fully prepared for the taper, the Fed would follow through with their plan.  However, during the post-meeting press conference, Bernanke explained that conditions were not right for them to justify the action.  With that, euphoria returned to the stock market as all major indices rallied sharply higher on the news of the continued flooding of the money supply.  Perhaps Bernanke and the members of the Open Market Committee believed that a reduction in easing would worsen capital markets just before the debt ceiling debate.  Certainly, as the newest debt ceiling deadline approaches, markets are again showing signs of nervousness.  Nonetheless, with the market in equilibrium and the Fed regaining a modicum of credibility with the anticipated decision, the reversal made little sense and, arguably further damaged the credibility of the Central Bank.  Certainly, Richard Fisher, the President of the Dallas Federal Reserve was not happy about the about-face.

 

Perhaps best highlighting the relative calm in the market over the last month was Verizon’s pricing of $50 Billion in corporate debt.  Verizon agreed to pay Vodaphone $130 Billion to buy the 45% of Verizon Wireless that it doesn’t already own.  The purchase will conclude a 14-year, oft times contentious, joint-venture between the American and British Telecommunication companies.  Verizon decided to fund the purchase with a mix of corporate bonds, loans, and stock.  The initial talk was that new debt would be offered at a significant concession to secondary market prices and in the amount of $30 billion.  Demand for the new issue was robust and to such an extent that the underwriters were able to sell the entire $50 billion float at better than expected rates.  We did not participate in the offering and remain skeptical of the value.  From a credit perspective, the debt further gears the already highly levered Verizon balance sheet at a time that Verizon is facing a capital expenditure build out that is likely to register $20 billion this year.  Should the carrier fail to deliver anything other than “as expected” results, the bonds could be at risk of a fall in price much greater than the commensurate yield-to-maturity offered.  Recall that earlier this year Apple set the record for corporate new issuance with an $18 Billion deal that was met with robust demand, only to find the bonds falling sharply in price when operating results began to weaken.  We fear Verizon is at risk of such a reversal.

 

Going into the important fourth quarter selling season we are closely monitoring consumer confidence for any signs that political nonsense is weighing on the spending plans of Americans.  Our baseline forecast is for continued economic expansion aided by housing, manufacturing, and continued employment gains.  However, brinkmanship politics could upend that forecast and force us to reposition accordingly.  Especially since the negotiations are likely to heat up again just as Americans settle in for the holidays.

August 2013 – Monthly Commentary

The fixed income market saw massive redemptions suffered by the largest fixed income mutual funds over the last several months.  The highly visible spokesmen for those funds have appeared in the media with increasing frequency stating and restating their bullish stance, while simultaneously selling bonds to meet rising redemptions.  That hefty selling need, approximately $41 Billion, or 14% of the assets of the flagship fund, over the last four months at the largest bond manager, has weighed on the fixed income market, and has resulted in mark-to-market losses on securities that we deem to be attractive investments.  Given our high conviction on the value of those securities, we expect that the spread widening will reverse in the coming months, turning those mark-to-market losses into gains.  As anticipated, our hedging program has offset the interest rate sensitivity of the portfolio, and we believe will continue to provide downside protection as interest rates rise.

 

The catalyst behind the selling has been the gradual realization that the Federal Reserve will announce in September a reduction in the purchase of Treasury bonds in the secondary market; the so-called taper.  Since first mentioned in May, investors have debated “will they or won’t they” taper, seemingly ignoring the consistently better than expected economic data witnessed with each successive release.  As it stands, we expect that Chairman Bernanke will confirm that the Open Market Committee will begin to taper purchases commencing in October and expect that those purchases will be trimmed by $15 to $20 Billion per month.  In addition, we’ll look for clues as to timing of further tapering and the Fed’s thinking on an ultimate rate hike, which is likely to be deemphasized by the Chairman.

 

Reacting to the anticipated tapering, emerging markets have continued to suffer significant collateral damage.  For the four months ending August 31st, the two darlings of the emerging markets, Brazil and Mexico, have suffered significant losses in their bond markets and the value of their currency versus the U.S. Dollar.  For the period, the Brazilian Real and Mexican Peso have fallen, 19%, and 10.30%, respectively.  Similarly, the local currency denominated 10-year Treasury notes issued by Brazil and Mexico have fallen in price by 18% and 9.1%.  For dollar-denominated investors, that translates into losses of 37% and 19.4%.  Recall that earlier this year, money was pouring into those investments under the thesis that everything that was wrong with the developed markets was right with the emerging markets.  They were net exporters with budget surpluses, their economies were growing strongly, and after years of sky-high inflation, they had achieved relative price stability.  The inflow of cash was so great that on several occasions the Brazilian government took steps, including taxing the Real at time of conversion, to dissuade “hot money” speculators from buying into Real denominated investments.  That entire dynamic reversed when the Fed mentioned the prospect of tapering.  Much of the investment had been driven by macro hedge funds and the pursuit of yield in this world-wide low interest rate environment.  Those hedge funds deduced that the intention to taper open market purchases would be followed by an outright increase in interest rates.  With an increase in rates, the U.S. market would become attractive again so it would be prudent to sell emerging market debt and repatriate the currency back to U.S. dollars before other investors did so.  What transpired is similar to what happened when investors fled ETF’s earlier this year.  Sellers overwhelmed the market and buyers emerged only after valuations had plummeted.  While emerging market debt can, at times, play a role in the fixed income asset class, investors need to understand that liquidity can disappear in the blink of an eye.  Despite the fall in price of the bonds and the currencies, we do not view emerging market debt as a buy at this time.

July 2013 Monthly Commentary

Longer term interest rates rose in July as the yield curve continued to steepen, albeit at a slower pace than witnessed in May and June.  For the period, the yield-to-maturity of the 10-year note rose 10 basis points to finish the month at 2.58%.  The ETF related spread widening that occurred in June and was described in the last monthly update began to reverse, but the improvement has been inconsistent.  High quality investment-grade corporate bonds have retraced most of the spread widening, while lower-rated investment grade and sub-investment grade bonds have retraced only a fraction of the move.  Municipal bonds, on the other hand, continue to trade at the wide end of the spread range reflecting investors continued confusion as to the implications of the bankruptcy filing of Detroit, Michigan.  Because of that confusion, investors have been net sellers of muni bonds in fear that other issuers would follow the bankruptcy course of action.  While the municipal bonds held in the fund have suffered from “baby and the bathwater” type spread widening, our rigorous credit analysis leads us to conclude that the spread widening is not warranted for those issues and that the price action will improve in time, serving as an alpha generator for investors.

We mentioned on several occasions during the second quarter that anecdotal evidence of economic activity didn’t seem to jibe with Wall Street economists forecast for growth.  Consensus estimates among the large brokerage firms handicapped annualized GDP growth for the period at a paltry 0.5%, warning that the economy was nearing “stall speed.”  When the growth report was released in late July, investors were pleasantly surprised to learn that the first estimate of economic activity advanced at a 1.70% rate.  Moreover, that rate is likely to be revised to as high as 2.3% when the impact of the trade deficit is ultimately factored in.  The June trade report was also a pleasant surprise, as the deficit registered $34.2 billion, falling approximately $10 Billion from the prior month.  Driving the improvement was a record dollar amount of U.S. goods and services sold to foreign buyers.  Impressively, exports increased by $5 billion while U.S. citizens imported $5 Billion less foreign goods and services.  With economic activity in the second quarter registering more than four times what had been estimated, a tapering of bond purchases in September now seems a certainty.

June 2013 – Monthly Commentary

As detailed in the last monthly update, we believe the normalization of interest rates has begun, as the vicious bear market witnessed in May continued into June.  During the month, the 10-year note reached a high yield of 2.61% before closing the month at a yield-to-maturity of 2.49%.  That’s nearly one hundred basis points higher than the 1.62% low touched in early May.  While we have been anticipating rising interest rates and had prepared for such a move with our hedges, we were surprised by the magnitude of the widening in credit spread that occurred during the month.  To the contrary, a central tenant of our investment thesis is that as interest rates rise credit spreads will contract to the point that some investment grade corporate issues will trade at a small discount to Treasury paper.  The fundamental rationale for that view is that corporate balance sheets are quite strong while the national debt has ballooned, causing an excess supply of Treasury debt.  We expect that excess supply will be unmanageable once the Federal Reserve ceases to buy Treasury notes in the secondary market.  Counter to that view, in June, corporate and municipal prices fell faster than Treasury notes due to a technical imbalance related to Exchange Traded Fund (ETF) liquidation.  The sharp rise in interest rates “spooked” investors, prompting overwhelming selling of fixed income ETF’s.  With the elimination of proprietary trading desks as a result of Dodd-Frank legislation, the risk appetite of Wall Street to absorb such selling has been severely reduced.  As a result, the number of outstanding shares in several fixed income ETF’s were forced to contract, which resulted in selling of the securities that comprised the ETF.  As the ETF selling cascaded and the float contracted, share prices fell to a substantial discount creating a vicious-circle of selling.  While the selling imbalance only lasted two days, the impact to the credit market remained through month end, as dealer desks struggled to digest their newly bloated inventory.  At the time of this writing, credit spreads have begun to tighten back to their pre-crisis valuations and we expect a full recovery.  As such, we are maintaining our current positions and have added exposure in several names.

 

Turning from trading technical’s to economic fundamentals, the U.S. economy continued to surprise to the upside during the month, led by robust sales of cars, homes, and retail goods.  In the housing sector, demand for homes is evident in the rise in prices.  As measured by the S&P/Case-Shiller Index of 20 cities, the average home price has risen 12.05% year-on-year.  The improving jobs market has been a driver of spending.  In the past 12 months, the U.S. economy has added an average of 195,000 jobs per month, with average hourly earnings rising more than 2%.  That mix of more people working and wages rising paired with the wealth effect of rising home prices and stock prices provides the foundation for a sustainable economic recovery.  From that foundation, we expect that the Federal Reserve will be able to begin “project taper” without severely destabilizing the capital markets or tipping the economy back into recession.  However, the path to normalized interest rates is likely to include periods of volatility as investors speculate as to when, and by how much the Fed program is amended.  Our expectation is that the Fed will announcement their intention to begin tapering purchases at the press conference following the September 18th FOMC meeting.

Monthly Commentary – May 2013

The normalization of interest rates has begun.  We’ve warned for some time that Fed-engineered interest rate manipulation would result in investor losses once the central bank ended the practice.  May was the beginning of that trend.  Comments made by several members of the Federal Open Market Committee suggesting that the Fed was contemplating “tapering” the pace of their open market bond purchases was enough to panic investors into selling fixed income securities.  For the month, the price of the 10-year Treasury note fell 3.5%, while the price of the longer duration 30-year Treasury bond dropped 7.3%.  The broad market, as represented by the Barclays Aggregate Bond Index generated a loss of -1.76%.  Performing even worse, AGG, the ETF that tracks the Barclays Index, lost 2.00% for the month.

 

We interpret the discussion of tapering as the second of a six stage process in moving from emergency monetary accommodation to a normalized monetary/interest rate policy.  As we see it, the initial stage was the public debate among Fed officials about the need and appropriateness of quantitative easing that has been ongoing for the last twelve months.  The second stage, which began in earnest last month, witnessed consensus-like public statements from Fed members indicating that the central bank is ready to begin tapering the size of open market operations.  Prior to last month, comments by the Fed led investors to believe that such a tapering would not occur until sometime in 2014.  With the change in policy coming nearly a year sooner than was expected, the reaction was swift, as witnessed by the sharp fall in bond prices.  We expect the third stage of the process to be the instance when the Fed actually implements the tapering of bond buying, and expect details to be announced at one of the next three Federal Open Market Committee meetings.  Presumably, the Fed would want to make the announcement at a post-FOMC press conference.  Since the July meeting doesn’t end with such a conference, September is most likely, given that the June meeting is only one week away.  However, at that meeting, Chairman Bernanke is likely to face a barrage of questions about the timing and mechanics of tapering.  Once they begin the process, attention will shift to when quantitative easing ends altogether, the fourth stage.  Given the “lower for longer” interest rate philosophy of the Fed, we may not see an end to easing until the first quarter of 2014.

 

The final two stages of the process are raising interest rates and liquidating the portfolio of securities that they acquired over the last few years.  As a best guess, we’d look for the first rise in overnight Fed Fund rates 12 months from now, and likely in a “non-Greenspan like” one-time jump to 1%.  As for when the Fed begins liquidating the Billions of dollars of bonds bought over the last several years, we’re likely years away.

 

Also weighing on bond prices during the month was improving economic fundamentals.  Consumer Confidence, as measured by both the University of Michigan and the Conference Board, both reported levels that were the most optimistic since 2007.  Another encouraging sign of economic strength is the current shortage of construction workers.  The National Association of Home Builders reported that 46% of the industry has fallen behind on completions because they are unable to find enough qualified workers to complete building in time.  The Association also reports that 15% of the industry has turned down work, while another 9% had sales canceled due to construction delays.  With the prime building season upon us, the shortage is likely to result in constrained deliveries and rising home prices.  One beneficiary of the shortage is the workers themselves, as contractors report that poaching of workers at the job site has become a problem with increasing frequency.

 

As a consequence of rising interest rates, corporate bond issuance was up sharply in May.  In aggregate, new issue corporate paper totaled $107 Billion in May.  Despite the heightened supply, investor demand was strong, especially for the weakest credits.  J.C. Penny, the CCC-rated department store with approximately six months of operating cash on hand, marketed a floating rate loan to borrow $1.75 billion with an interest rate of 5.75% above LIBOR.  Demand was so strong that the deal was upsized to $2.25 Billion and the terms lowered to 5.125% above LIBOR.  While the collateral backing the deal, namely Real Estate, should give investors some comfort, the coupon is simply not enough to compensate for the price volatility the issue will experience if J.C. Penny files for bankruptcy sooner than is expected.  Similarly, The Republic of Italy sold $6 Billion of Euro-denominated 30-year bonds for a yield-to-maturity of 4.98%.  There were nearly $12 Billion in orders for the debt despite the fiscal issues that continue to plague the country.  As volatility returns to interest rates, we expect the demand for such lower rated credits will wane.

 

The foregoing discussion is for illustrative purposes only.  No Halyard client currently holds either J.C. Penny or Republic of Italy bonds, nor is Halyard making any specific recommendation of any such bonds.