The U.S. Economy Marches On To An Unsteady Beat
BondWave Advisors
By Team
February 2, 2012
At the beginning of the month, the FOMC released the minutes from its December 13th meeting, in which they enacted a new plan that would enhance communication to the markets. According to the new procedure, Fed officials will publish their interest rate forecasts, which will be made public after policy meetings along with narrative. The first such report was released on January 25th, in which the seventeen Fed officials that participate in the meetings gave year-end forecasts for the fed funds rate for the next few years. The most notable outcome of the meeting was the extension of the period of exceptionally low rates, which the FOMC stated would be "at least through late 2014". The statement continued to express the desire for policy to be "highly accommodative" to support stronger recovery.
According to the published forecasts, of the seventeen officials, 3 believe that firming should occur in 2012, 3 in 2013, 5 in 2014, 4 in 2015, and 2 in 2016. Only two officials believe that the fed funds rate will be above 1% at the end of 2013 while six place the fed funds rate above 1%, with a range between 1.5% and 2.75%, at the end of 2014.
S&P Ratings Services attempted to make Friday the 13th a bit of a horror show for Europe as it made sweeping changes to sovereign debt ratings. Nine countries suffered downgrades, including France and Austria, who were stripped of their triple-A rating. Spain, Italy, and Portugal were all dropped two notches, with Portugal's downgrade sinking them to junk territory, BB. Fourteen of the nations were given a negative outlook, indicating a chance of additional action in the next two years. Thus far Germany has remained impervious, retaining its triple-A rating and receiving a stable outlook.
S&P's actions, however, flopped at the box office as there was minimal market reaction to what had been expected by most. Investors have been more concerned with the political wrangling in Europe and the details of potential debt restructuring and fiscal firewalls.
Despite the misgivings by the Fed about the recovery, and with much of Europe teetering on recession, domestic economic data continues to suggest moderate expansion in both output and employment. Stocks took notice and posted decent gains while bond yields remained quite low thanks to the Fed's accommodative stance. The DJIA, S&P 500, and Nasdaq Composite rose by 3.40%, 4.36%, and 8.01% respectively.
European headwinds will continue in February. February also brings the end of the two-month tax cut extension that brought so much drama to the end of 2011. The extension of the payroll tax cut and federal extended unemployment benefits are set to expire at the end of the month if no action is taken by Congress. Look for another heated battle on Capitol Hill, with the results potentially playing a role in consumer spending and confidence during following months.
Market Summary
Bond Yields
Economic Indicators
Employment
Employment figures continue to improve, with January's economic releases exceeding expectations. The Bureau of Labor Statistics reported that nonfarm payrolls were higher by 200k in December, exceeding estimates by approximately 50k jobs. The ADP report also surprised to the upside, reporting job growth of 325k (versus expectations of 178K). The household survey showed that the unemployment rate dipped to 8.5% from an adjusted 8.7% the previous month. While the long-term unemployment rate and the labor force participation rate were little changed, there were fewer discouraged workers and involuntary part-time workers. January employment gains, due to be released this week, are expected to be more moderate than those in December. A positive employment picture was affirmed by a continual drop in weekly jobless claims, which continue to trend downwards and fell as low as 352k, a new low since the 2008 financial crisis. The four-week moving average stands at 377,500, near to where it was four weeks ago.
Manufacturing
Manufacturing figures continue to indicate a moderate recovery. On the national stage, ISM Manufacturing rose from 52.7 to 53.9, with the employment, new orders, and production components all higher. Factory orders were also 1.8% higher, reversing two months of negative readings. Industrial production grew by 0.4% in December, also reversing a negative month in November. The first estimate for Q4 2011 GDP was 2.8%, slightly below expectations of 3.0% and somewhat disappointing to the market. Regional indicators from New York, Philadelphia, Richmond, and Dallas improved. The Empire Manufacturing Index rose for the fourth consecutive month. Richmond hit highs dating back to early 2011 on strong shipments, new orders, and employment while Dallas hit similar highs with widespread gains across components. Chicago PMI slipped from 62.2 to 60.2, but still remains firmly in expansionary territory (above 50). The service sector also showed moderate improvement, with the ISM Non-manufacturing rising from 52.0 to 52.6. The production component was flat, while new orders and employment both showed small gains.
Prices
Easing food and energy prices led to tame inflation readings for the month of December. Import prices and producer prices fell by 0.1% while consumer prices were flat. However, core prices (without food and energy) crept higher. Core producer prices rose by 0.3%, more than expected, while consumer prices were 0.1% higher, in line with expectations.
Consumer
University of Michigan confidence rose for the fifth consecutive month, reaching 75.0, the highest this indicator has been since February 2011. January's reading by the Conference Board showed a small decline, from 62.2 to 61.1. Despite the unexpected decline, the indicator remains above the survey results from the previous six months. Personal spending, which was expected to be flat, rose by 0.1% while personal income rose by 0.5%, also exceeding expectations. Retail sales grew by 0.1% in December, while core sales (without the auto component) were unexpectedly down by 0.2%. Despite the unexpectedly weak figures, retail sales have been growing consistently. Until December, neither the headline nor core figures have had a down month in a year and a half.
Housing
A horizontal trend continues in the housing market. According to the National Association of Realtors, pending home sales slid 3.5% in December, reversing gains in the prior months. New home sales also fell in December by 2.2%, while existing home sales edged higher. These figures continue to remain at historically depressed levels, albeit at numbers that are modestly above the lows of the recession. Housing starts and building permits both edged slightly lower in December. According to the S&P / Case-Shiller Home Price Index, home prices for both the 10- and 20-City Composites slid 1.3% last November. Consistent with recent trends, declines were widespread, with only one city (Phoenix) with positive gains for the month. The report noted that current price levels are only slightly above their lows: 1.0% for the 10-City Composite and 0.6% for the 20-City Composite.
Economic Calendar (February 2012)
US Treasury Market
Treasury yields teeter-tottered in the first two trading weeks of the year influenced by a mix of economic data and Fed President William Dudley stating more monetary accommodation is appropriate. The 10yr benchmark yield reached a peak of 2.09% on 1/23, the highest close since 12/1, as Greek debt negotiations seemed promising and the Fed began selling Treasury notes as part of Operation Twist. It wasn't long before the benchmark note was back below 2% on the release of the Fed statement which was a positive surprise to bond investors.
Most market participants expected the Fed to reiterate its pledge from the previous meeting to hold rates low until mid-2013 but they extended this low rate pledge to late 2014. In an effort to increase transparency, this was the first FOMC meeting in which rate projections were published for each member, underscoring the vastly different views. 11 officials expect the first rate increase to occur in 2014 or beyond while 6 believe it will occur in 2012 or 2013. The Fed is also considering additional bond purchases as policy makers are "prepared to provide further monetary accommodation". The statement was more dovish than anticipated and therefore bullish for bonds. A day after the announcement, the Treasury sold $29 billion of 7yr notes at a record low yield of 1.359%.
As fears have been rising over long term inflation, investors have been pouring money into TIPS as a hedge. January saw the first auction in history in which TIPS sold at a negative yield, -0.045%. The bid-to-cover of 2.91 was the strongest demand since March when the securities sold at a yield of 0.49%. The day after the Fed announcement, the breakeven rate of inflation, calculated by subtracting the 10yr TIPS yield from the 10yr Treasury note yield, increased to 2.10% from 2.06%, indicating that investors expect annual inflation to be higher over the next ten years.
Treasuries ended the month stronger with the benchmark note yield sliding to 1.83%, the lowest yield in 5 weeks as a European Central Bank member said he "can't be sure" that Greece will be able to carry out the necessary fiscal and economic measures to stay in the Euro-zone and several domestic economic reports have demonstrated growth still faces an uphill battle. The 5yr note closed the month at an all time low of 0.71%. Most see no reason for rates to move higher in the short term as the economy continues to struggle.
Corporate Bond Market
The markets focused on fourth quarter earnings in search of uplifting news to take their minds away from the apparition of the debt crisis in Europe hanging over the markets. The varying change in status of the Greece settlement talks kept the market busy trying to anticipate the consequences of the potential outcomes and how they would affect their investments. Earnings provided some positive news on the health of companies and gave investors the confidence to accept more credit risk in search of yield. The Markit Investment Grade Index tightened roughly 18bps to close at 101.255bps for January, after closing at a four-month low of 100.21bps on January 27th.
Fourth quarter earnings have been generally positive with good revenue and sales but profits and future outlooks have been underwhelming. The effect of the low interest rate environment is affecting company profits as pension costs begin hitting the bottom line of big corporations. UPS reported a 29% drop in fourth quarter earnings that was attributed to a big pension charge. A low interest rate environment necessitates firms have to post higher amounts of capital to cover future obligations since the return on those investment is expected to be low.
The Barclays Capital U.S. Corporate Index returned 2.21% for the month of January, outperforming similar duration Treasuries by 1.77%. Continued firming in Treasuries carried over from December and helped the price component of the index return 1.809% in January. The 5-7 year component performed best returning 3.03% while the least return came on the short end of the curve (1-3 years) returning 1.09%. From the sector perspective, financials retuned 3.66%, industrials returned 1.58%, and utilities 1.15% as financials benefited from investor demand for yield. The hunt for yield helped lower rated securities as they beat higher rated securities in January. BBB-rated securities returned 2.34%, A-rated returned 2.31%, AA-rated returned1.55% and AAA returned 1.15%.
Credit Suisse Group AG purchased a parcel of risky mortgage backed securities with an outstanding par value of $7billion from the Federal Reserve Bank of New York. The securities were part of the Maiden Lane II portfolio that the New York Fed took as part of the bailout of AIG. The sale came as a result of interest shown by Goldman Sachs Group to purchase the securities. This led the NY Fed to request bids for the securities that Credit Suisse subsequently won. The debit card rule amendment of the Dodd-Frank Act, dubbed the Durbin amendment, has helped small banks to the angst of their larger rivals. Financial institutions with less than $10 billion in assets were left out of the rule meaning a transaction of $100, would yield $0.95 for a smaller bank versus $0.26 for a big bank. J.P. Morgan stated the rule cost the bank $350 million in fourth quarter revenue, according to the WSJ.
Municipal Bond Market
The muni market felt a much different tone compared with last January when fears were stoked of widespread municipal defaults. Despite Illinois and Connecticut being downgraded, the month was otherwise very positive. Continued strengthening municipal finances, flight-to-quality due to global economic worries, and a supply /demand imbalance all contributed to positive performance for the month.
There were approximately $35 billion in coupon payments and principal redemptions throughout December and January, $20 billion in January alone. Since new issue supply has been extremely light, this reinvestment cash flow has created a supply/demand imbalance driving prices higher. Consequently, yields reached record lows on Bond Buyer indices as well as MMD AAA yields. The Bond Buyer's 20-bond GO index, which was compiled in 1900, reached its lowest level since 1967 and the 11-bond GO index also reached a 45-year low. The 10yr MMD AAA muni yield closed the month at 1.68% just shy of the record low of 1.67% on 1/18. The 30yr fell to a record low of 3.14% on 1/31.
Munis benefited from the European debt crisis which resulted in a flight-to-quality as did Treasuries, but due to structural factors munis performed even better out longer on the curve than Treasuries. The muni yield curve slope from 10-30 years continually decreased since the beginning of the year causing muni/Tsy ratios to be richer than the average for the 4th quarter, yet still above its historical ten year average. New yield lows were reached on the long end of the curve on the last day of the month with the following MMD AAA yields :15yr 2.21%, 20yr 2.70%, 25yr 3.08% and the 30yr 3.14%.
As investors are faced with near zero rates of return on money market investments, even the paltry yields on short-term munis look relatively attractive. Retail demand has been strong as evidenced by 8 weeks of inflows in municipal bond mutual funds, the longest stretch since November 2010.
Expectations for muni yields throughout 2012 are slightly mixed but generally range-bound with the possibility of a rise in rates in the second half of the year. The European credit crisis, presidential election, domestic inflation, and an increase in new issuance all have the potential to affect muni yields. Additionally, if the Bush tax cuts are allowed to expire or if President Obama raises marginal tax rates on the "rich", munis would be more appealing to investors.
General Investment Disclosures
This publication has been prepared by BondWave LLC. This publication is provided for informational purposes only. Neither the information, nor opinion, nor prices in this publication constitute a solicitation to buy or sell any financial instrument. This publication is not intended to provide personal investment advice. The securities discussed in this publication may not be suitable for all investors. Investors should independently evaluate each issuer, security, or instrument discussed in this publication and consult with their investment advisor before making any investment decisions.
Information contained in this publication has been obtained from sources believed to be reliable, but BondWave Advisors does not represent or warrant that such information is accurate or complete. The information in this publication is not intended to predict actual results, which may differ substantially from those reflected. Past performance is not necessarily indicative of future results. Any opinions in this publication provided by BondWave LLC are as of the date of this publication and are subject to change. BondWave LLC has no obligation to update its opinions or the information in this publication.
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The yields shown in the charts specified as BondWave curves are based on the known and applicable MSRB/TRACE trades for that same date (as reported by MSRB for municipal securities and TRACE for corporate securities, as applicable). Trades must have a minimum par value of $50,000 to be included and the resulting curves are based on the par-weighted values of the yields.
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