The grind toward higher Treasury yields—and June’s bearish momentum in interest rates—persisted through most of last week, only to reverse on Thursday with an escalation in geopolitical concerns, especially Iraq. After reaching a high of 2.70%, 10 year Treasury notes recovered on the selloff in risk assets and closed the week up only 1 basis point, at 2.60%.
Of particular concern to the economy was the sudden rise in commodity prices, especially oil, as a result of the events in Iraq. As the probability of western intervention increased, participants became increasingly concerned that the conflict will lead to disruptions in oil production and further increases in energy costs. Currently at nine month highs at over $107 a barrel (WTI), Castleton is of the position that the sudden rise in oil prices acts as a tax on the consumer and threatens growth, rather than being a material driver of inflation expectations.
Aside from the geopolitical forces that will continue to dominate headlines, we expect that this week’s domestic attention will turn squarely to the two day meeting of the Federal Reserve’s Open Market Committee (FOMC). With market complacency high on the timing and pace of future interest rate policy and inflation, we suspect the Committee will recognize the recent gains in employment and raise their inflation forecasts for 2015—implying an economy moving closer to full employment and stable inflation. This implicitly leaves us biased toward flatter yield curves in fixed income products for the second half of 2014.
Weekly Change: 10Y Treasury Yields vs. 10Y AAA MMD
Source: Bloomberg, Thomson Reuters and Castleton Partners
Ratio of 10Y Muni Yield to 10Y Treasury Yield
Source: Bloomberg, Thomson Reuters and Castleton Partners
Tax exempts continued their recent sell off, recording their first two-week decline since March. Feeling the weight of a recent spike in supply, municipals underperformed Treasury rates, as over $9 billion of new debt was priced—the second heaviest week of 2014. Fund flows, however, remain supportive of broader interest. Over $300 million of new cash was received last week, marking the sixth consecutive week of positive inflows. In sharp contrast to 2013, weekly fund flows have only been negative 6 times so far in 2014.
With a yield of 2.33%, ten year benchmark yields have now risen 17bp in June, versus a 12bp rise in ten year Treasuries. We maintain a constructive view on tax exempts, believing the superior taxable equivalent yields and improving asset quality will continue to reflect strong investor interest and relative outperformance against taxable products. Periods of technical imbalance—such as the current one of outsized supply—should be viewed as opportunities.
Supply this week reverts back toward its 2014 weekly average, with approximately $6 billion expected to price. The largest loan is a $928 million general obligation sale for the State of Georgia (Aaa/AAA). Other large sales include a $900mm Texas G.O. loan (Aaa/AAA), a $600mm Chicago Transit Authority (AA), and $500mm Metropolitan Transportation Authority of New York (A2/A+).
Since the onset of the 2007 financial crisis, policy—be it central bank (FOMC) or Washington—has exerted outsized influence on asset prices and investment decisions. The surprising defeat of highly influential Congressman Eric Cantor last week reminds us, yet again, that changing dynamics in Washington can increase volatility and uncertainty in financial markets. With politicians focused on international events at the moment, we are reminded that the upcoming midterm elections are expected to exert a high degree of influence on policy and political leadership for the next several years. As a reminder, the following offices are up for reelection/ election in November:
- All 435 seats in Congress
- 33 out of 100 Senate seats
- 38 state and territorial governorships
AAA Municipal Market Data (MMD) Yield Curve
Source: Thomson Reuters
Weekly Municipal Mutual Fund Flow Data
Source: Lipper AMG Data
Investment grade taxable bond spreads were able to tighten yet again last week. The financial and energy sectors registered the best performance among all sectors, narrowing 4 basis points relative to Treasuries. Owing to uncertainty surrounding the implantation and reimbursement rates of the Affordable Care Act (ACA), healthcare continues to be the biggest underperformer so far in 2014. Castleton continues to favor financials in our taxable fixed income allocation models, viewing the improved balance sheets, increased regulatory oversight, higher asset quality, and decreased leverage as favorable traits.
Coming as somewhat of a surprise, mutual fund flows into taxable high grade bond funds were negative last week. At -$650 million, fund flows experienced the largest weekly decline since October 2013. Despite flows being negative, issuers priced over $30 billion of new debt. At 34% of weekly issuance, financials dominated the calendar, with the 5 year sector the most issued tenor.
Of late, the general consensus in taxable fixed income has been that the current environment of low yields, low volatility, and expectations of stronger second half growth in 2014 would be very supportive of credit spreads. The situation in Iraq is a reminder that volatility rarely stays low for long and can seemingly arise out of nowhere. With equities having recorded a sharp correction on the events in the Middle East and Ukraine, it remains to be seen how much longer investment grade spreads can maintain their multiyear credit tights, should global event risk increase.
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