Geopolitical headlines, coupled with renewed stress in European markets, led to a strong rally in US Treasuries last week. Further supporting the decline in interest rates was the perceived dovish overtone to the minutes of the June Federal Open Market Committee meeting. The yield curve flattened yet again, as intermediate and longer dated maturities registered outsized price gains relative to shorter dated notes and bonds. The US Treasury yield curve—specifically the spread between 5 year and 30 year bonds—has now fallen to its lowest level since February 2009 (+169bp). Risk assets, namely stocks, generated price declines as the market exhibited a classic “risk off” feel throughout the week.
As we embark on the second half of 2014, Castleton fully expects the yield curve to continue its flattening bias. The recent improvement in economic data—especially employment—will likely lead to a more hawkish tone from the FOMC going forward, producing more volatility in financial markets than was realized during the first half of this year. As market pundits publicly debate the timing and size of interest rate increases, expected to begin sometime in 2015, we expect the Fed-influenced front end of the yield curve—namely the 1 to 5 year area—to underperform. Given an economic recovery quieter than hoped for (as noted by negative GDP growth for the first six months of this year), the future direction of any interest rate policy may ultimately be lower than consensus, as a sustainable recovery is still impaired by a consumer experiencing flat wage growth and high debt levels.
The Federal Reserve will most likely remain in focus again this week, with Chair Yellen’s semi-annual testimony before Congress tomorrow and Wednesday. As for economic data, a host of tier one reports are scheduled for release, as well (Retail Sales; PPI; Industrial Production).
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
The first full week of July was not kind to municipals, with benchmark rates exhibiting sharp nominal and relative weakness versus their taxable counterparts. Muni underperformance is best measured by the cheapening of various Muni/ Treasury ratios last week. On average, Muni/ Treasury ratios across the maturity spectrum rose by 4-6 points. The 5y ratio (79%) now rests at its cheapest level since March, while the 10y (93%) is at its highest level since February. Uncertainty related to the recent universal downgrades of all Puerto Rico credits by the three main rating agencies, and concerns of escalating fund redemptions as a result, were the primary culprits for the tax exempt sell off. In fact, mutual funds did experience outflows of $790mm, the first such outflow in ten weeks. Though we do not anticipate a material muni yield correction, we do feel there is a good chance of the market “over correcting” on Puerto Rico through mutual fund induced selling—creating a buying opportunity in tax exempt debt. As mentioned above, we anticipate market volatility rising during the second half of this year. With its stable income stream, tax efficiency, and improving credit profile, we fully expect tax exempts to generate the best returns in fixed income for the balance of 2014.
Tax exempt supply this week stands at nearly $7 billion. Heavily influenced by such high tax states as California and New York, the largest loans this week are a $1.2b deal for San Francisco Bay Area Toll Bridge revenue bonds (Aa3/ AA-) and a $800mm loan for the New York City Transitional Finance Authority (Aa1/ AAA).
AAA Municipal Market Data (MMD) Yield Curve
Source: Thomson Reuters
Weekly Municipal Mutual Fund Flow Data
Source: Lipper AMG Data
Though interest rates were able to rally last week, investment grade credit spreads actually widened, on average, 2 basis points across all sectors. With second quarter earnings season set to escalate this week, we expect a fairly subdued new issue market for corporate debt. As such, we expect market direction to be dominated by activity in the secondary market and the dealer community. The most recent data from the Federal Reserve Bank of New York shows dealers holding $14.2b of investment grade bonds and notes on their books—a near 100% rise from April.
With the first six months of 2014 now in the books, high grade debt has returned a respectable +5.68% according to Barclays, outperforming taxable high yield debt (+5.46%).
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