Economic Review 4Q 2015
US Federal Reserve
On December 16, 2015 the Federal Reserve raised the Fed Funds rate target range to 0.25% - 0.50%. The low interest rate environment has been in place for several years at the 0.0% - 0.25% range.
Fed policymakers concluded the benefits of the zero interest rate policy were being outweighed by the costs, specifically the misallocation of capital into riskier and higher-yielding sectors.
The FOMC stated that the pace of rate increases will be gradual and monetary policy will remain highly accommodative. Expectations are that there will be 3 – 4 additional rate hikes in 2016.
Given the turmoil in the markets so far in January 2016, fewer rate hikes may actually occur, but the Fed is still indicating 3 to 4 rate hikes. Fed funds futures contracts show that traders expect the central bank to raise rates at least twice in 2016, and are reducing bets on a third hike by December, 2016.
At the September 17, 2015 FOMC meeting, the Fed had cited global financial and economic developments that could impact and restrain US economic growth and keep inflation low. This may delay further hikes.
Reverse Repo Program (Fed RRP)
The Fed raised the overall cap on the overnight Fed New York (Fed NY) RRP to $2 trillion from $300 billion. The Fed NY RRP is an important policy tool for managing the fed funds rate floor, now 0.25%, and meeting money market fund demand. Without sufficient RRP there would be potential disruptions in repo, securities lending, T-bills and other funding operations. The sizeable increase in RRP provided funding market stability.
FOMC Forecast for Fed Funds
The FOMC’s forecasted average Fed Funds rate for 2016 is 1.375%. The forecast average for 2017 was reduced to 2.375% and 2018’s forecast average was revised to 3.25%. The longer run average remains unchanged at 3.5%.
The US economy created around 292,000 net new jobs in December or 257,000 private payroll jobs, exceeding the 252,000 increase in November that was stronger than previously estimated. The unemployment rate held at a seven-year low of 5%. Some analysts, however, noted that many of the December jobs were part-time delivering no wage growth.
Investors focused on volatility in Chinese markets after the country sought to quell losses in equities and stabilize its currency. Fresh concern that China’s slowdown will hamper global growth has emerged again. Policy makers are struggling to revive an economy that’s the world’s biggest user of resources. China Securities Regulatory Commission announced the suspension of a new stock circuit- breaker that forced local exchanges to shut for the second day in the first week of January. The move added to worry that policy makers are struggling with how to contain the months-long turmoil in its financial markets.
The World Bank cut its global economic growth forecast for 2016, saying the weak performance of major emerging market economies will hamper activity overall, as will anemic showings from developed countries such as the United States.
In the U.S., economic growth should increase slightly, from an estimated 2.5% in 2015 to 2.6% in 2016, with rising employment, wage growth and consumer spending countered by lagging capital investment and manufacturing.
Oil and High Yield bonds
Oil prices fell to 12-year low for a fourth day last week, lurching again to 12-year lows as new financial market turmoil in China brought a $32 per barrel price for the commodity. Recently, oil’s close below $30 a barrel heightened fears of disinflation fueling concern that junk-rated energy producers won’t be able to stay solvent. A collapse in commodity prices has been the main driver for high-yield’s setback since September and there may be some defaults in energy-related credits.
Junk Bond Selloff
The high yield market sell-off was sparked by declining oil prices and concerns about energy and commodity companies. The closure of a Third Avenue bond mutual fund sparked a wider sell-off in the credit market. Several high yield bond ETFs were hit with major redemptions as a result of the junk bond selloff.
Headline consumer prices remained flat in November, in line with consensus expectations, pulled lower by declining oil and food prices. Headline inflation is now up 0.5% from November 2014, while the energy index is down 14.7% in the same time. Core CPI inflation increased to 2.0% year over year growth and improved by 0.1% month over month.
With the drag from energy prices expected to fade in early 2016, headline inflation should also move closer to the Fed's 2.0% mandate in the medium term.
In October, the Institute for Supply Management (ISM) reported that the U.S. manufacturing sector fell to 50.1, slightly above 50, the level between expansion/contraction. This is a sign that the strong US Dollar and tepid overseas demand is weighing on manufacturers.
corporate issuance returned to the market in January with over $19 billion in supply. For 2016, economists are expecting corporate issuance to exceed $1.1 trillion, which would be in-line with 2015’s supply.
While investors cope with the turbulence sparked by China, another source of consternation is looming as the corporate earnings season begins. Investors will begin to contend with another expected decline in corporate earnings.
During the quarter, investment-grade corporate bonds underperformed Treasuries and agencies amid the risk-off environment and credit spreads widened. Treasury prices were volatile on speculation that China will continue to sell U.S. debt to raise cash to defend its currency and support its stock market. Corporate profits are expected to slow due to falling energy prices and a high U.S. dollar.
During 2015, investment grade corporates issuance was 17% higher than 2014 with $1.33 trillion in new supply. US corporate issuance in 2016 is expected to be as high as the acquiring companies in M&A deals continue to issue investment grade debt.
Recently there has been a noticeable deterioration in credit quality as newly announced M&A transactions are leading to high corporate debt issuance by the acquiring companies. These companies in turn are being downgraded by the ratings agencies although the overall credit quality is expected to improve over the next 18 months. Issuance related to the M&A activity is especially pronounced in the below investment grade bond market.
U.S. corporate defaults hit a four-year high for below investment grade bonds that increased from 2.1% to 2.5% in 3Q2015. Investment grade bonds have also seen a downward trend in credit ratings.
Market sentiment has become cautious with heightened market volatility rising over the last 3 months. The rate hike by the Fed was basically priced into the market. The shorter-end of the yield curve has seen spread widening in anticipation of the Fed action. During the quarter, the yield curve continued to flatten in December as rates on the 2-yr and 5-yr both climbed 12 bps for the period. The yield on the 10-yr rose 6 bps during the month, while the 30-yr rose 4 bps.
Negative market sentiment is not being driven by the Fed, but by the collapse of oil and commodity prices. The OPEC meeting in mid-December did not resolve the supply glut.
Banks that are lending to the energy sector or holding leveraged loans on their books may also have some credit problems on their books. If lending to the weak high yield oil sector is stopped, some of those issuers may have liquidity problems.
Higher quality, energy-related names may come under short-term pressure and their bonds will have spread widening. Australian banks and some Canadian banks may be impacted if they have substantial loans to the energy and commodity-related industries.
Third Avenue Focused Credit Fund froze redemptions and Stone Lion Capital Partners LP, a distressed-debt specialist, stopped redemptions on its credit hedge funds due to falling commodity and junk-bond prices in December.
Although the portfolio is all investment grade, our cautious view is that we may be entering into a period of credit spread widening, and overreaction by the ratings agencies, being quick to downgrade credits. The pace of credit downgrades has been accelerating over the last few months.
U.S. short-term and long-term rates are rising in contrast with other countries where rates are falling. The USD is expected to continue strengthening against other currencies.
Liquidity in the US bond market has changed dramatically from the period before the financial crisis. Historically, broker-dealers carried securities inventories on their balance sheets and were willing to make markets in securities and take market risk. The change in making markets, and the record corporate issuances and low interest rate environment have made it difficult for broker-dealers to make markets and inventory securities. Fixed income trading has become less liquid.
Fixed income investors face longer holding periods than they would have considered in the past. Lower turnover strategies have a lower impact on transaction costs on portfolio especially when there are changes in market liquidity. Trading now requires a more deliberate approach to minimize transaction costs. Conversely, there are attractive prices for buyers when there are forced sellers in the market.
The liquidity in fixed income markets has changed across all sectors including Treasuries. The ability to trade in large blocks has changed. Primary dealers that purchase directly from the Fed have been buying fewer Treasures and volume has fallen. The size of the Treasury market has doubled since 2008. US and foreign investors have purchased a higher percentage of Treasuries sold by the Fed than the dealer community.