The US economic recovery continued to accelerate in 2Q2021 as the rollout of COVID-19 vaccinations expanded the economic re-opening across the US. Economic growth is expected to continue to expand rapidly for the rest of 2021 into mid-2022.
Inflation fears came to the forefront as the global economy re-opened and recovered with the extraordinary accommodative central bank policies and stimulative fiscal policies.
The Federal Reserve minutes indicating that some members favored tapering asset purchases in 2021 weighed on markets during part of 2Q2021.
Economic data showed evidence of a faster recovery than anticipated. The Federal Reserve may taper its Treasury and MBS purchases sooner than expected as the US experiences strong growth and rising inflation during 4Q2021 through mid-2022. The Fed may start to raise short-term rates in 2022-2023. These Fed actions would lead to higher rates and a steepening of the yield curve.
The USD is expected to move lower as stronger international growth should expand as vaccines are broadly distributed globally.
Despite mixed economic data and the recent FOMC meeting minutes, investor appetite for risk assets persisted in June. Unfortunately, the fixed income market tone began to weaken with growing concerns of the highly contagious Delta strain of COVID-19.
By some measures, inflation is at its highest level in over a decade, and several factors could sustain these levels. Conversely, other metrics point to a more benign environment, and suggest the recent increase may be “transitory.” Overall inflation risks appear elevated, particularly given current spreads and valuations.
Fiscal Support
President Biden agreed on a $1.2 trillion bipartisan infrastructure plan that would increase government spending over 8 years and potentially boost economic growth. A larger reconciliation bill could provide substantial fiscal stimulus and growth for the economy. The infrastructure bill may impact the state issued taxable and tax-exempt municipal bond market that may increase their issuance.
Fiscal response increased the budget deficit in 2020 to almost 15% of GDP, compared to the 50-year average of 3%.
FOMC
In the June FOMC meeting minutes, several Federal Reserve officials commented that the conditions for beginning to reduce the pace of asset purchases might be earlier than anticipated. Markets expect that the Fed may begin to taper its purchases in early 2022.
FOMC meeting minutes released in June, showed median projections of the fed funds rate at 0.60% by the end of 2023, correlating to two rate hikes from March.
Some Fed officials noted in the FOMC April 2021 meeting minutes that the Fed should consider a process to curtail future asset purchases, yet they emphasized the economy was still far from attaining its primary goals of full employment and price stability.
At the June FOMC meeting, several committee members, as reflected in the dot plot, indicated that some expected to raise rates in 2022, sooner than in previous sessions. The Fed’s guidance did not reflect some of the member’s changes. The Fed funds rate will remain in the 0% - 0.25% range for an extended period. Fed Chair Powell stated that the FOMC will continue to be accommodative until actual progress in employment and inflation is achieved. The Fed will act in a methodical and well-announced fashion so that the market will not be surprised by its actions.
The Fed’s goal is to reach maximum labor market employment. The Fed Chair reiterated that it is willing to tolerate inflation running above 2% to achieve its employment goals.
The FOMC released its quarterly assessment of Summary of Economic Projections, or dot plot. The dot plot is not a committee forecast but a compilation of what each member projects. Most FOMC members feel the Fed will keep the target funds rate at the current level through 2023. The economic outlook has improved but remains uncertain and policy will remain supportive to mitigate any potential downside risks.
The Fed announced on June 2, 2021, that it would wind down its Secondary Market Corporate Credit Facility (SMCCF), one of the emergency lending programs used during the pandemic to help stabilize credit markets. AS of April 2021, the facility holds $5.21 billion of investment-grade bonds and $8.56 billion of high-yield bonds and high-yield bond ETFs. The facility was approved for bond purchases totaling $250 billion.
Monetary Support Programs
On June 7, 2021, the Fed began selling its holdings in corporate bonds and corporate ETFs that it had amassed over the last year under the SMCCF. Sales of the corporate securities are to be completed by year-end 2021.
The Fed has stated that its QE monthly purchases of $120 billion will continue through 2021, however, the market expects that the Fed may moderately reduce its purchases during 3Q2021 if economic growth and employment increases as the unemployment benefits expire.
Economic Data
The inflation narrative continued with stronger economic data. The Producer Price Index (PPI) headline and core figures both increased at rates that were higher than recent months. There were supply chain pressures arising from delays at U.S. ports and a global semiconductor shortage that led to temporary shutdowns in auto production lines.
Inflation data exceeded market expectations with the CPI, PPI, and Core CPI (+3.0% YoY) all reporting large gains in May 2021 that were historically high. Core PCE (personal consumption expenditures) is at 3.4% year-over-year, well above the Fed’s average 2% target.
Fed officials were surprised by the higher inflation numbers but repeated that they continue to view inflation risks as transitory and would let the economy run hot until employment goals have been met.
The Leading Economic Indicators Index, which measures forward-looking general economic conditions, increased 1.6% in April, higher than expectations of 1.2%.
The University of Michigan Consumer Sentiment Index fell unexpectedly from 88.3 in April to 82.8 in May due to higher inflation expectations.
Consumer confidence came in at 121.7 in April, which hit a one-year high, and also neared the pre-pandemic mark of 132.6 in February 2020.
Job openings remain at record highs. The number of firms not able to fill positions is also high. Hospitality and leisure sectors are seeing significant wage growth. There are still over 7 million jobs short of pre-pandemic levels. Enhanced unemployment benefits will expire in September and will force more workers back to the workforce. Currently, there are 9.2 million job openings.
The US added 850,000 jobs in June, exceeding expectations. The number of unemployed remains at 9.5 million. The labor participation rate was 61.6% in June, relatively unchanged.
The May jobs report was revised upward to 583,000. The unemployment rate rose slightly to 5.9% in June compared to 5.8% for May. Average hourly wages year-over-year rose 2%.
The ISM report also showed strong, with broad-based strength in employment, new orders, and business activity which offset weakness in inventories and export orders.
US Banks
The Fed’s one-year supplementary leverage ratio (SLR) capital relief program for large U.S. banks expired on March 31, 2021. The Fed had eased the rules beginning April 1, 2020, allowing banks to exclude U.S. Treasuries and banks’ deposits at the Fed from its calculation of banks’ SLR. Without the exclusion, the SLR margins would have been slimmer than Global Systemically Important Banks (GSIB) typically prefer.
The largest U.S. banks may limit absolute balance sheet growth after the elimination of the exclusion. The banks could also issue additional Tier 1 capital, qualifying preferred stock and/or retain earnings. These decisions would likely not impact the banks’ credit ratings. This regulatory change is being viewed as an improvement for banks’ outlook for this year.
On balance, regulatory or market conditions that boost bank capital requirements and heighten attention to physical and transitional climate risks should strengthen balance sheets and reduce overall risks to generally favor credit ratings and bank bondholders.
LIBOR Alternative Reference Rates
LIBOR was scheduled to be discontinued by year-end 2021 and to be replaced by Secured Overnight Financing Rates (SOFR). There is serious consideration to extending the transition from year-end 2021 to the end of June 2023. This would be favorable to legacy asset classes that lack adequate transition language in their debentures.
The Federal Reserve and several organizations including ISDA and ICE are coordinating the regulation and transition. New York state passed legislation that amends fallback language for legacy (LIBOR) securities and contracts. There may be additional Federal and state of Delaware legislation, where many corporate issues are incorporated. The Fed has stated that the stability and success of the transition is important and that it will try to achieve a smooth transition.
In addition to SOFR, there have been other Alternative Reference Rates (ARR) that have begun gaining acceptance including the Bloomberg Short-Term Bank Yield Index (BSBY) and Ameribor Unsecured Overnight Rate (AMERIBOR). Another ARR being developed is the ICE Bank Yield Index (still under development). Additional information is included in Alternative Reference Rates section of this report.
US Treasury
Despite concerns about higher inflation, Treasury yields fell and the yield curve flattened. The yield curve which had steepened in 1Q2021, flattened during 2Q2021. Foreign investor demand was strong as the search for higher yields increased the purchases of USD bonds.
US pension funds were re-allocating out of equities into bonds to monetize their fully funded status.
Pre-COVID-19, the US Treasury held $400 billion in cash balances as a precaution for liquidity purposes. With the declaration of the global pandemic, the US Treasury increased the cash balance in its Treasury General Account (TGA) to over $1.8 trillion in 2020. Under US Treasurer Janet Yellen, the US Treasury intends to reduce the TGA to $500 billion by 3Q2021.
Taxable municipal issuance totaled almost $10 billion in June, bringing the year-to-date total to $52 billion.
Corporate Bonds
In June, year-to-date issuance of investment-grade debt reached $800 billion. Credit spreads shrank despite the new supply in June. Investors continued to seek yield by buying higher yielding BBB rated bonds causing the spread between A-rated bonds and BBB-rated corporates to narrow.
Strong demand for corporate bonds continued. Investment-grade corporate issuers are projected to bring $100 billion to market in July.
Credit markets were helped by the global economic reopening that generated strong corporate earnings and overall, better corporate balance sheets. Investors continue to seek yield causing credit spreads to tighten for investment grade bonds. The high demand for yield has allowed companies to issue in longer maturities.
The economic recovery has helped weak companies shore up their balance sheets. Investment grade and high-yield total returns were positive for 2Q2021.
Rating agency downgrade activity is moderating based on stabilizing fundamentals. The number of investment grade issuers downgraded to below investment grade or “fallen angels” declined as corporate profits improved. As the economy recovers, corporate revenues and earnings may rebound sharply, which will drive improved credit fundamentals across most sectors.
Corporate credit fundamentals improved during the pandemic as they refinanced their debt by replacing short-term debt with longer maturity debt that strengthened their cash flow and balance sheets. As business conditions improve, companies may start share buybacks, mergers and acquisitions and special dividends. Global M&A activity transactions tend to have a negative effect on credit ratings.
In June, the G-7 agreed to support a global tax rate of at least 15%. The group is a long way from approving and implementing this substantial global policy.
Securitized Debt
Securitized sectors lagged corporates during the month. In June, Agency mortgage-backed securities (MBS) underperformed other securitized sectors amid concerns of increased supply and a reduction in Fed QE4 purchases.
Prepayment speeds on seasoned, shorter-duration residential mortgages (RMBS) began to slow as less refinancing occurred. The Federal Reserve’s QE4 purchasing program of MBS has kept spreads at historically tight levels. Should the Fed begin to taper, yields will rise. Interest rate spreads for AAA-rated mortgage-backed securities (MBS) and agency commercial mortgage-backed securities (ACMBS) were rangebound.
The expiration of the pandemic-related forbearance programs may accelerate prepayments in the agency MBS or Government National Mortgage Association (GNMA) MBS markets. The Fed stopped buying agency CMBS (commercial mortgages) in March 2021.
The Fed is the largest single holder of MBS (and Treasuries), but they do not actively rebalance their duration. Rather, they buy long-term securities with the intention of holding them to maturity. As a result, their QE purchases effectively retire a portion of the available Treasury and MBS market float for good.
Demand for single-family homes has risen sharply with social distancing and work-from-home adjustments to daily routines. The Fed’s QE4 purchases of MBS has maintained mortgage rates at all-time historic lows coupled with limited housing supply resulting in the escalation of national home prices.
Agency MBS underperformed Treasuries, as a result of the potential tapering of asset purchases by the Fed
There was moderate new issuance of asset-backed securities (ABS) during the quarter with $114 billion in deals year-to-date as of May 2021. Other ABS which exclude auto, credit card, equipment, and student loans, accounted for approximately 30% of that volume.
The limited supply of ABS and heighted demand during 2Q2021 caused spreads to compress for AAA-rated ABS. Demand also extended for ABS subsectors, esoteric structures and along the capital structure in the search for yield which also kept spreads at historically tight levels.
ABS new issuance in early July is expected to reach $1 billion in bonds which will be quickly absorbed by investors.
CMBS
The spreads of CMBS (commercial mortgage-backed securities) remained range-bound. There has been demand for subordinate bonds and single asset/single borrower (SASB) securitized deals.