The quarter continued the onslaught of events and factors that challenged the markets. Fixed income was impacted by weak global economic data and the continuation of negative yields on non-US bonds which makes the US bond market relatively attractive for investors. The periods of an inverted yield curve in the US and the Federal Reserve pivoting on its monetary policy added to recession fears. Geopolitical risks to the markets include the protracted China-US trade war, the Brexit drama, and potential oil shocks from the attacks on the Saudi Arabian oil refineries. There were also market disruptions to the repo market in mid-September and political uncertainty from the launch of a presidential impeachment inquiry.
Global trade tensions continue to be unresolved. Along with political turmoil across Europe and a slowing China, the global economy is facing a slowdown. PMI data showing manufacturing activity has fallen indicates that China, Germany, the Euro Area, Taiwan and Korea are all in contraction. Services PMI is also weakening. Still, the global economy is not likely to stall in 2019.
Although the labor market is still very tight, concerns about slowing global growth, negative impacts from ongoing trade tensions between the U.S. and China, and muted inflation pressures have global central banks back on the path of easing monetary policy. The Federal Reserve has cut rates twice in 2019, characterizing it as a “mid-cycle adjustment.” However, the Fed has not clearly signaled whether there will be more cuts, indicating that there may be one more rate cut in 2019, depending on economic conditions.
Repo Market Disruption
Banks routinely borrow and lend to each other on an overnight basis to ensure that they have sufficient funds to meet daily cash flow needs and that banks with excess funds can earn interest on them.
Funding instruments used in the interbank markets include:
Fed funds - overnight, uncollateralized interbank loans that can only be traded by banks.
Repo (repurchase agreements) - collateralized loans between banks, dealers and insurance companies. Repos can be negotiated on an overnight and longer-term basis. Repos use general collateral such as Treasury, agency, and mortgages to back repo loans
The Fed encourages banks to keep the reserves locked down by paying them a rate of interest on the reserves that was higher than the Fed funds rates and other available money market rates. This rate is called the interest on excess reserves (IOER). The Fed pays banks 2.25% IOER for excess reserves left at the Fed.
On September 16, 2019, the repo funding market became dislocated as banks were unwilling or unable to lend on a collateralized basis using high quality collateral. Overnight general collateral repo soared to 7% - 8% which is much higher than the Fed funds rate. The repo markets needed to finance $54 billion in new issue US Treasury bonds that settled on September 16. The majority of the Treasuries were held on dealer balance sheets.
The next day, September 17, overnight repo rates again jumped 3% above the Fed funds rate.
To stabilize the repo markets that day, the New York Federal Reserve Bank conducted open market repo operations by offering up to $75 billion at a minimum bid rate of 2.10% to help bring funding rates closer to the Fed's target range. Dealers took down $53.2 billion of Fed repo financing on September 17, and a total of $75 billion from September 18-19. The program was successful in adding $75 billion in liquidity to the system which lowered repo rates to 1.85% - 1.90%, within the mid-point of the Fed target rate.
Some analysts believe that the lower bank reserves in the financial system have reduced the ability of banks to absorb demand for repo funding. Others believe that Saudi Arabia withdrew billions in cash from the system to support its economy after the attacks on its oil production facilities.
On October 11, 2019, the Federal Reserve announced its program to address the dislocations in the short-term lending markets experienced in mid-September that sent overnight rates surging. The Fed had said that its repo operation would end November 4, 2019.
The Fed will now be extending its temporary overnight repo operations through January 2020 and will also be buying short-duration T-Bills through 2Q2020. The Fed stated that this operation will grow the Fed’s balance sheet, increase the level of bank reserves, and keep the Fed funds rate within its target range. The T-bill purchases will include maturities between 5 to 52 weeks and is expected to be large, around $60 billion in the first month of this program. Chairman Powell stated that the Fed will expand its $4 trillion balance sheet by purchasing T-bills.
GDP
The consumer sector has been a positive contributor to growth. Consumer spending represents 70% of GDP and has remained steady.
In contrast, business capital expenditures and exports weakened due to uncertainties and anxieties from prolonged and escalating trade tensions. The uncertainty has contributed to businesses postponing spending. Government spending and business investment continue to be weak as business sentiment is poor, keeping capital expenditures in check.
Real GDP growth was 2.0% due to consumer and government spending. Looking ahead to the third quarter, inventory growth should decline further while consumer spending and government spending will likely grow at a more moderate pace, and trade numbers are expected to remain weak. ISM manufacturing PMI dropped to 47.8%, the lowest since 2009, and ISM services dropped to 52.6% from 56.4%. Below 50% indicates the sector is in contraction.
Unemployment
The labor market is tight and wage growth is limited. The unemployment rate fell to 3.5% in September and the labor force participate rate remained steady at 63.2%. Nonfarm payrolls were up by 136,000 but below the expected 150,000 in September. Wages were flat for September and rose by only 2.9% over the last year. The labor force is limited and could constrain long-term growth.
Inflation
Inflation continues to be lower and remain low for a longer period than originally predicted. Economists expect continued low inflation and slow growth. Headline CPI inflation was 1.7% year over year and reflects a decline in energy. Core CPI increased to 2.4% due to increases in medical care, shelter, recreation, airfare, and used cars and trucks. The Fed’s monetary stimulus, economic growth and low rates have boosted home prices and financial assets but have not significantly impacted consumer prices.
Federal Reserve
The Federal Reserve cut interest rates on September 18, 2019 for the second time this year. They cut the rate by 25 bps to a range of 1.75% - 2% as inflation continues to be stubbornly low. Consumers are deleveraging by increasing their savings and spending less. The market is anticipating one more Fed rate cut in 2019.
The Federal Reserve encountered liquidity disruptions in the repo market in mid-September, due to high treasury issuance which impacted the shape of the yield curve. The Fed’s open market operations were quickly used to temporarily resolve the issue.
Central Banks
Global central banks have shifted towards easing monetary policy, which should prove supportive to the global economy.
Near-term challenges to the market are presented by the ongoing trade tensions that are already impacting a slowdown in global growth. Low inflation is troubling to central bankers of developed economies because if inflation drops too low an economy could have a prolonged period of disinflation. The European Central Bank (ECB) in September dropped its deposit rate to a record low of –0.5% and announced plans to restart quantitative easing (QE). Trade tensions contributed to concerns about further global economic slowdowns.
Interest rates in Japan and parts of Europe fell further below zero. China’s growth has been slowing to 6%. At this point, a number of emerging and developed markets are linked to China’s economic success through trade. German economic data pointed to an impending, significant slowdown. Manufacturing activity globally has trended downwards at a concerning level.
US
Despite extremely low unemployment in the U.S. over the past few years, wage growth has been modest. U.S. workers have less bargaining power than they once did when unions played a more prominent role. In August, Trump announced additional tariffs on Chinese imports.
At historically low levels of unemployment, wage growth has been anemic. Yet the consumer is confident and in good shape. With globalization of the workforce, technology is leaving workers with even less bargaining power. Employers won’t feel as much pressure to lift wages, and inflation will suffer. Household debt-to-GDP is down to 76%.
Fed and other central banks will continue to face challenges in their efforts to increase inflation. U.S. economic data in July was generally positive, with employment, retail sales, and personal consumption all topping Wall Street estimates. U.S. Manufacturing data however was weak. Related pressures remain, along with broad concerns around a further deceleration in global growth.
Investment Grade Corporates
Corporate debt levels keep rising with new issuance. Corporate bond buyers fluctuated from risk-off to risk-on during the quarter. Corporations took advantage of the lower interest rates in September and issued $165 billion in new investment grade corporate debt. The heavy corporate bond debt issuance caused spread widening as the supply was absorbed. Investment grade bond returns were positive in September and offset the negative performance in August. By quarter-end, spreads narrowed on investment grades bonds generating positive excess returns across all credit ratings, maturities, and industry sectors.
Corporate earnings will be impacted by oil prices, the stubbornly strong US dollar, slower global growth, pressure on margins and the minimal benefit from tax reform.
Interest Rates
Rates and market moves have been volatile from August to September. August saw a bond market rally with yields dropping, then rising in September. Increased Treasury and corporate issuance impacted yields on bonds. Economic data, such as strong consumer sentiment, strong retail sales, and an increase in core CPI, raised bond yields in September. Positive trade news such as the exemption of U.S. pork and soybean from new Chinese tariffs, helped improve the macro-environment.
Residential Mortgage Backed Securities (RMBS)
Residential Mortgage-Backed Securities underperformed relative to credit and corporate bonds at quarter-end as investors sought yield and increased their appetite for risk. The 30-year mortgage rate increased to 3.64% as Treasury yields rose on stronger economic data. RMBS spreads are expected to widen slightly due to the expected increase in RMBS issuance, uncertainty about short-term funding rates. The housing market data and fundamentals remain steady.
CMBS
In general, spreads on CMBS (Commercial Mortgage Backed Securities) narrowed slightly in September which was a volatile rate environment. New issuance by quarter end had increased. CMBS underperformed the corporate sector. From an excess return perspective, CMBS eked out 3 bps, with longer duration outperforming shorter duration and down in credit outperforming up in quality risk assets. The CMBS market is vulnerable to increased volatility, increased construction in the commercial real estate market, slower property price appreciation, and geopolitical uncertainty.
Asset Backed Securities (ABS)
Senior tranche AAA ABS underperformed security tranches lower in the capital structure as investors sought higher yield and were willing to take more risk.
The ABS primary market priced $24.7 billion in new deals through September. Autos had another strong month, with $10 billion of issuance followed by more esoteric ABS sectors with about $7.3 billion. Credit Card ABS had its strongest month of issuance since January, with $4.6 billion of deals pricing. Subordinated Credit Card and Auto ABS spreads held in better than spreads on their AAA peers. Excess returns on the lower quality ABS sectors were positive while AAA excess returns were modestly negative.