U.S. fixed income results were positive across all sectors and durations in 2019, supported by falling yields, compressing credit spreads, and strong fundamentals. The U.S. consumer remained confident with low unemployment. The U.S. continues to experience tight labor markets, lower corporate profit margins, and a yield curve that has flattened, inverted and steepened.
During the quarter, escalating trade tensions with higher U.S.- China tariffs and slower global economic growth depressed corporate capital spending plans.
To counter the low growth, inflation and negative impact of tariffs, the Federal Reserve cut the Fed Funds rate three times, by a total of 75 bps. to return to a positive yield curve by year- end 2019.
Recession concerns have calmed. The passing of the US- Mexico-Canada trade agreement, the phase one deal with China, and an expected orderly Brexit after the UK election each eased uncertainty about growth in 2020.
US Congressional impeachment actions had little adverse impact on markets that focused on fundamentals instead of political events. The expectation of a phase one trade deal between US and China on January 15, 2020 was reassuring to the markets.
Repo Market Disruption
In September 2019, overnight government repurchase agreements (repos) spiked up to ~10%. The Federal Reserve responded by adding liquidity into the repo market through open market operations.
The Federal Reserve addressed the dislocations in the short- term lending markets experienced in mid-September that sent overnight rates surging by instituting a temporary overnight repo operation.
The Fed extended its temporary overnight repo operations by offering $120 billion in overnight repo and $35 billion in two- week term operations through January 2020. The Fed will also purchase $60 billion in Treasury bills per month through 2Q2020. T-bill purchases will include maturities between 5 to 52 weeks.
The Fed will also continue to purchase Treasury securities to reinvest principal payments from Agency, MBS and maturing Treasury securities. Up to $20 billion per month are reinvested in Treasuries and paydowns and over $20 billion are reinvested in agency MBS.
Chairman Powell announced that the Fed’s $4 trillion balance sheet will expand with the purchase of Treasury bills. The Fed stated that the operations increase the level of bank reserves and keep the Fed funds rate within its target range.
The Fed conducted daily and term repos over quarter-end and year-end through temporary open market operations. Over year-end total temporary liquidity was almost $500 billion compared to the total tri-party repo market of $2.1 trillion.
Corporate cash managers are indirectly exposed to the repo market when they invest in government and prime money market funds that use government repos as liquidity investments.
Recent SEC 2a-7 changes or money market fund reform with CNAV and FNAV choices resulted in cash managers’ shifting assets from Prime to Government money market funds. Government funds rely heavily on government repos while Prime funds invest primarily in commercial paper and bank obligations. Corporations’ tax payment dates also had a large impact on money funds and the repo market.
The Federal Reserve indicated that it will refrain from raising rates until inflation really becomes a concern. The Fed will be more accommodative than economic fundamentals might
indicate. During 2019, the Federal Reserve’s shift toward rate cuts and balance sheet expansion helped calm recessionary concerns as U.S. banks tightened lending standards for commercial and industrial loans in 4Q2019. Inflation now plays a much larger role in the Fed’s monetary policy decisions than it has in the past. Inflation is expected to remain below 2% which means that the Fed may cut rates further in 2020. The futures market continues to anticipate that the Fed will make one more rate cut in 2020.
Global central banks were accommodative amid modest growth and tepid inflation. Global monetary policy was more accommodative and challenges to growth continued. Easy money and liquidity continue to elevate asset prices higher despite moderate to weak fundamentals. The supply of available sovereign bonds has diminished due to continued central bank purchases. Weak global manufacturing and lower trade activity are expected to continue. Central banks are trying to offset these factors with more accommodative monetary policies in developed economies. At this point, some of those policies appear to be effective in preventing a global recession.
The economy slowed in 2019 going from 3% growth to 2% growth by year-end. Manufacturing showed weakness, as the ISM Manufacturing PMI registered at 47.2 for December, the fifth month of contraction and the lowest level since June 2009. In contrast, the service-sector ISM and industrial production remained strong.
US economic data continued to show a healthy consumer, as early estimates of December retail sales were up 3.4% over the prior year. The consumer remains in solid shape amid tight employment conditions. Lower interest rates have kept consumer debt service manageable and boosted housing activity.
Employers added 145,000 jobs in December and unemployment stayed at a 50-year low of 3.5%, posting 10 years of consecutive payroll gains.
Wage growth remained tepid with private-sector wages advancing 2.9% from a year earlier, the smallest annual gain since July 2018. Payrolls for November and October were revised down by a net 14,000 jobs.
The de-escalation of the U.S.-China tariff confrontation could provide some boost to business sentiment, although the apparently narrow scope of the deal may not boost capital spending.
U.S. Treasury yields ended 2019 sharply lower overall and declined modestly in recent weeks. The yield curve flattened slightly over concerns of escalating tensions between the U.S. and Iran. Expectations for a Federal Reserve (Fed) rate cut in 2020 rose to 66% on deteriorating risk sentiment. Lower interest rates have helped stimulate the housing market.
U.S. Treasury yields rose the last few days of 2019 before ending the first week of January lower. The year finished with interest rates sharply lower overall, led by short maturities. Declining Treasury yields are usually associated with a negative market tone, but last year’s move was largely propelled by Fed policy cuts. Market sentiment was mostly positive, as reflected by a steeper yield curve and outsized returns from risk assets. The difference between long and short maturity Treasury yields increased steadily after bottoming in late August. However, the yield curve flattened modestly recently due to escalating U.S./Iran tensions.
Treasury yields were generally down over the first week in January, 2020 as tensions flared in the Middle East. The possibility of further conflict initially drove oil prices higher and equity markets lower.
The 10-year yield dropped as much as 18 bps., but then retraced as both sides called for de-escalation; oil prices and equity markets similarly gave back their respective gains and losses
Investment Grade Corporates
Non-Treasury sectors experienced strong outperformance in 2019. Investment grade credit spreads edged up 3 bps. in the first few days of 2020, after narrowing in mid-December to below 100 bps. for the first time since early March 2018. There is limited opportunity for spreads to compress further, but they could remain in their current low range through 2020, given the support of strong fundamentals and technicals.
The first week of 2020 was highlighted by heavy supply, as investment-grade issuers priced over $47 billion in new issue, surpassing initial estimates of $30 -$35 billion.
The surge in supply was caused by issuers taking advantage of low rates, as credit spreads neared post-crisis tights. Despite the heavy supply, demand remained strong, and corporate spreads widened just 4 bps. to close at 97 bps.
The low rate environment and flat yield curve pushed investment grade supply out to the long-end where it was met with great demand, particularly from foreign investors searching for positive yielding assets. The year 2020 may represent the late stages of the credit cycle but while leverage remains high, coverage is strong and fundamentals are relatively healthy.
Valuations continued to appear high for bonds across the corporate bond market compared to recent history. Corporate credit spreads were driven lower by capital flows into US bonds from overseas investors, limited supply and demand for fixed income bonds from pension funds de-risking and locking in equity gains. Bonds outstanding with yields total more than $11 trillion. At year-end 2019, investment grade corporate debt issuance used to finance mergers and acquisition was 30% lower for the year.
Banks continue to show better than expected earnings despite the low-rate environment. Corporate balance sheets are highly levered across industries, yet the fundamentals are strong as the cost of debt is at a very low rate. Most of the corporate issuance has been to take advantage of low rates and term out debt maturities which is a financially sound practice. In 2019, 36% of new investment grade new issuance had been in 3 and 5 year maturities while 63% had been in maturities 7 years, 10, years and 30 years.