What market conditions had a direct impact on the bond market this quarter?
During the quarter, corporate and asset-backed spreads continued to tighten on strong investor demand, while short U.S. Treasury rates rose on the back of the June 14th rate hike. On the economic front, employment remained solid while inflation measures weakened vs. the Federal Reserve's (Fed's) 2% target level.
Economic Activity - Second quarter U.S. GDP growth is expected to improve on the first quarter's disappointing 1.4% pace. Employment conditions reflected continued strength as Non-farm Payrolls added a healthy 581,000 jobs and the U3 Unemployment Rate fell 0.1% to 4.4% in the quarter. Initial Jobless Claims - an excellent indicator of current employment conditions - remained near 40-year lows. Despite solid labor growth, Average Hourly Earnings remained well-behaved with workers seeing only 2.5% year-over-year (yoy) gains, down from March's 2.6% level. The moderate wage gains were in line with the softening of most of the quarter's inflation indicators. May's U.S. Consumer Price Index fell to 1.9% yoy vs. March's 2.4% reading on falling oil and commodity prices. May's Core Personal Consumption Expenditure Index fell to 1.39% from March's 1.56% reading. June ISM Manufacturing and Non-Manufacturing Indexes surprised to the upside with readings of 57.8 and 57.4, respectively, reflecting strong growth in both sectors. Given the consistent strength in employment conditions and a noticeable lack of broad sector bubbles in the real economy, the risk of a near term recession appears low.
Credit Markets - Credit spreads tightened further as investors shrugged off the general dysfunction in Washington and the dimming prospects for fiscal and tax reforms. The option-adjusted spread of the BofA Merrill Lynch 1-5 Year AAA-A U.S. Corporate Index tightened from 68 basis points (bps) to 60 bps over the quarter, adding additional return to the index's incremental coupon income. Secondary market liquidity remained robust as market volatility remained relatively low during the quarter.
*Corporate index outperformed the Treasury index by 32.2 bps in the quarter
The public rating environment for AAA- to A-rated bank and corporate credit remained relatively benign, although the Canadian and Australian banking sectors experienced one-notch downgrades in the quarter on growing domestic mortgage and housing concerns.
*Long index outperformed the short index by 20.5 bps in the quarter
The U.S. Treasury yield curve flattened in the quarter, with one-year yields climbing 21.1 bps while five-year yields actually fell 3.3 bps. The flattening of the curve benefitted the three- to five-year area of the curve and fueled the outperformance of longer benchmarks vs. shorter counterparts. Absolute short yields continued to rise following the June 14th rate hike.
Monetary Policy - The Fed raised its target rate 25 bps at the June 14th meeting, the third increase since November. The Fed's updated Dot Plot median forecast called for one additional fed funds rate hike in 2017 with three additional hikes in 2018. The median longer run forecast called for a terminal fed funds rate of 3.0%. Despite the Fed's guidance, fed funds futures placed only a 16% chance of a September rate hike and a 52% probability of one additional rate hike by the end of 2017. Investor doubts were driven by recent price data indicating inflation levels had declined somewhat below the Fed's 2% goal. Also in the June 14th statement, the Fed noted it expects to begin implementing a balance sheet normalization plan this year. The normalization program would gradually reduce Fed Treasury and mortgage-backed securities holdings by decreasing reinvestment of principal payments from those securities. The consensus from market strategists for the future path of Fed policy normalization seemed to coalesce around a September move on balance sheet reduction and a third 25 bp rate hike in December.
Fiscal Policy - Investor expectations for promised tax cuts and fiscal policy reforms waned in the quarter, as the White House and Congress struggled to come to agreement on most key issues, including a repeal and replacement of the Affordable Care Act. Initial optimism was high for fiscal reforms coming as early as August; however, Administration officials and Republican leaders have publically tempered expectations and now most expect any reforms to come late in 2017 or early 2018. The Trump Administration has made progress on reducing the regulatory burdens placed on the economy following the financial crisis at the administrative level rather than through legislation.
What strategic moves were made and why?
Taxable Portfolios - We continued to overweight credit and spread product in our strategies based on continued U.S. economic growth and a generally solid corporate credit environment. Our overweight credit strategy includes allocating a greater portion of portfolio assets to credit vs. benchmarks, having higher duration in credit vs. Treasuries and / or moving portfolio allocations toward investment policy limits. This strategy benefitted portfolios as credit spreads tightened on strong investor demand for income, adding price return to the incremental coupon income of credit. We strived to keep portfolio durations short to their benchmarks on our view that continued Fed policy tightening would, in turn, result in higher levels across the yield curve. The short duration strategy was effective as yields three-years and in rose in the quarter. Absolute coupon returns for short fixed-income portfolios benefitted from Fed rate hikes in December, March and mid-June.
Tax Exempt and Tax-Efficient Portfolios - Short-term municipal market conditions provided little incentive to take on additional risk during the quarter. Looking back at performance for several short muni benchmarks with average portfolio durations inside two years confirms total returns had little dispersion. The slope of the yield curve between seven-day variable rate demand notes (VRDNs) and three-year, AAA-rated investments approached the 15 - 20 bp range at times. Given our forecast for continued rate increases by the Fed, we did not consider this to be sufficient yield pick-up to extend portfolios. We were content to limit the majority of reinvestment to VRDNs and allow overall portfolio durations to shorten. Muni issuance continues to underwhelm, with total year-to-date volumes down over 15%. Valuations for municipals have richened relative to U.S. Treasuries, with one- to three- year maturities trading well below levels seen earlier this year when prospects for tax reform and other fiscal stimulus appeared brighter. For tax efficient accounts, we found better opportunities in the corporate bond sector and increased allocations accordingly.
How are you planning on positioning portfolios going forward?
Taxable Portfolios - We expect the Fed will raise benchmark policy rates one additional time in 2017, as well as begin the long process of balance sheet wind-down. There is some uncertainty over the timing and order of these actions, as the Fed becomes more focused on economic data over progress on promised fiscal and regulatory reforms, particularly given the recent decline in inflation measures. Regardless of the timing, we believe the short end of the yield curve - five years and in - will be higher by year end, leading us to continue our overall short duration strategy. The degree of "shortness" will be adjusted by individual portfolio duration limits, with shorter duration portfolios likely closer to benchmark durations than their longer duration counterparts. For all strategies, we will strive to position portfolios to more rapidly react to anticipated Fed tightening. LIBOR-based floating-rate notes, commercial paper and certificates of deposit will continue to play a prominent role in portfolio construction in order to accomplish this goal. Based on a solid economy and reasonably quiet credit market conditions, our overweight to credit and spread product will continue in the coming quarter - although the strategy could evolve, as the cumulative tightening of credit spreads has reduced the potential for incremental price gains on further tightening. We continue to believe the banking sector offers greater return opportunities than industrials on higher absolute spreads and yields, lower event risk and strong balance sheet fundamentals. While we always strive to maximize participation in the new-issue debt markets whenever possible, the relative lack of product and tighter spreads seen in the secondary market make this tactic even more beneficial in the current environment.
Tax Exempt and Tax-Efficient Portfolios - We expect market levels to remain fairly stable over the next couple months and do not see any significant changes to our strategy at this point. The Fed is unlikely to raise rates before September at the earliest, which should keep VRDNs hovering in the vicinity of 85 - 90 bps. Shorter, fixed-rate maturities (one to three years) are also likely to continue to be supported near current levels for the time being, as there are just not enough bonds being issued to satisfy reinvestment needs in July and August. However, we anticipate both variable- and fixed-rates will be higher at year-end. However, as these seasonal factors impacting demand subside and the Fed follows through with another rate hike, we expect rates will move higher over subsequent months and into year end.
Federal Reserve, Chair's FOMC Press Conference Projections Materials, March 15, 2017, (www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20170315)
Federal Reserve, Chair's FOMC Press Conference Projections Materials, June 14, 2017, (www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20170614)
Municipal Market Monitor