What market conditions had a direct impact on the bond market this quarter?
Volatility returned with abandon in the first quarter of 2018. The S&P 500 retreated from its January highs with multiple one-day declines over 1%, including a treacherous 4.1% fall on February 5th - the first day of Jerome Powell's tenure as Federal Reserve (Fed) Chairman. Inflation concerns sent ten-year U.S. Treasury yields up almost 55 basis points (bps) from year-end levels, peaking at 2.95% before retreating to 2.74% at quarter end. President Trump's foray into steel and aluminum tariffs, along with his attacks on important tech and pharmaceutical companies, had investors questioning the President's pro-business loyalties.
Economic Activity - In the quarter, the U.S. economy is expected to grow in the 1% to 2% range, slower than Q4/17's 2.9% print, but in line with the developing trend of soft first quarter GDP data. ISM Manufacturing and Non-Manufacturing readings of 59.3 and 58.8, respectively, remained high vs. historical levels, signaling further expansion. Employment data reflected continued strength, with Non-farm Payrolls adding 605,000 jobs in the quarter and the U3 and U6 Unemployment Rates coming in at 4.1% and 8.0%, respectively. March's Non-farm Payrolls gain of 103,000 was well below estimates, but generally shrugged off as a smoothing of February's robust 326,000 print. Initial Jobless Claims - an excellent indicator of real-time employment conditions - remained near 50-year lows. Average Hourly Earnings (AHE) has become an increasingly important market focal point for building inflation pressures. March's AHE rose 0.30% resulting in a 2.72% gain year-over-year (yoy), meeting expectations but not triggering significant inflation concerns. Interestingly, a similar 0.26% monthly gain in January's AHE is credited with sparking inflation fears which, in turn, contributed to the jump in equity market volatility and pushed ten-year U.S. Treasury yields toward 3.00%. Inflation measures continued to trend higher at a controlled pace, with February's Consumer Price Index up 2.20% yoy and February's Core Personal Consumption Expenditure Index up 1.60% yoy. Given the consistent strength in ISM data and employment conditions, the risk of recession remains low through 2018, with higher inflation, increased debt levels in the system and an overly-aggressive Fed the principal threats to sustained growth and equity valuations.
Credit Markets - Reversing recent quarterly trends, credit spreads widened as market volatility, a decline in general market liquidity and negative market technicals pushed spreads wider in the last two months of the quarter. Three-month LIBOR jumped 62 bps in the quarter, far more than the single 25 bp hike in the Fed's key benchmark rates. The dramatic rise in LIBOR is more a function of supply and demand technicals in the short-term funding markets than an indication of growing bank or financial distress. LIBOR and, to a lesser extent, repo rates have been impacted by several factors affecting the supply and demand for U.S. dollar funding: 1) the Fed's methodical reduction in the size of its balance sheet is effectively reducing bank reserves in the system (increased issuer demand), 2) the Federal debt ceiling was extended into March 2019 allowing the U.S. Treasury to issue Treasuries - including T-bills - to replenish the cash balances held at the Fed back toward $350 billion (increased issuer demand), 3) anticipated higher federal budget deficits due to tax cuts and spending increases have increased the need for greater Treasury issuance (increased issuer demand), 4) U.S. tax code changes have made it less efficient for U.S. subsidiaries of foreign entities to receive dollar swapped funding from their parents which, in turn, forces those subsidiaries to obtain dollar funding on their own (increased issuer demand), and 5) repatriation and other U.S. tax code changes have reduced the appetite of cash-rich multinationals to invest in short corporate debt (reduced supply). While the increase in LIBOR rates and spreads negatively impacted the prices of legacy investments, investors did benefit from rolling over maturing debt into higher yielding instruments and holders of floating-rate notes benefitted from higher coupon resets.
*Corporate index underperformed the Treasury index by 17.2 bps in the quarter
The rise in credit spreads was pervasive in the investment-grade space, with the ICE BofA Merrill Lynch (ICE BofAML) 1-5 Year AAA-A U.S. Corporates & Yankees Index's option-adjusted spread increasing 16 bps from 40 bps to 56 bps, while the 1-5 Year ICE BofAML BBB U.S. Corporate and Yankee Index spread widened 24 bp from 79 bps to 103.
*Short index outperformed the long index by 24.8 bps in the quarter
Short-term U.S. Treasury yields rose across the board, reflecting an almost parallel shift with one- and five-year yields rising 35.1 and 35.6 bps, respectively. Not surprisingly, short duration strategies outperformed their longer-term counterparts. The shift to higher rates was not unexpected given the combination of Fed rate increases and rising inflation expectations from higher projected economic growth fueled by December's tax cuts.
Monetary Policy - As expected, the Fed raised benchmark rates 25 bps at the March 21st meeting. The median forecast from the Fed Dot Plot saw policymakers forecasting two additional 25 bp rate hikes in 2018 and three more in 2019. The Fed continued to taper the principal re-investments of maturities and mortgage paydowns in its portfolio with a first quarter 2018 cap of $20 billion per month. To date, the pace of the Fed's balance sheet reduction has not been reaching the established caps, partially attributable to a decline in mortgage refinancing, due to higher mortgage rates. Investors focused on the March 21st statement, Dot Plot and press conference for greater clarity on the pace and magnitude of 2018 rate hikes given market strategists seem to have coalesced around four hikes in the year vs. the Fed's median forecast for three. For his part, Chairman Powell gave a strong and assured performance at his inaugural press conference, balancing a confident outlook with an alertness for signs of inflation acceleration. San Francisco Fed President John Williams has been appointed to fill the key role of President of the Federal Reserve Bank of New York, a permanent voting position on the Federal Open Market Committee.
Fiscal Policy - Financial markets continued to digest the impact of sweeping changes to the U.S. tax code. In addition to triggering expectations for faster U.S. growth and higher corporate after-tax earnings, the tax code changes have clearly impacted investor behavior and supply / demand dynamics in the funding markets. President Trump's tariffs on steel, aluminum and other products have sparked fears of a trade war with several U.S. trading partners - China in particular. There is a general sentiment the President's actions are more about positioning for future trade talks rather than a true desire to implement new taxes on American consumers and industries. However, China's retaliatory actions and rhetoric have increased concerns the situation could escalate into a full-blown trade war. The President's seemingly arbitrary attacks on certain U.S. companies - Amazon in particular - are in stark contrast to the Administration's earlier efforts to praise American companies and extol the virtues of the U.S. economy. The Administration's change of tone and perceived haphazard approach to policymaking has increased investor anxiety and, in turn, market volatility.
What strategic moves were made and why?
Taxable Portfolios - Market volatility and a general widening of credit and LIBOR spreads negatively impacted USBAM's strategy of focusing on coupon income through increased allocations to credit and spread product. The increase in credit spreads was relatively orderly but widespread, with both industrials and financials across the yield curve experiencing negative price action on adverse spread movement. Market liquidity was available for security sales, although bid / ask spreads were wider than normal and, on the margin, fewer banks were willing to bid for paper. While headline risk remained a concern for non-financials, reductions in issuer-specific credit quality and public ratings were reasonably muted. Our strategy of being short to benchmark duration was the most positive driver of performance in the quarter, with the majority of the move higher in yield curve rates occurring in January. Our focus on securities maturing within 18 months was beneficial, given the relative flatness of the yield and credit curves beyond the year and a half mark. The performance of floating-rate notes (FRNs) was mixed, as coupons increased meaningfully with the bounce in LIBOR rates but prices deteriorated on meaningful spread widening of FRNs.
Tax Exempt and Tax-Efficient Portfolios - After a flurry of activity going into year end, one might say the first quarter was the calm following the storm for municipal buyers. Both new issue supply and our own trade activity took a noticeable turn lower during the quarter. The impact of tax reform's changes to market access for advance refunding bonds was evident, with first quarter refunding volumes falling over 70% vs. first quarter 2017 and total issuance off by approximately 30%. One- to three-year municipals outperformed taxable fixed-income alternatives by a wide margin, in large part due to these very supportive supply / demand factors. On the downside, however, these market conditions increased prices, presenting us with very few compelling opportunities to add new municipal positions keeping us on the sidelines for the most part. With one- to three-year Treasury yields up 35 - 40 bps, tax-efficient accounts were active in adding corporate bond allocations at higher levels.
How are you planning on positioning portfolios going forward?
Taxable Portfolios - We continue to see elevated market volatility in the near-term and, as a result, corporate and spread product remain vulnerable to further widening. In general, credit should benefit from continued GDP growth and increased after-tax cash flows resulting from tax reform. Headline risk remains an ever-present threat for investment-grade credit, but we continue to believe the threat is to spread levels and public ratings rather than to principal. Given this outlook, we will continue to lower spread duration in our portfolios by focusing on securities maturing in eighteen months or less. This strategy will also help us manage credit risk in the portfolios given the better optics on credit trends for shorter debt and the more muted price impact of any negative events and trends. Overall, we continue to believe the banking sector offers greater return opportunities than industrials on higher absolute spreads, lower event risk and strong balance sheet fundamentals. Going forward, it is important to note that portfolios have already absorbed the negative impact to performance of wider spreads. Should levels stabilize at these levels, portfolio performance will benefit from the higher yield-to-maturity of remarked holdings.
Regarding the yield curve, we remain wary of forecasts for an aggressive path of Fed tightening and feel the ultimate pace and magnitude of future hikes will be lower than Fed projections and more hardline street forecasts. That said, with the Fed Dot Plot forecasting two additional rate hikes in 2018 and market sentiment clearly looking to push short rates up, we anticipate yield curve rates will be higher at both the end of the second quarter and the end of 2018. Over time, the yield curve should flatten further as skepticism over aggressive Fed policy projections and muted increases in inflation mean longer rates should not rise at the same tempo as Fed rate hikes. Given our outlook, we will continue to be short duration to benchmarks and migrate toward a more bulleted portfolio structure. An increasingly limiting factor to portfolio construction and re-balancing is the jump in yields and widening of credit spreads, which have created unrealized losses for most legacy fixed-rate positions and some FRNs. For portfolios with sensitivity to realized losses, maturities and other cash flows are the best options for re-balancing portfolios, which can limit the scale of any adjustments, particularly in duration management.
Tax Exempt and Tax-Efficient Portfolios - With another fed funds rate hike looking like a good possibility at the June meeting, we continue to see rates trending higher. Accordingly, we will continue to make use of variable rate securities (variable-rate demand notes and FRNs) and position portfolio durations short to benchmarks. The summer months are likely to be particularly bleak in terms of municipal new issuance vs. reinvestment needs and these dynamics may keep a lid on tax-exempt muni yields to some extent. The seasonality around April tax payments in the coming weeks may present our best opportunity to extend durations of muni-only mandates. Corporate bonds will most probably continue to be a better alternative for tax-efficient portfolios and we would expect those allocations to increase.
Federal Reserve, Chair's FOMC Press Conference Projections Materials, December 13, 2017, (www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20171213.pdf)
Federal Reserve, Chair's FOMC Press Conference Projections Materials, March 21, 2018, (www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20180321.pdf)
Federal Reserve, Chair's FOMC Statement, December 13, 2017
Federal Reserve, Chair's FOMC Statement, March 21, 2018
Municipal Market Monitor