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Weekly Fixed Income Commentary: Treasury yield curve flattens as the Fed remains steady
Highlights
- Preferred securities posted the best returns, followed by emerging markets and senior loans.
- Municipal bonds were range bound, but maintained a constructive tone.
- Non-U.S. markets outperformed the U.S. market, buoyed by strong returns in the European region.
Shorter U.S. Treasury yields rose while the 30-year yield fell slightly last week, causing the yield curve to flatten. The Federal Reserve (Fed) made no changes to monetary policy last week, and Chair Jerome Powell’s comments seemed to support the view that the Fed has no clear bias toward a cut or hike as its next move.
Fed outlook pushes short Treasury yields higher
Shorter-maturity U.S. Treasury yields finished the week higher, while the 30-year yield fell slightly.1 The Treasury yield curve flattened as a result, as generally stronger economic data put upward pressure on the short end. After Wednesday’s Fed meeting, the 2-year Treasury yield led a move higher and continued climbing on Thursday.1 The increase in rates was partly offset on Friday when strong headline readings on the April jobs report were overshadowed by disappointing wage inflation. The 5-year Treasury led a slight decline in yields.1
Most non-Treasury sectors outperformed U.S. Treasuries last week.1 Preferred securities posted the best returns, followed by emerging markets and senior loans.1 These sectors were the top performers in April as well, when all domestic non-Treasury sectors posted positive total returns and only mortgagebacked securities lagged similar-duration Treasuries.1 Last week, only the investment grade corporate sector suffered a lower total return than Treasuries.1 Longer-maturity high grade corporates underperformed and dragged down overall sector performance.1 Non-U.S. markets outperformed the U.S. market, buoyed by strong returns in Europe.1
Markets have struggled in recent months to interpret Fed Chair Powell’s communications. Last week was no exception, as the Fed’s policy statement and Powell’s postmeeting comments sent mixed messages about the persistence of weak U.S. inflation. This caused market-based probabilities of a policy rate cut to decline and market yields to increase. Interestingly, although the market’s Fed policy outlook reflects a stronger economic forecast, market-based inflation indicators fell last week.
Over the next three months, municipal money available for reinvestment is expected to total $117 billion.
Municipal supply remains scarce
Municipal bonds and Treasuries were range bound last week, yet both ended with constructive tones.1 New issue supply was $5.1 billion and was readily absorbed.2 Weekly fund flows continued to be positive for the 17th consecutive week at $1.2 billion.3 This week’s upcoming supply is expected to increase to $6.5 billion and should be readily absorbed.2
The fixed income market was slightly disappointed by the Fed’s lukewarm support last week for low rates. But the fact remains: There is no inflation in the economy, even with yet another stellar jobs report on Friday. Many continue to suggest that municipal bonds are “too rich” compared to Treasuries. However, municipals don’t have a reason to get cheaper until proposed new issue supply increases dramatically, which will not likely happen soon. New issue supply is expected to average $26 billion for the next few months.2 Yet we expect strong municipal demand will continue. Over the next three months alone, municipal money available for reinvestment is expected to total $117 billion from June 1 through August 1.2 It’s hard to make a case for tax-exempt yields to cheapen given this supply/demand imbalance.
The City of Philadelphia issued $190 million general obligation bonds last week (rated A2/A).4 Bonds started out priced aggressively, and strong demand allowed underwriters to lower yields upon final pricing. The city’s fiscal management continues to improve, and Pennsylvania has high state income taxes and lower deductions due to reduced state and local taxes (SALT).
The average yield for the Bloomberg Barclays High Yield Municipal Index increased last week, due to higher yields on the weaker tobacco securitization sector and the addition of Virgin Trains USA bonds into the index.1 Virgin Trains bonds, even after contracting 50 basis points, still yield substantially more than the index average and are a large enough issue to skew the index higher.1 Yields for other sectors continue to grind tighter.1 Inflows remained strong at $297 million net positive flows last week.3
High yield adds to gains as supply remain tight
High yield corporates gained for the eighth week in a row.1 The asset class has now delivered positive results in all but two weeks of 2019.1 Factors contributing to last week’s performance included spread tightening, muted new-issue volume, fund inflows and support from the equity market. Among the detractors were volatile oil prices, which caused high yield energy names to move lower, as well as uncertainty around inflation and Fed rate policy. In terms of quality, higher-rated (BB) bonds outperformed B and CCC issues.1
Investment grade corporate bonds posted a small loss.1 Spread widening hurt autos and energy the most, while financials held up better. With Japan observing its Golden Week holidays, the investment grade market lacked a strong component of overseas demand. On the supply side, primary market activity picked up, with 20 issuers pricing a combined $21.1 billion in new deals.2 Year to date, new issuance is down 11% compared to 2018, a decline driven largely by substantially lower volume in the financials sector.2
Emerging markets (EM) debt improved after the previous week’s listless showing. Narrower spreads, stronger fund flows and a sense that the U.S./China trade talks are reaching their end game helped EM bonds outpace most other taxable fixed income sectors last week. The Argentine peso rebounded from recent weakness, rising 3.2% to lead all other EM currencies.
High yield corporates have delivered positive results in all but two weeks of 2019.
In focus: Fed: “solid” growth but no rate hikes—or cuts—for now
As expected, the Fed left the target federal funds rate unchanged at its May meeting. The Fed made few substantive alterations to the language in its policy statement, painting a relatively bullish picture of the U.S. economy.
In his post-meeting press conference, Chair Jerome Powell downplayed concerns that stubbornly low inflation reflected broader economic weakness. Instead, he argued that “transitory” factors may be keeping inflation subdued. This statement supports the view of a patient Fed content with waiting for clear signs to guide its next rate move.
Markets, on the other hand, were looking for clues that the Fed was considering lowering rates. Indeed, coming into the meeting, fed funds futures—used by traders to bet on the direction of interest rates—showed a 67% chance of a rate cut by the end of the year. After Powell’s comments, that probability began to decline and stood at 53% (still high) immediately following the meeting.
We’re not convinced a rate cut is where the Fed is headed. Yes, the Fed’s first quarter dovishness and moderating policy forecasts almost certainly suggest rates will stay put for now. In fact, we don’t expect the Fed to make any changes to rates in 2019. But given the U.S. economy’s solid performance and diminishing slack in the job market, we think there’s a better chance of a hike than a cut before the end of the year.
Sources
1 Bloomberg L.P.
2 The Bond Buyer, 3 May 2019.
3 Lipper Fund Flows.
4 Market Insight, MMA Research, 1 May 2019.
Any reference to credit ratings refers to the highest rating given by one of the following national rating agencies: S&P, Moody’s or Fitch. Credit ratings are subject to change. AAA, AA, A and BBB are investment grade ratings; BB, B, CCC, CC, C and D are below-investment grade ratings.
Bloomberg Barclays Municipal Index covers the USD-denominated tax-exempt bond market.Bloomberg Barclays High Yield Municipal Index covers the USD-denominated, below investment grade tax-exempt bond market. S&P Short Duration Municipal Yield Index tracks the municipal bond market with maturities from 1 to 12 years. Bloomberg Barclays U.S. Aggregate Bond Index covers the U.S. investment grade fixed rate bond market. Bloomberg Barclays U.S. Treasury Index includes public obligations of the U.S. Treasury. Bloomberg Barclays U.S. Government-Related Index includes debt guaranteed, owned and sponsored by the U.S. government; it does not include debt directly issued by the U.S. government. Bloomberg Barclays U.S. Corporate Index is a broad-based benchmark that measures the investment grade, fixed-rate, taxable corporate bond market. Bloomberg Barclays U.S. Mortgage-Backed Securities Index is the MBS component of the U.S. Aggregate index and includes the mortgage-backed pass-through securities of Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). Bloomberg Barclays CMBS ERISA-Eligible Index is the CMBS component of the U.S. Aggregate index and includes CMBS investment grade securities that are ERISA eligible under the underwriter’s exemption. Bloomberg Barclays Asset-Backed Securities Index is the ABS component of the U.S. Aggregate index and includes credit and charge cards, autos and utilities. ICE BofA Merrill Lynch U.S. All Capital Securities Index is a subset of the BofA Merrill Lynch U.S. Corporate Index including all fixed-to-floating rate, perpetual callable and capital securities. Bloomberg Barclays High Yield 2% Issuer Capped Index measures the market of USD-denominated, non-investment grade bonds and limits each issue to 2% of the index. The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market. Loans are added to the index if they qualify according to the following criteria: The highest Moody’s/S&P ratings are Ba1/BBB+, only funded term loans are included, and the tenor must be at least one year. Bloomberg Barclays Emerging Market USD Aggregate Index is a flagship hard currency Emerging Markets debt benchmark that includes USD denominated debt from sovereign, quasi-sovereign, and corporate EM issuers. Bloomberg Barclays Global Aggregate Unhedged Index measures the performance of global bonds. It includes government, securitized and corporate sectors and does not hedge currency. One basis point equals .01%, or 100 basis points equal 1%.
A word on risk
Investing involves risk; principal loss is possible. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, derivatives risk, dollar roll transaction risk and income risk. As interest rates rise, bond prices fall. Below investment grade or high yield debt securities are subject to liquidity risk and heightened credit risk. Preferred securities are subordinated to bonds and other debt instruments in a company’s capital structure and therefore are subject to greater credit risk. Foreign investments involve additional risks, including currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. Asset-backed and mortgage-backed securities are subject to additional risks such as prepayment risk, liquidity risk, default risk and adverse economic developments. The value of convertible securities may decline in response to such factors as rising interest rates and fluctuations in the market price of the underlying securities. Senior loans are subject to loan settlement risk due to the lack of established settlement standards or remedies for failure to settle. These investments are subject to credit risk and potentially limited liquidity, as well as interest rate risk, currency risk, prepayment and extension risk, and inflation risk.
Investors should contact a tax advisor regarding the suitability of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on the state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.
This information represents the opinion of Nuveen, LLC and its affiliates and is not intended to be a forecast of future events and or guarantee of any future result. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. There is no assurance that an investment will provide positive performance over any period of time
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