June 30, 2014
The second quarter was most notable for a lack of major US financial market moves, and the most notable domestic capital markets trend lately has been multi-year lows in both interest rate and equity volatility. The VIX, which was above 15 last time we wrote this shortly after the end of the 1st quarter, is now barely above 10. The Merrill Lynch Option Volatility Estimate (MOVE) index, which measures interest rate volatility as an index on interest rate options, is close to multiyear lows as well. Global bond yields have plummeted, as the Spanish and Italian 10-year bond yields are both well below 3%. As we write this, the Spanish 10-year bond yields 2.67% - on top of the US 10-year Treasury yield. Recall that in July of 2012, Spanish 10-year bonds yielded 7.51% as the Euro crisis caused global bond market fear. One implication of easy global money has been heavy demand for US fixed income, continuing to keep spreads compressed in both the investment grade credit and high yield sectors, and keeping US rates from leaking higher. The most recent example was the European Central Bank's negative overnight rate which has been a factor in demand for US Treasuries. Another factor has been large institutional investors rebalancing into fixed income after such a large trailing 12 month equity rally and after a very poor 2013 in the US Treasury market. Fundamentally, the U.S. economy has seen several encouraging data points that have pointed to a stronger second half. The monthly Non Farms Payroll report has been above 200K for each of the past 5 months, and has posted improvements not seen since the late 1990's. As we write this, the latest jobs number heavily surprised to the upside with the monthly Non-Farms Payroll printing a +288K versus economists' expectations of +215K. Recent housing numbers have also surprised to the upside, with new and existing home sales both posting very positive numbers. Existing home sales were up 4.9% month-over-month while new home sales were up 18.6%. Many of the banks have noted that the bond market rally this year, and the subsequent decline in the 30-year fixed mortgage rate from above 4.5% to start the year to 4.15% as of June 30th, has helped improve homes sales. This has largely helped investors move beyond a very poor -2.9% GDP revision for 1Q 2014.
The market will shortly move on to second quarter earnings and the growth of corporate profitability remains a concern in a market with valuations already pricing in a good deal of successful corporate operating results. For example, the trailing P/E of the S&P500 is now above 18 and short and intermediate duration credit spreads are very tight compared with historical averages. For example, 3 to 5 year investment grade credit spreads are in the top 1% of all-time results according to a recent research report by Morgan Stanley, with a current spread of 64 bps compared with the average of 95 bps from the lull of 2003 to 2007. The low print of 3 to 5 year credit spreads was 62 bps according to the same report. Long end spreads have rallied as well to 146 bps, but are still slightly wide of the 2003-2007 average of 141 bps. Strong technicals such as a global dearth of credit-worthy yield have helped support credit spreads, as well as institutional demand by pensions and insurers. The market has largely shrugged off the Fed's tapering of their QE program, which has decreased purchases of Agency MBS and US Treasuries by $10 billion a month. The real effects of the Fed's tapering, like so many other fiscal and monetary policies, were largely seen on the announcement in the second quarter of 2013 as Treasury yields spiked (rather than the actual action). This year the only real weakness in the credit markets came alongside the mini stock correction in the first quarter of about 6%. Spreads were also a bit weaker in early March on some of the Ukraine news regarding Crimea, but the credit markets have shook off both events and are now tighter than the start of the year.
Bonds continued to rally in the second quarter after experiencing the worst sell-off in 2013 since 1994. The 10 year US Treasury yield finished the second quarter at 2.53%, from 2.72% at the end of 1Q 2014 and 3.03% at the end of 2013. The 10-year has sold off a bit as we write this to start July on the back of improved economic data, especially the jobs numbers we touched on above. Still, the 10 year yield is north of its 2013 average of 2.33% and well north of its low of 1.39% in July of 2012. The return on the Ryan Labs 10-year Treasury Index for the year through 6/30 was 6.11% after posting a -7.73% in 2013. With a recent increase in CPI to 2.1% alongside better-than-expected macroeconomic indicators such as the ISM print of 55 and industrial production increasing, US Treasury yields have increased a bit in the last few trading sessions.
Within high-grade fixed income, credit spreads in the Barclays Aggregate Index ended 2011 at 217 bps, 2012 at 133 bps, tightened to 111 bps to end 2013, and finished the second quarter of 2014 grinding tighter to 96 bps from 103 bps at the end of 1Q 2014. Spreads largely followed both stocks and the macroeconomic environment but have been a benefactor of a low vol environment. Spreads on financial credit ended the second quarter at 96 bps, tighter from the 103 bps posted in the first quarter of 2014. Despite legal headline risk, many of the US banks have posted higher capital ratios and are running balance sheets with much lower leverage, and lower associated ROE. While the ROE numbers have drawn the focus of some equity investors, more conservative operations in a post Dodd-Frank/Volker Rule environment have been positives for their credit. On the other hand, much of the nonfinancial sector has begun to re-lever, with increasing net Debt/EBITDA ratios and share buy backs. Despite this trend, industrials finished the quarter tighter at 102 bps from 105 bps in the first quarter and 114 bps to end 2013. The agency MBS sector has outperformed duration-neutral Treasuries for the second quarter and the year, even as the yield curve flattened. The excess returns of the agency MBS sector was 42 bps versus duration-matched Treasuries for the month of June and 68 bps for the year. The optionadjusted spread at the end of the quarter was 38 bps.