2018 Annual Bond Market Awards

Posted on December 13, 2018

Government Bond of the Year – Italy BTPS 0.05% due 4/15/21. Things were so different back in April. As the Federal Reserve was scrambling to raise rates and run down its balance sheet, Italian debt was enjoying its own mini Renaissance. European growth looked reasonably strong, the Euro was weak vs the USD, and ECB QE meant that European government debt would be continuously supported. Italy seized the opportunity and sold EUR4B in debt at a yield of 0.05%. Within 6 weeks, the bonds had sold off to a yield of 2.80% as the market worried that the new Italian government was headed toward fiscal reflation. Mamma mia!……why didn’t the Italians get off a 10 year maturity instead of a 3 year!?

Corporate Bond of the Year – Petsmart 7 1/8% due 3/15/23. I suppose any bond could be a dog, but really! Petsmart snacks on Chewy to the tune of $3+B and then rolls over and barfs all over the bond holders who were already struggling with the company’s distressed debt. Mostly debt was used for the acquisition and then a 20% stake was dividended out to its private equity owner before another 15% stake was sent to a non-guarantor subsidiary. So much is packed in here about covenant interpretation and end of credit cycle red flags that even a dog could see red.

Central Bank of the Year – Peoples Bank of China (PBOC). Well, I for one am impressed by their policy response to the tariffs. Rather than sit idly and twiddle their thumbs while the …ahem…’scuffle’ was unfolding, they quickly assessed that trade math was against them and responded with broad based ease. Unintentionally, perhaps, they also managed to get under the skin of President Trump who watched his own central bank continue to tighten monetary policy as a trade skirmish was evolving. The PBOC has come a long, long way since their pre-crisis days.

Central Banker of the Year – President Donald J. Trump. Snicker at me if you want…but as an investor in assets, why shouldn’t I want monetary policy which will keep the economy chugging along and do so without creating broad based inflation – other than in the assets I might invest in! And by the way, has anyone noticed what has happened to equities/credit/emerging markets since the start of October? Who knew…….

Currency of the Year – Japanese Yen. Started the year at just under 113….finishing the year at exactly the same level. I can’t tell if anything actually happened in Japan this year or if it simply got lost with all the other stuff going on with Brexit, Italian budgets, US-China trade, Quantitative Tightening etc…. No matter, the importance of the BOJ will be significant this year as the global economy slows, the markets correct and the BOJ is the last source of balance sheet expansion.

Comeback Player of the Year – Volatility. 2017 was soooo boring. Asset prices generally went straight up and the absence of volatility meant that it was difficult to opportunistically exploit valuation shifts and to differentiate performance from competitors. After trading around 10 most of 2017, the VIX (equity market vol) has been spending 18Q4 between 20-25. Bond market vol (MOVE) has spiked from 45 to 60. Is everyone having fun now?!

Villain in a Leading Role – Quantitative Tightening (QT). William McChesney Martin would be having a right old guffaw today. When he famously uttered the Fed’s job was “to take away the punch bowl”, Quantitative Ease (QE) and markets drowning in barrels of punch couldn’t have been imagined. Is it just coincidence that the month QE converted to QT saw the beginning of an immense correction in risk assets? When the final chapter on the great monetary experiment is written, I think it will be a painful read. Heck, I’d rather the central banks leave balance sheets where they are today and let the banks grow into them over the next 20 years!

Unsung Hero – $ Cash. In an era of QE, ZIRP/NIRP (zero interest rate policy/negative interest rate policy) and rampant asset price inflation – cash was truly trash. Raise official rates for three years and deflate asset prices by running down the central bank balance sheet and, presto-chango, cash is suddenly a legitimate asset class again. If you want to sit out the volatility in the equity markets or you’re confused whether 3% US Treasury yields are still distorted, you can wait it out in cash at close to a 3% yield.

Most Valuable Player – US Tax Reform. It entered 2018 with a lot of fanfare and was soon dismissed as giving the economy nothing more than a short term sugar rush. I disagree. I think there are an awful lot of good things that are being done that warehouse good times for the future. First, companies will have the drop from 35% to 21% tax rates on an annual repetitive basis (at least until there’s a new administration in D.C.). Combine that with all the capital they repatriated and there is a lot of firepower available. Second, we estimate consumers enjoyed about 60% of the benefits of tax reform. Their balance sheet is as strong as it’s been in decades. Finally, companies took advantage of the ability to contribute to their pension fund in 2018, using the 2017 deduction. A lot of this money went into plans, but is still sitting in cash. Again, another source of stored firepower to come in and support the markets. It’s just hard to imagine a recession over the foreseeable future with tax reform still in the background.

Author’s Note – This year, we have reduced the number of awards from 10 to 9. In an era of fee compression, technology led efficiency and QT – we are doing our best to lean into any potential unsustainable excesses!

Posted in Investor Insights.Tags: bond yields, central banks, Michele, QE, QT, Trump, volatility.

New12/13

Andrew Norelli

Portfolio Manager, U.S. Macro Strategies

The Dovish Course Correction (ish)

Posted on December 6, 2018

Frequent readers may recall that I’ve been using a Three Phases model to guide macro views and positioning for most of 2018, and that is continuing now. However, I’ve made a significant change to my expected price action in the later stages of this macro evolution, specifically in Phase 3. A few weeks ago, I suggested that the events of October kicked off a Three Phases cycle in miniature, which would culminate in Phase 3-type price action once the Fed responded to tighter financial conditions with a “dovish course correction.” Well, what has transpired since then should constitute such a shift. Now that it’s happened though, I found myself modifying the expected Phase 3 price action for reasons I’ll discuss. The change partially reflects some lingering uncertainty about whether the rhetorical shift in the Fed’s language is actually “enough” of a dovish lean to truly open up Phase 3. According to the roadmap I’ve described all year, such a dovish lean into tight financial conditions should be cause for a significant relief rally in risk assets, and a material rise in long term interest rates as risk aversion abates. At this point though, I no longer think Phase 3 results in much of a rise in rates.

First, the course correction: in the week of November 12th, Richard Clarida, Raphael Bostic, Patrick Harker, and Chairman Jerome Powell all had on-the-record comments which signaled a pause or take-it-slow approach to further rate hikes, and that the committee was shifting to data dependency for further tightening. The various comments also re-injected some precision to their estimates of the neutral rate, in contrast to October’s speeches which effectively blurred the committee’s estimates. Then of course, last Wednesday Chairman Powell said the policy rate was currently “just below the broad range of estimates of the level that would be neutral for the economy.” That comment was pretty clearly intended to walk back his “we’re a long way from neutral” soundbite from October 3rd.

If following the Three Phases playbook, which has served as a reliable anchor for our macro-driven views all year, one should respond to dovishness by keeping or adding to risk assets, and reducing duration exposure. I felt compelled to call a bit of an audible though, and continue to favor duration. My reasoning was as follows:

The October comments which kicked off the Three Phases in miniature did the most harm by raising and obfuscating the Fed’s estimates of the neutral rate – and by extension, the terminal rate on this tightening cycle. Reversing this, through acknowledging the impact on the economy of the policy tightening which has already occurred, should lower the expected neutral rate and terminal rate, which in turn should put downward pressure on long term yields.
I believe the appropriate neutral rate (especially in the near-term) ought to be conditional on continued Quantitative Tightening, which should result in a neutral rate that is lower than it otherwise would be without QT. The dovish course correction represents a Fed acknowledgement of this idea, while at the same time suggesting nothing about slowing down QT.
In a regime where Fed officials do not react to negative market developments, and instead telegraph an intent to press ahead on a rigid tightening path, yields can’t decline that much in the long end in the absence of clear policy-error evidence (which was absent). But once the Fed shifts to data dependency and away from policy rigidity, this allows yields to decline and for duration to once again function well as a risk-reducing diversifier in a portfolio. Additionally, the dovish shift was not so dramatic or ill-timed as to look inappropriate from a policy perspective, which kept breakeven inflation rates from exploding higher (in fact they shrank).
Perhaps most importantly, I’m not convinced that the rhetorical shift is truly sufficient to result in a durable risk-on. I continue to believe that liquidity drain is the most important medium-term driver of markets from here, and there is still no hint in the Fed’s communications that they acknowledge this particular angle. So, in other words, there’s a risk that markets are still in Phase 2, in which duration is helpful to portfolios.

For these reasons, I have cautiously continued to hold duration and to deviate from the Three Phases model’s original prescription for Phase 3 positioning. A bit of a hedge though: very recent price action in rates looks grabby, as if a capitulation is occurring toward the ideas I’ve presented here or something similar. That’s a reason to be patient on entry level, even though I think generally these ideas still apply.