It has been much the same story in most of the fixed income markets over the past week. While we could certainly blame Easter and school vacation holidays for declining volumes and volatilities over the past few weeks, we think this is a convenient excuse and simply affirms broader trends that have been in place for the better part of the year. In particular, rates remain range bound, with the 10-year trending between the 2.6% and 2.8% levels that have been in place since mid-January. Corporates continue to be a low volatility treasury alternative pushing to lower spread levels in light of the mild sell-off in the govie market over the past week. The recently maligned high yield market, whose returns have lagged the IG market on a risk adjusted basis over the past few weeks, outperformed as its spreads pushed down to levels not seen since the summer of 2007. Even emerging markets (EM), which appeared on the brink of repeating last summer’s meltdown, have moved from being one of the weakest fixed income asset classes to being the strongest market over the past few months. Taking a step back and looking at other fixed income markets shows that equity indices are largely unchanged in the developed world, whereas most major FX pairs have seen compressing volatility while the dollar index is mostly unchanged from where it started the year. BNY Mellon Weekly Fixed Income Market Commentary - April 23, 2014 April 23, 2014 20140423

BNY Mellon Weekly Fixed Income Market Commentary - April 23, 2014

It has been much the same story in most of the fixed income markets over the past week. While we could certainly blame Easter and school vacation holidays for declining volumes and volatilities over the past few weeks, we think this is a convenient excuse and simply affirms broader trends that have been in place for the better part of the year. In particular, rates remain range bound, with the 10-year trending between the 2.6% and 2.8% levels that have been in place since mid-January. Corporates continue to be a low volatility treasury alternative pushing to lower spread levels in light of the mild sell-off in the govie market over the past week. The recently maligned high yield market, whose returns have lagged the IG market on a risk adjusted basis over the past few weeks, outperformed as its spreads pushed down to levels not seen since the summer of 2007. Even emerging markets (EM), which appeared on the brink of repeating last summer’s meltdown, have moved from being one of the weakest fixed income asset classes to being the strongest market over the past few months. Taking a step back and looking at other fixed income markets shows that equity indices are largely unchanged in the developed world, whereas most major FX pairs have seen compressing volatility while the dollar index is mostly unchanged from where it started the year.


Amongst this backdrop, we have heard the common lament that volatilities have collapsed this year, which our review largely confirms. Of the broad asset categories we track most have seen their year-to-date (YTD) volatilities fall from last year’s levels, with only commodities seeing a slight increase from 2013 averages. We would argue that the current environment is just what the Fed ordered, with lower volatilities needed given the lack of liquidity in the market. A recent Bloomberg article (http://www.bloomberg.com/news/2014-04-21/wall-street-bond-dealers-whipsawed-on-bearish-treasuries-bet-1-.html) pointed out that primary dealers had an overall negative treasury position in mid-March, the first time a net short position had been established since 2011. However, this bearish view does not appear part of a paired trade, with primary dealer inventories (sum of govie, corporate, HY, agency, MBS and CMBS holdings) also at their lowest levels of the past year according to this same Fed data. Of course we are cognizant of cause versus effect in this interpretation, but with Basel III and supplemental leverage ratios all the rage during bank earnings calls, we see little reason to expect the street to increase their market making activities. Recall that the Fed has recently mentioned financial market stability as one of its objectives, along with maximum employment and price stability. We keep this in mind as Janet Yellen is set to lead her second meeting as Fed Chairman, where we and the market largely expects an additional $10 billion reduction to the quantitative easing (QE) program and another dovish policy statement. Since there is no presser following the April 30 meeting, we won’t have the potential for post-meeting fireworks, but again would expect the Fed to try and keep volatilities low and trading within current ranges given that the market is behaving just like the doctor ordered.

The upcoming week has the potential to shake things up a bit, with vacations schedules ending, a Fed meeting, a massive economic calendar and a crescendo to the earnings reporting season. As stated, we don’t expect much from the Fed, although wonder if they will try to improve inflation expectations, with the continued outperformance of the Bond and subsequent flattening trade only justified by a benign inflation outlook for an extended period of time. Next week’s economic calendar will include the litany of releases that characterize the start of every month, including the trio of employment readings, monthly retail data, along with consumer confidence, ISM manufacturing and various regional manufacturing reports. We would point out that the Citi economic surprise index appears to have recently troughed after falling steadily over the winter from a two-plus year high hit in mid-January. Lastly, earnings remain in full force and have recently improved from a lackluster start. We are 25% through the earnings season and companies are beating estimates approximately 70% of the time, with 19% of companies missing estimates, largely in line with recent averages. More impressive has been the move up in overall earnings, which are now posting a +1.9% year-over-year growth rate, versus the -1.3% expectation at the start of the earnings season. The improvement in earnings has had little impact on corporate spreads however, with additional spread tightening becoming an increasingly difficult proposition given that we are at mid-2007 tights.

Below please find the views from our trading desks. We will be rotating through various asset classes each week and are highlighting the view of risk takers from our treasury and agency desks this week. We would appreciate any feedback on these changes/enhancements, along with the new format that we have just implemented.

 

Treasury Trading (by: Tom DeQuinzio)

Since the beginning of January, 10-year treasuries have basically been stuck in a 25 basis point (bp) range as market participants continue to anticipate a much quicker acceleration from accommodation to tightening than what the Fed has been signaling.  That mindset continues to be tested daily as ever changing developments in Russia, concerns over the strength of the Chinese economy, and weather-related effects of first quarter productivity all weigh counter to the rising rate theory. While markets always try to get ahead of the Fed, it is also a fact that participants get the most emotional at range extremes. This has seemed to be the case in this most recent four month cycle as possible green shoots have only added to the confusion and kept ranges intact. With the April FOMC meeting upon us and May’s non-farm payroll report two days afterwards, we believe that the curve should maintain its flattening bias through next week as the 10-year yield continues to hover around either side of 2.70.

There are many uncertainties facing the Treasury market as we head towards the summer that will continually affect price action. Domestic economic strength, developments in Ukraine, Emerging Market concerns, the transition at the Fed, continued tapering, possible cutbacks in Treasury issuance, and mid-term elections will all garner market attention and dictate price action. While most forecasters are sticking with their higher rate predictions, so far that has proven ineffective as investors have flocked to Treasuries and have kept rates confined. We would expect similar price action going forward as the curve maintains its gyrations from the belly to the longer end as the front end stays anchored. It seems that for the foreseeable future, discipline will remain the proper strategy with ranges well defined as markets continue to weigh the balances of tepid growth, low inflation and a still accommodative Federal Reserve.

Agency Trading (by: David Isaac)

The first half of April was relatively quiet in Agency land after the NFP induced rally and the Easter break. Nonetheless, agency spreads continued to tighten throughout the month and remain at historically tight levels versus treasuries and LIBOR. Supply/demand dynamics in GSE’s and deal flow receiving in swaps will continue to keep spreads bid in the short term. Longer term, there has historically been some summer catalyst that would drive things wider. We think that this catalyst is more likely an external event than anything in the Agency world that forces the move. Fannie & Freddie’s term needs will remain light unless we rally out of the range in which we find ourselves stuck. Moreover, today Freddie passed on its Reference Note issuance slot for the fifth time this year.

The typical demand for front end paper remains insatiable as accounts continue to park money there waiting for the rate move that never seems to materialize. With net discount note issuance down $50+billion from Q1 2013, flows have moved into T-bills. In callables, with spreads tight and volatility remaining low, coupon pick-ups versus bullets have not looked as good as they had earlier in the year. However, with some cheapening from Freddie Mac and FHLB, new issue coupons look more compelling, again at +15-20 versus matched maturity bullets. Callables tend to outperform in the range trade, which is where we have been since the beginning of the year; just in time for tax inflows to be invested.

Looking ahead, we maintain our short spread bias, or if you prefer to remain in bullets, consider flatteners where the back end may have a little more room to tighten. Also, we find value in the carry and roll down profileof callables inside of five years with at least a 15bp pick versus treasuries.

 

 

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