BNY Mellon Weekly Fixed Income Market Commentary

December 1, 2016

Strained Relationships

The post-election trade remains mostly intact with rates continuing higher, the dollar retaining its strength and US stocks leading most DM equity markets higher. We continue to lack hard policy details, as the incoming administration continues to slowly fill cabinet posts. The markets have nevertheless been forced to interpret aspects of campaign promises and imply their impact on asset values. In particular, the stronger tone in stocks continues, buoyed by expectations of fiscal spending and a more favorable tax and regulatory environment for corporate America. These equity gains have occurred despite the increase in yields, which are on their longest losing streak since 2009. Higher yields have been prompted by the view that larger deficits and higher inflation await debt investors under the new administration. Deficits would be driven by tax cuts and the previously promised fiscal stimulus, while inflation may become a by-product of tight labor markets facing off against fiscal spending. Additionally, possible tariffs or trade restrictions have also historically been an inflationary catalyst. While Treasury yields were mostly unchanged over the past week, they nonetheless have not been able to hold onto any gains, and we still think the path of least resistance is towards higher yields. Recent commentary from the incoming administration's nominees can be read as supporting the bond market's concerns and therefore feed into the existing market theme.


Dollar strength is the third pillar of the developing market commentary that we think bears watching. While US financial assets always have a global market impact, the US dollar likely has the most immediate market transmission into global asset values. This has been on display over the past several years, with the stronger USD playing a role in the collapse of oil prices, driving market angst over the weaker renminbi, and negatively impacting corporate earnings and contributing to the longest earnings recession in over a decade. We would also cite that these prior periods of market stress have often been relieved with a combination of lower yields and a weakening dollar. Therefore the recent combination of a 50 bps increase in yields and the 4% increase in the USD would have previously been a catalyst for risk aversion. Instead, we have seen markets graciously absorb higher yields and the stronger currency without much of a ripple in other asset classes. As a result, we have seen many historical correlations break down, with the USD at the center of the most extreme moves. Attached above are the biggest breakdowns in a wide ranging spreadsheet of asset pairs that we follow, and as can be seen, USD relationships have been the most affected. At the top of the list is emerging market currencies versus the S&P 500, which presently shows a 3+ STD breakdown. A graph of this asset pair is shown below, and the extreme divergence is easily seen over the past several weeks. Essentially the chart shows us the S&P's ability to ignore the weakness in emerging markets, despite the fact that over ½ of its revenues are internationally based. We see other warning signs, such as the highest SHIBOR rate since the CNY devaluation in 2015, even as there has been recent stability and slight strengthening in CNY and CNH. Of course, since we previously seen SHIBOR rates spike as the PBOC attempted to stabilize CNH, we will watch these developments closely.


As we close out the month, returns data certainly corresponds to the market moves discussed above, mainly strong stocks and challenged fixed income markets. Treasuries will report a -2.5% total return for the month, marking the fourth consecutive monthly decline for the asset class. This monthly return and a four month cumulative loss of -4.5% is the largest negative return for Treasuries since 2009. The 50 bps increase in yields over the over the past month negated any coupon payments from all bond asset classes, as negative returns were de rigueur in the debt markets. Ironically, it was not credit that posted the largest negative returns but safer municipal and EM hard currency sovereign debt. EM sovereigns posted a -4.1% monthly loss, while tax exempt municipals and their taxable brethren were both down approximately 3%.Preferred debt also posted a large 3.5% loss for the month, with the longer duration in the preferred and municipal spaces creating the most headwind for these asset classes. Ironically, high yield has been one of the strongest asset classes during the month, posting a -0.6% return, with YTD gains still approaching 15%. The 6.5% average coupon for high yield and 40 bps of tightening offset the higher and steeper Treasury yield curve. Corporates tracked the Treasury market more closely, posting a -2.6% return for the month as spreads were fairly stable over the month. Issuance has also been robust over the past few months, albeit in lumpy fashion caused by the elections. October sales were over $100 billion, and while November issuance will be closer to $80 billion; this is fairly strong given that issuance was very light during election week.


In contrast, US stocks are between 3% and 6% higher during the month, with larger industrials leading the way. While buying appeared more rotational in basis at the start of the post-election rally, it has recently become more broad based. International bourses have had more mixed results, with several reporting negative monthly returns led by the emerging markets, especially LATAM. Looking back at correlation, these results also stand in contrast given generally weaker currencies. Exceptions o these rules have been the Nikkei and Shanghai, which have been buoyed by the weakening Yen and Renminbi over the month.


There has been less focus on the prospects of a Fed rate hike, likely given that the odds of a December hike are presently set at 100%. Fed commentary has also been fairly consistent and supportive of that hike occurring as has been recent data releases. The most important data beats recently have included durable goods, Michigan sentiment, revisions to 3Q:16 GDP and today's ADP employment report. The last piece of the rate hike puzzle will come this Friday, with the release of the November employment report. Consensus presently estimates +180,000 jobs with a stable 4.9% unemployment rate. Like last month, we think the threshold for a continuing tightening of the jobs market is fairly low and find it difficult to see how one weak number will deter the Fed in December. Of more interest will be their updated economic projections and updated dots plot. We suspect that the Fed is also struggling to model the intent of the new administration into its models given the lack of concrete plans but will nonetheless need to acknowledge the rise in inflation expectations since the elections. We will just have to contend with the ECB meeting prior to the Fed meeting, with the BOE the day after at the BOJ the following week. The vote in Italy and Austria are both scheduled for this weekend, with the Italian vote the more likely of the two to generate market volatility. With the "No" camp" in the lead for the past several weeks, the market has likely priced in any surprises to arise from the vote. Unlike Brexit, Italians will not be voting for a referendum, although certain developments may facilitate such a vote in the future. Our colleagues in London have provided excellent updates on the nuances of this vote over the past few weeks/months and we will gladly forward those articles to any readers interested.



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