BNY Mellon Weekly Fixed Income Market Commentary

February 15, 2017

Lightly Throwing Down the Gauntlet

Chairman Yellen's testimony to the Senate banking committee yesterday was in the spotlight as there remains a lack of details on the Trump administration's economic plans and economic data has lately been mostly of the mid-tier variety. That's not to say that the Administration has lost sway on the investor's psyche, as President Trump's simple mention of upcoming tax changes was enough to reverse most of the 13 bps decline in 10y yields that followed the employment report at the start of the month. We sense that the market's hawkish bent from last week was in place going into yesterday's testimony, and the Chairman's statement that "waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly" ultimately supported these concerns. Of course this statement, along with most of her other statements, were consistent with what she said the last time she spoke publically in mid-January and therefore provided little new information in our view. We suppose we can forgive the market for viewing the testimony as hawkish, given that we have been witness to almost 10 years of extreme dovishness that ultimately manifested itself in just two begrudging rate hikes over the past two years, which seemed as much about saving face as it was about tightening credit conditions. Therefore, any modicum of hawkishness can be interpreted as a large shift in Fed thinking, when it appears more as being less dovish to us.

For instance, while stating that waiting too long to hike rates may put it behind the curve, the FOMC still expects just gradual increases in the funds rate. These hikes are tied to a neutral rate that will rise "somewhat" over time but remains well below pre-crisis levels. The hawkish view has also been supported by recent Fed speak, which had Richmond Fed President Lacker stating that a March hike was compelling at almost the exact time that Yellen was set to start her testimony. Other Fed speakers today rounded out the spectrum of opinions, with Dallas Fed President Kaplan not wanting to fall behind the curve and Atlanta President Lockhart stating that he did not see a reason to rush towards a March hike. So left to our own devices, we still think that inflation has not made a compelling case to rush a hike in March. There were enough questions posed by the January employment report, which unless immediately reversed in the next non-farm report on March 8th, continue to make a March hike an unlikely event in our view. If the FOMC were to pass on March, May 3rd and June 14th are the remaining meetings in 1H:17, which we do believe will include a single hike. Conventional wisdom would argue for June, which will have a scheduled presser, although this would make for a busy second half of the year for the FOMC if it maintains its call for three hikes this year. From this perspective, we are starting to lean towards a May hike, which would break the need to use a press conference meeting to announce policy changes, while providing additional flexibility if it chose to raise rates an additional two to three times after that meeting. Futures presently put the odds of a March hike at 34%, May at 53%and June at 74%, each up approximately 4% versus before yesterday's testimony.

There has been growing discussion regarding the fate of the Fed's portfolio, with a procession of Fed speakers since the start of the year mentioning a reduction in its $4.2 trillion in SOMA holdings. Prior to yesterday's testimony, St. Louis President Bullard last mentioned reducing the balance sheet less than a week ago, advocating for a more natural rise in rates across the yield curve during the current tightening cycle. We interpret this to mean allowing the yield curve to steepen, versus the likely flattening that would emerge if the Fed needed to more aggressively hike the funds rate while maintaining a large balance sheet that would limit the ability for longer rates to increase. Chairman Yellen however appeared to quash these thoughts with statements that indicated she would rather wait until the economy was on a solid course and seeing the funds rate reach levels that could support any weakness created by shrinking the portfolio. In any event, she stated that the FOMC would begin discussing options around reinvestment strategy in the next few meetings. This would seem to make 2017 an unlikely year in which we would start to see balance sheet reduction . However, the Trump administration will have the opportunity to appoint several new members to the board of governors, and a discussion on balance sheet reduction as a way of reducing government involvement in markets is not overly far-fetched. The attached chart shows that there is a spike in treasury maturities in 2018, which provides an easy entry point to change the reinvestment policy if this is considered the least disruptive approach for the market. We view three basic options for shrinking the portfolio, a halt to reinvestments, investing only a proportion of maturing proceeds, and outright liquidation of the portfolio. Operation Twist pushed out maturities, so the treasury portfolio is comprised of only notes and bonds. We are therefore wary of a steepening of the curve by year-end possibly driven by changes in the portfolio even if the market's base case of only two rate hikes comes to fruition. There has also been a shortening of duration in the Fed's treasury portfolio since QE3 purchases were tapered, which if combined with more term debt from Treasury could also lead to a steeper curve.

The Senate Banking Committee pressed the Chairman on possible fiscal policies, but like us, she was short answers because we are short details. Our final comments on the Senate part of the congressional testimony were questions on changes to the composition of the FOMC. Yellen did say she would finish her term as Chairman, which is set to expire in February, 2018 unless she is reappointed. There are two existing vacancies on the Fed board, which the Administration has stated it will try and fill quickly. Additionally, Daniel Tarullo just announced that he would leave the Fed in April as it became clearer that President Trump would use one of the two vacancies to appoint a financial regulator at the Fed, a role that Tarullo has held unofficially . The Administration will therefore be able to fill three of the seven board seats in short order. If Yellen were not to be reappointed, which we think is certainly possible, and she chose to leave the board (she could stay as a non-chairman governor until 2024) there would be another open Fed seat. The same scenario exists for Vice Chair Fischer, whose role expires in June, 2018, although he too can stay on as a governor through 2020. This increases the potential for five new appointees at the board level in the next 18 months. Additionally Fed President's Lockart and Lacker are retiring this year (Lockhart in February and Lacker in October). The Fed may therefore be a very different organization in the coming year, bringing with it additional uncertainty until all new members are identified, their priorities understood and voting records analyzed.

The moves in the market since Yellen's testimony followed the hawkish story with yields marginally higher and the USD stronger. Equities remain decoupled from this commentary, however, continuing to trade higher despite the higher rate hike odds and implied gains in inflation. We have commented on the divergence between equity and fixed income volatility measures (Move vs VIX) in the past, and while the spread between the two has not widened, there have also been no signs of convergence. While we have had bouts of volatility in individual asset classes, we have been decidedly range bound since the start of the year, with equities once again proving the exception to this observation. Treasury yields are between flat to 5 bps higher, with just a slight flattening bias, while the USD (DXY variety) is off by just 0.7% after trading almost 3% during the first five weeks of the year. Bund yields have trended lower over the past week, although we suspect this is more flight to quality moves idiosyncratic to the EU as Italy and France have lagged based on perceived risk from their election processes.

As mentioned equities continue to trader higher as volatility remains near all-time lows. Volatility also remains low in credit, with investment grade spreads remaining in a tight range near low levels last seen late in 2014. An example of the low volatility exhibited in IG land has been the essentially unchanged spreads in the aggregate index and most broad industry groups since the start of the year. From a ratings perspective, there has been some spread widening in the triple-A category, for which the triple-B space has compensated, while the remaining ratings categories are also unchanged. Given that issuance has outpaced last year by almost $100 billion, it's safe to say that demand for corporates remains strong. Yields in high yield are also at lows last seen in 2014, although they too have been mostly stable since the start of the year, somewhat decoupling from equity strength. Moves by duration have been consistent with the aggregate, while triple-C's have seen yield compression towards 9%, while the remaining ratings categories have been mostly stable.

We are at the waning stages of the earnings reporting period, with almost 80% of the S&P companies having reported. According to Bloomberg, 80% of companies have beat expectations, versus 20% missing, near longer term averages. Y/Y EPS growth is running in the 5% range, versus 3% at the start of earnings season, which we grade as a B+ effort given lower negative revisions coming into the start of earnings season. Positive momentum is expected to continue, with 10% EPS growth expected for the next several quarters, while valuations remain elevated with a P/E of 17.3x forward expectations. Earnings will therefore be limited in the coming week, as will economic releases, with the February minutes the most watched, although the impact may be limited after this week's congressional testimony. Data continues to mostly exceed expectations, as the surprise index remains near multi-year highs. Particular attention will be placed on inflation given the importance that Chairman Yellen has placed on it over the past few days. This is especially true as a March rate hike begins to again creep into investor psych, although we continue to believe it remains a distant possibility. Recent CPI and PPI readings are likely to only fuel these concerns, with m/m readings of the former hitting levels last seen in 2013, while PPI posted its strongest figure since 2012. Y/Y results along with core readings have been closer to recent trends, which continue to tick higher, although not at alarming levels. We get a few looks at the housing market over the next week along with the first look at the consumer in February via the University of Michigan survey. On a programming note, we will not be writing out weekly commentary next week but will return at the start of March.

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