Slip Slidin’ Away
- As we awoke from our slumber this morning, the yield of the 10-year U.S. Treasury stood at 2.196% (barely breaking through the bottom end of our 2.20% to 2.80% range). However, its time there was short-lived as better earnings from C, WFC and JNJ relieved some fears. We believe that there are sufficient global headwinds to prevent long-term rates from rising dramatically, but enough domestic growth to prevent U.S. long-term rates from falling much farther.
- If there is more downward pressure on U.S. rates, it will likely come from the Eurozone. Year-over-year Eurozone Industrial Production came in -1.9% versus a Street consensus of -0.9% and a prior revised +1.6% (down from +2.2%). German investor sentiment declined and Germany ratcheted-down growth forecasts for 2014 and 2015. We have been saying this since we began publishing Bond Squad reports in March 2012: The Eurozone, as presently constituted and structured, is untenable. It is fiscally broken and unprepared to participate in a global economy in which flexibility is essential. As such, it will probably take extraordinarily accommodative monetary policies just to keep the Eurozone economy from contracting. Even aggressive monetary policies might prove insufficient.
- Many readers make the mistake as viewing the Eurozone as a “United States of Europe.” This is not true. The Eurozone is an economic and (mainly) a currency bloc. Fiscal policies are set at the sovereign level. Thus, monetary policies which help one economy can prove disastrous for another. Member states must be on the same page for the Eurozone to work effectively. We do not see that happening anytime soon.
- This morning the financial media was filled with comments expressing surprise over how lower oil prices are not boosting investor sentiment and market valuations. We believe one reason is that lower oil prices might mean a cessation of wage growth in one of the few sectors of the economy (and regions of the Country) which has experienced meaningful wage growth. If oil prices continue to decline, there could be layoffs in the oil industry. In the past (when domestic oil production was less important to the overall economy), lower oil prices were almost totally beneficial. Lower fuel prices meant more surplus money in household budgets and job cuts in the energy industry affected only a small subset of the economy. Today; lower oil prices might mean an extra $50 or $100 disposable income in typical household budgets, but it could result in layoffs and the loss of household income in the energy sector. A lower price for oil is more of a mixed blessing than it was in the past.
- The International Energy Agency slashed its forecast for global oil consumption. At the same time producers show little desire to reduce oil output. The IEA cut its forecast for global demand growth by about 22%. The new estimate calls for a consumption increase of 700,000 barrels a day, down from a prior estimate of 900,000 barrels a day. The IEA forecasts oil consumption to increase to 1.1 million barrels a day in 2015, but also expects production to outstrip demand. Bond Squad’s view is that we are experiencing is a price/supply war. OPEC nations are almost totally reliant on oil to “fuel” their economies. The rise of alternative sources has sparked a global battle for market share. We expect oil prices to trend lower and remain fairly low for an extended period of time. This has put bond prices of energy companies under pressure. It might be a good time to take a look around the sector for opportunities.
- One of the few Fed officials who is not ridiculed by pundits is well-respected Fed Vice Chair, Stanley Fischer. Last Saturday, at the annual IMF conference, Mr. Fischer warned on global economic growth. He stated: “If foreign growth is weaker than anticipated, the consequences for the U.S. economy could lead the Fed to remove accommodation more slowly than otherwise.” Mr. Fischer’s comments roiled the markets yesterday which were already jittery on global growth concerns. Can we please consider this the last nail in the coffin of decoupling and finally bury this flawed theory?
- In the past month (or so) we have seen bonds issued by corporations in dollar sensitive sectors of the economy sell off quite dramatically. We believe that the dramatic selloff is partially due to portfolio managers receiving requests for liquidations or an attempt to manage portfolios based on short-term performance. This has resulted in potential opportunities for sophisticated and volatility-tolerant investors to pick up potential bargains via bonds issued by solid corporations which participate in beaten-down sectors of the economy. This is one way an astute investor, advisor or portfolio manager can generate returns/income in a low yield environment. As always, suitability trumps all other factors.
- For many months we have warned about reduced liquidity in the corporate bond market. We have also discussed how this can be used to our and our clients’ advantage. An article in the 10/13/14 edition of the Wall Street Journal spoke to this. The article noted: “Banks have cut the bonds they own for trading by almost 75% since 2007 to conform with new regulations, while bond funds have more than doubled in size over the same period to about $4 trillion.” Although this has made the trading of large blocks of bonds more difficult, it has leveled the playing field for smaller firms, including WS&M LLC Bond Squad. Thanks to new financial regulations and technology (such as electronic communication networks); we have the capability to sniff-out bids and offers in a way which might not have been possible in the past. Remember: It is not the size of the dog in the fight, but the size of the fight in the dog.
- Over the weekend; we had a very intelligent conversation with a subscriber regarding how fixed-to-float securities might perform in a variety of interest rate and yield curve scenarios. The conversation morphed into a general discussion of bond duration. We welcome such questions from readers. If readers believe it helpful, we could devote an entire report to the discussion of bond duration, price volatility and convexity (important when investing in callable securities). Please let us know. For now readers should understand that long-dated and perpetual Libor floaters and fixed-to-float securities tend to perform better (in terms of price) when the yield curve flattens. It should also be understood that bonds with higher coupons tend to have shorter durations and less price sensitivity to interest rates than low coupon bonds with similar maturities credit quality. The call feature on a security typically benefits the issuer rather than investors. The call price limits the rise in price during falling interest rate environments. Therefore, callable bonds and preferreds are said to be negatively convexed. If you wish to learn more, please let us know.
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- We concluded our 2014 Mid-year outlook (published 7/4/14) with the following commentary: “At the present time we are keeping some cash on the sidelines. Many areas of the market appear frothy and (as the VIX indicates) too complacent. There is no denying that central bank policy has contributed to lower volatility and a greater reach for yield by many investors. We prefer to keep some of our powder dry for better opportunities. When might that be? Corrections probably occur when the Fed becomes clearer on when and how it will tighten policy. Our advice to readers is: Enjoy the summer, take some profits in assets with prices difficult to justify by fundamentals and be ready to come out swinging in September. The last four months of the year could be interesting (or not).” Were we mostly correct? You make the call.
By Thomas Byrne – Director of Fixed Income – Investment Consultant
Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.
- November 2012 – Present, Wealth Strategies & Management LLC, Stroudsburg PA
- December 2011 – November 2012 – Bond Squad, Kunkletown, PA
- April 1988 – December 2011, Citigroup and predecessor firms, New York, NY
- June 1986 – March 1988 – E.F. Hutton, New York, NY
Director of Fixed Income
Wealth Strategies & Management LLC