We had yet another commute with snow, and, while we badly want to leave the frigid memories of this winter behind us, we are reminded of this movie quote: “Just when I thought I was out, they pull me back in” (The Godfather: Part III). This also draws us back to the broad market expectations at the start of the year before the term “polar vortex” became part of popular lexicon. What strikes us is just how wrong most of us were in expecting that we were finally going to get higher rates via stronger economic activity and less active central banks. While we begrudgingly accepted that view, we nonetheless had found ourselves as part of this herd. Instead, we now find the yield on the 10-year and 30-year, 40 and 50 bps lower than where we started the year. This has done nothing to dampen demand for spread product, with corporate and high yield at six-plus year lows (pre-crisis), despite the faltering equity market. Rates have been driven to these levels through a combination of shifting opinions on Fed policy, mixed economic messages and various flight to quality catalysts, both financial and geopolitical. Along the way, we have witnessed changing relationships between various asset pairs that provide us with concerns that that market is not simply changing its asset allocation strategy. We will review some of the more interesting market moves that we are watching and delve into any deeper meaning that these movements may imply.
Despite rates doing the exact opposite of consensus expectations at the start of the year, we have effectively remained range bound since February on the 10-year, with 2.6% representing the lower boundary and 2.8%-2.85% the upper edge of the range. In contrast, the 30-year has had no such limitation, trading down in yield to levels not seen since last summer while we were in the midst of the taper tantrum. The curve has subsequently flattened with the belly versus long end (five-year vs 30-year) also moving back to last summer’s levels. The strong buying of the Bond has been one of the movements that has surprised us the most, leaving us scratching our head as to who wants 3.45% for the next 30-years. This buying (and curve flattening) is possibly explained by insurance and pension plans needing to add duration after last year’s strong equity rally left fixed income under-represented. There has also been chatter on the mystery buyer in Belgium, which has elevated the small country to the third largest holder of treasury securities. To be clear, the buying occurred in Belgium and, therefore, is reported as Belgium, and is not the country itself adding massive amounts of govies to its currency reserves. Other discussions have centered on changes to the terminal value of Fed funds, which would presumably justify owning a historically low yielding long bond as the entire term structure of the government would shift downward. What is clear to us is that these rates are only justifiable if rate hike expectations have been drastically moved into the far distant future and that inflation is taking a permanent hiatus rather than just a temporary leave of absence. While we are of the camp that inflation will take longer to re-appear than many investors expect, we cannot yet accept that it will never re-appear. Additionally, while the winter has impacted data and earnings, we have been generally encouraged by relatively stable economic results since winter’s grip started to wane. We therefore would favor rates returning to the upper end of recent ranges, with a re-steepening of the curve on continued positive economic data points.
The recent moves in asset values have also stretched various relationships to statistically significant levels. We know that the selling in equities has been centered in a few momentum-oriented sectors, and the recent correlation between the NASDAQ and S&P 500 indices has decoupled and is now a +3 standard deviations (STD) event from its mean. High yield is historically strongly correlated with stocks, but recently has been resilient in the face of weaker stocks, with the weaker correlation also a three STD event. Since we talked about the curve above, we will point out that stocks versus the 2-year/30-year spread is presently 1.7 STDs from the mean of the last two years. Other significant relationships that we are watching include AUD to gold, BRL to copper and the euro to various European bourses.
The market wrap for the past week has been a generally stronger treasury market and little to no movement in spreads. Treasury yields out to five years are flat to a few bps higher, while seven-years through 30-years are up to nine bps lower. The curve has subsequently flattened by up to 10 bps from a two-year vs 30-year and five-year vs 30-year perspective. Even 10-years/30-years found themselves five bps flatter on the week, given the strong moves in the long bond. Interestingly, breakevens imply slightly higher inflation expectations, although one-year to five-year breakevens are tightly clustered around 1.85%, indicating a very stable and low inflation outlook. Credit has been stable in light of equity weakness, with spreads largely unchanged on the week. The IG index stands at +106 bps, while high yield has an average yield of 5.06% and an average spread of +387. The continued dearth of new issuance remains highly supportive of these levels, and is unlikely to increase notably until earnings blackouts are lifted in the next few weeks.
Earnings season is just starting, so there is not too much that we can infer from reports to date. Having said that, we are 6% through the S&P 500 companies, with 55% of companies beating and 29% missing estimates. That compares to 66%/22% beat/miss ratio for 4Q:13 and 70%/20% longer term average. So, so far we are trailing and generally disappointing, although we would say that the last few earnings seasons have started slow but caught up during the last two big weeks. Again, it is too early to make any calls on trends, but we are presently expecting a -1.6% decline in EPS for the quarter, which would mark the first negative quarter since 3Q:12 if accurate. Since we started the year expecting a 4% year-over-year gain for 1Q:14, expectations have gone the way of temperatures in a polar vortex, namely way down. Earnings pre-announcements have also had a large negative tone, with a 5:1 negative/positive ratio or 80% of pre-announcements were negative. Historical context puts the average at 65%. There are a few remaining significant issuers this week, including Intel, IBM, GOOG, MS and GS, and we get into the heart of earnings next week, with technology and consumer firms on tap.