February 15, 2017

What follows is a synopsis of 3D’s Advisor Success Series, “Trump versus Bonds,” focusing on discussion points surrounding current issues facing fixed income investors.  A recording of the webcast can be found here.  On February 14, I had the pleasure of serving as moderator on a panel with two fixed income ETF specialists (Paul McGinn from First Trust and James Meyers from Powershares) discussing the challenges facing fixed income investors following the steep 4th Quarter 2016 sell-off of interest-rate sensitive assets. 

1.    How much of the 4Q2016 can be viewed as fundamentally-driven given the shifts in the political and monetary landscapes as opposed to an overreaction to perceived outcomes?

    • Prior to the November election, the bond market was pricing in deflationary protection consistent with the pattern we’ve seen with the “New Normal” environment that has characterized the global macro landscape since the 2008 Great Recession.  Bond markets are now in a wait-and-see mode with the benchmark 10-Year Treasury Yield fluctuating between 2.4 to 2.6%. 
    • Market pricing reflects a diversity of opinion over the outlook on the growth and inflation implications of proposed Trump administration policies.  Those espousing a cyclical reflationary outlook liken the U.S. economy as one transitioning from a plough horse economy to a racehorse economy given the strong readings in employment, wage growth, and consumer spending. 
    • The panelists also note that the U.S. Treasury term structure embodies two sets of expectations as reflected in different parts of the term structure.  The intermediate part of the curve (2- to 7-years), or the belly, has priced in a reflationary cycle and Federal Reserve rate tightening while the longer end (10- to 30-years) has flattened following the November sell-off.  The belly is also biased higher due to pressures on short-term financing stemming from the money market reforms imposed late last year. 
    • There are different interpretations as to what is driving the flattening on the long end.  One panelist opined that there is inherent demand for safe long-duration assets by financial entities with long-tailed liabilities such as insurance companies and pension plans.  However, the other panelist pointed out that foreign investors, who hold 43% of outstanding US debt), turned into net sellers from net buyers, resulting in $200 billion of net selling in 2016.  The two largest foreign debt holders, China and Japan, were notable net sellers, although China had been drawing down its foreign exchange reserves to support its currency.  A flattening of the long-end would also indicate that New Normal conditions of secular disinflation would prevail following the lapse of the current reflationary cycle. 
    • Panelists generally see a flatter yield curve by year-end.

2.    Does the Fed Funds Futures Market risk falling ‘behind the curve’ when pricing in expected rate hikes for the next year versus what has been implied by Federal Reserve communications?

    • Both panelists acknowledged the increasingly complex environment from which the Fed is expected to produce monetary policy given their mandate to achieve full employment with benign inflation.  In effect, the Fed has become the global central bank, as it cannot set policy in a domestic vacuum but rather must also be cognizant of the global macro environment.  Hence, the Fed, in its longer-term desire to normalize policy from the emergency measures enacted following the 2008 recession, will set a rate hike course that will remain largely data-driven while also having to navigate around ‘global macro tape-bombs.’ As long as core inflation remains relatively low (although it has crept up more recently), the Fed can afford to let the ‘data’ drive its pace of rate hikes. 
    • Even though Janet Yellen, in her Congressional testimony on Tuesday, put a March rate hike back on the table, panelists believe that the Fed is acting to anchor market expectations around a range of outcomes, namely two to four rate hikes this year. 
    • One panelist opined the Fed runs the risk of falling behind the inflation curve based on the Taylor rule which implies a 4% Fed Funds rate based on current U.S. economic conditions, although much of the rule depends on a proper assessment of the difference between current real economic output versus potential output. 
    • June appears to be the likely month for another rate hike, but questions still remain as to whether the Fed will raise rates two or three more times in the second half of the year. 

3.    Where are the main risks within fixed income should the Fed enact a more aggressive rate hike schedule than what is expected by the markets?

    • Both panelists acknowledged that core, intermediate-term fixed income, as embodied by the Bloomberg Barclays Aggregate Bond Index, is at higher risk in a more aggressive rate hike scenario.  70% of the index consists of U.S. government debt and mortgage-backed securities; sectors that are most highly price-sensitive to rising interest rates. 
    • Investors concerned about a more aggressive Fed should look to more credit-sensitive securities such as senior loans and corporate debt.  Investors may also want to bring down the duration of their fixed income portfolio. 

4.    Municipal bonds were hit especially hard over concerns about their reduced appeal to tax-sensitive investors in light of proposed changes to tax policies floated by the Trump administration and Congress.  What are your views concerning the relative appeal of municipal bonds versus taxable equivalents (i.e. US Treasuries) in light of these proposals?

    • Tax reform proposals can be broken down into three categories: personal, corporate, and changes to tax treatment. 
    • Both panelists assigned a low probability that the tax-exempt status enjoyed by states and local municipalities will be reduced or removed.  State and local financing is highly reliant upon the tax-exempt status which helps keep down borrowing costs. 
    • Both panelists assigned higher probabilities to personal and corporate tax reform that will likely result in a reduction and simplification of tax rates. 
    • However, even if the top personal rates were to drop, this would not likely result in a significant decline in municipal bond demand.  Most of the personal muni bond investors reside in the 25-30% effective tax rate band, so demand should remain robust even if the top rates were to come down. 
    • The panelists were split on how much a reduction in corporate tax rates would impact muni bond demand.  Banks and insurers comprise the majority of corporate demand for muni bonds (estimated at 24% of the $4 trillion market). 
    • Both panelists agreed that relative to U.S. Treasuries, top-rated municipal bonds are priced at relatively attractive levels.  Exhibit 1 charts the AAA-rated municipal bond yield curve versus active U.S. Treasuries along with the tax-equivalent yield of municipal bonds using a 30% tax rate.  The 30-year municipal yield is 4-5% above the 30-year Treasury yield while the tax equivalent yield is nearly 50% above.

Exhibit 1 – Municipal Bond Yields Are Attractive Versus U.S. Treasuries


5.    Why do ETFs make more sense for getting exposure to fixed income markets as opposed to open-ended mutual funds? 

    • Secondary market liquidity in fixed income (which mostly trades over-the-counter as opposed to on exchanges) has become increasingly challenged as the broker/dealer community shrinks its inventory in the face of greater institutional demand.  ETFs help remove some of the ‘transactional’ risk in executing bond trades by entrusting the ETF manager to source fixed income securities on the investor’s behalf.  Using the share creation/redemption mechanism, ETF managers have many more tools at their disposal to conduct transactions such that a majority of trading occurs at the ETF share level rather than just through the underlying fixed income securities.  One study suggests that $1 in ETF share trades results in $0.20-0.30 trading of the underlying securities as opposed to the $1:$1 ratio for open-ended mutual funds.
    • ETFs enjoy more transparency and relatively lower fee structures than mutual funds.  ETFs have more policy tools at their disposal to meet redemptions, whereas mutual funds, faced with redemptions, must raise cash.  ETF trading activity also brings intraday price discovery to the underlying securities as opposed to close-of-day prices used to calculate mutual fund net asset values. 

6.    What does the inflation landscape look like for overseas markets and what threats do they pose to U.S. investors?

    • Both panelists expressed sanguine outlooks on overseas inflationary trends.  Japan and Europe are largely in catch-up mode and continue to lag the U.S. in growth recovery. 
    • Both panelists were also not concerned on rising inflationary pressures in China (Exhibits 2 and 3).  Year-over-year CPI is running at 2.5% while PPI is running at 6.9%.
    • I would add this post-mortem note to the synopsis.  Rich Farr, Chief Strategist at Merrion Capital, published a recent piece expressing concerns over how rising inflation could serve as the tipping point for unwinding China’s massive financial leverage as reflected in its property values and lending, just as $100 oil served as the breaking point for the U.S. housing market in 2008.  Higher living expenses eat into the ability to service debt which, at precariously high levels, can be sensitive to changes at the margin.  Higher inflation in China could serve as one of 2017’s black swan events.

Exhibit 2 and 3: Rising CPI and PPI in the U.S. and China

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