In this month's LDI market commentary:
• August’s Treasury market rally
• Credit outlook for metals and mining companies
Bond Market Activity — Treasury Market Rally
Yields fell unrelentingly in August. Geopolitical uncertainty stemming from North Korea, coupled with news of moderate inflation, provided the backdrop for a continuous rally in Treasury rates. With no hawkish statements coming from Jackson Hole, there was nothing to create fear of aggressive efforts to remove QE in the U.S. or Europe. Stronger economic reports also did not halt the rally. Equities bounced around at record levels but did not break through to new highs. Oil was also flat, but picked up a bit at month end with the dreadful impact of Hurricane Harvey.
Ten-year Treasury yields fell 17 basis points to 2.12%, as did 30-year Treasuries to 2.73%. Investment-grade credit spreads widened 7 bps with widespread weakness most visible in communications, pharmaceuticals and energy.
New issuance was above expectations at $95 billion as Amazon and BAT came with very large $16 billion and $17 billion deals. Expectations are for a big September at $100 billion to $115 billion. Year-to-date issuance is up 2% from 2016.
Sector Outlook — Metals and Mining
Over the past 12 months, the profitability of metals and mining companies improved due to increasing commodity prices, operating cost efficiencies and reduced capital expenditures. Commodity price gains were underpinned by Chinese government stimulus in infrastructure and robust housing demand, both of which are commodity-intensive sectors of the economy. In response to strong earnings and cash flow, metals and mining companies deleveraged their balance sheets further and most re-initiated dividend payments to shareholders. The supportive commodity price environment and proactive improvement of credit profiles drove credit spreads lower.
Mining company bond valuations did undergo a period of weakness in March and April 2017 as the Chinese government began to tighten stimulus policies, causing market participants to worry that commodity demand would weaken. However, over the summer, underlying commodity demand in China has proved resilient and when coupled with a weakening U.S. dollar, commodity prices have rebounded, particularly base metals. Mining company bond valuations have, in turn, retraced. Metals and mining companies, and associated investments, will continue to be heavily impacted by changes in the Chinese economy. We continue to monitor events there closely, particularly as the 19th Party Congress approaches, which will set the tone for Xi Jinping’s next term in office.
Structural Issues — Implications of QE Withdrawal for LDI Investors
At its September meeting, the FOMC is widely expected to confirm its plans to reverse quantitative easing, or QE. As the Fed allows its balance sheet to run down gradually, it would be logical to expect Treasury yields to rise and the yield curve to steepen. The reality may be more complex.
The Fed and other central banks resorted to QE to stabilize financial markets and counter headwinds to growth. So while there is a strong desire to exit these unconventional policies, they will not withdraw in a way that puts financial stability or economic growth at risk. In particular, they would respond to any adverse reaction by sending dovish policy signals and, if necessary, slowing the unwinding process.
Two other factors may contain any rise in Treasury yields. First, large scale QE continues in the rest of the world, as the ECB and especially the Bank of Japan continue to purchase assets, putting downward pressure on global yields.
Quantitative Easing, Quantitative Tightening
Second, under Basel II liquidity coverage ratio rules, banks must maintain minimum holdings of high quality liquid assets. Both excess reserves held at the Fed, and Treasuries and other very high quality bonds, count as HQLA. As QE unwinds and excess reserve balances decline, banks may buy Treasuries to replace them.
An additional complication for plan sponsors using swaps to manage their hedge ratios is that swap rates may decouple from cash bond yields. This could introduce risks to the plan, since liability discount rates are determined by the latter. Long tenor swap spreads have already widened substantially since November, and if normalized monetary policy leads to a full normalization in swap spreads, 30-year swap hedges may substantially underperform cash bonds.
(Portfolio managers Andy Barth and David Lee, along with analyst Mital Kotecha, contributed to this report.)
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