Thursday November 5

Stocks fall leading up to tomorrow’s non-farm payrolls report. The S&P500 fell 0.1% to 2,099 while the Dow Jones lost 0.02% to 17,863. Equities have traded slightly downwards over the past two days as investors begin to expect that the Fed will raise interest rates in December, and are cautiously positioning themselves ahead of important data tomorrow. In the UK the Bank of England came across as unusually dovish and left interest rates unchanged. The BoE along with the Fed who are on course to raise interest rates in the near future. The BoE went so far as to say that a rate rise won’t be necessary to control inflation until the spring of 2017. This announcement out of the UK sent down yields and the British pound The pound fell 1.1% against the dollar to $1.5214 and 1.3% against the euro. The announcement puts the initial rate rise out of the time frame for the first quarter of 2016. This continues the trend of monetary policy divergence that has come back into play over the past month. In general the dollar rose 0.1% today against peers with the dollar index closing at 98.01. The euro finished at $1.0975. The US two year yield was flat on the day at 0.84% and the ten year yield rose to 2.25% as spreads between comparable German bunds widen to notable highs.

Spreads between German and US bonds are increasing to the widest levels since 2006. The yield between the two year US Treasury and German counterpart is now as large as 117 basis points with the two year yield touching as high as 0.85% today. As the Federal Reserve comes closer to raising interest rates in December this is an upward pressure on US short term yields. In contrast in Europe expected monetary easing out from the ECB will put downward pressure on European yields. This story is also reflected in currency markets where the euro has fallen from $1.15 to $1.09 over the past month when the two year spread was only 80 basis points.
Up until today the Bank of England had been communicating forward guidance very similar to the Fed, expecting to raise interest rates in the near future with the expectation that interest rates would rise. This expectation had supported the pound year to date against the US dollar. However today the Bank of England revised its inflation outlook and now that inflation will not reach its target until 2017. This revised outlook sent the pound down more than 1% against the US dollar. The emerging market slowdown and the expectation that international growth rates will slow over the next year are the two main factors that the BoE expects to weigh on inflation. Low interest rates will continue to promote household and corporate spending which will hopefully bring inflation to the 2% target a little later than expected. The BoE said that it will not start to unwind its balance sheet until the benchmark rate had been raised to 2%.
The municipal bond market has proved resilient this year in spite of broader fixed income weakness. According to Barclays munis have returned 2% this year so far, on top of a 9% total return in 2014. By comparison Treasuries have returned around 1% and investment grade bonds are roughly flat. So far year to date muni mutual funds have experienced $2bn in inflows. Typically municipal debt performs well relative to other sectors in rising rate environments as the finances of states and cities tend to improve along with the general US economy.
One threat to the muni bond index performance is Puerto Rico, which is facing a $72bn dollar debt burden and a small likelihood of paying it back entirely. Prepa (Puerto Rico Electric Power Authority) today reached a deal with creditors to restructure its $8.2bn debt pile. Creditors accepted an effective 15% haircut and have the option exchange existing bonds for new bonds that carry an investment grade rating. The two options are to swap bonds for new bonds that pay 4-4.75% interest with no principal for five years. Another option is to exchange for bonds that accrue interest of 4.5-5.5% but do not make payments for five years. The White House has proposed that Puerto Rico receive access to bankruptcy courts and a financial control board to help restore fiscal stability.
Thursday November 5

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