Monday April 11

Stocks fall to erase modest gains made earlier in the session. The S&P 500 fell 0.3% to 2,041 and the Dow Jones lost 0.1% to 17,556. These slight losses came in spite of an increase in oil prices, which drive stock prices higher in the beginning of the day. WTI rose 1.61% to $40.36 and Brent rose nearly 2% to $42.77 as both grades of oil are now above the $40 threshold, near recent highs. THese gains have been made after investors have renewed optimism that Opec will come to an agreement to either cut or freeze production. As earnings season kicks off today, investors have weak expectations. Earnings from companies in the S&P 500 are expected to have fallen more than 8% from the previous year with energy names leading the way. The 10 year US yield rose one basis point today to 1.72% and the 2 year yield was unchanged at 0.70%. Gold prices rose as the dollar index fell back to a 7 month low. The Japanese yen rose 0.1% to Y107.97, and the pace of the yen’s appreciation has concerned investors who view the yen as a risk off indicator. The VIX rose, and an index of bank share prices rose as well ahead of earnings releases from JP Morgan and Bank of America later this week.

After years of extensive monetary easing and low interest rates, investors are now expecting inflationary pressures to return. The Fed pumped liquidity into the system through its QE programs and low interest rates have been present since the financial crisis, however no inflation has yet materialized. Investor expectations over the future inflation outlook are shifting as TIPS bonds have returned 4.57% this year. Investors shift into TIPS bonds when they expect inflation to pick up since inflation erodes the returns of normal Treasury bonds. This rebound in inflation expectations has coincided with higher oil prices, a weakening US dollar, and signs of pressure on core inflation measures. As a result some investors believe that headline inflation will follow suit shortly, which justifies the recent rally in TIPS. The five year breakeven rate has risen 50 basis points since February and now stands at 1.45%. TIPS funds have received $2.3bn in inflows over recent weeks, which is a spike from recent history.

The extensive size of the BoJ’s quantitative easing program is reflected through the central bank’s presence in the country’s government bond market. Over the last three years the BoJ has purchased an increasing number of government bonds each year. At the same time, the amount of total Japanese government bonds outstanding has risen only slightly. As a result the share of total government bonds outstanding owned by the central bank has risen, and at this rate it will own 50% of the market in two years time. This has made Japanese government bonds much less liquid, which is reflected through wider bid/ask spreads. For the forty year bond bid/ask spread has widened from 0.35% last year to nearly 0.55% now (as a % of bid price). For the ten year bond this increase has been less dramatic reflecting higher liquidity than the forty year bond. Similarly the turnover ratio (volume of transactions/ total size of the market) has been falling over the last few years to 2% now compared to 7% in 2012.

The prevention of corporate M&A has adverse ramifications for bond market investors. Over the last few years the US government has been very restrictive over corporate M&A. Just last week a law cracking down on corporate inversions shut down the Pfizer and Allergan deal. Similarly the government is seeking to prevent Halliburton’s takeover of Baker Hughes on antitrust grounds. Deals such as these are popular with bond investors since they are usually financed through debt. A total of $376bn worth of M&A transactions have been taken off the table this year. Investors have had solid demand for these types of deals, and the withdrawal of deals reduces the supply of M&A bonds available. Deals have been oversubscribed and yields have priced lower than expected as investors seek quality, investment grade issuances.

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Monday April 11

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