Thursday May 5

US stocks fail to sustain gains even in spite of rising oil prices. The S&P 500 fell marginally to 2,050 and the Dow Jones rose barely to 17,660. Stocks rose to start the day however they eased later in the session as a cautious tone returned. The US dollar also resumed a rally in spite of expectations that tomorrow’s data will come in weaker than expected. The dollar rose to $1.1405 against the euro and Y107.26 against the Japanese yen. As a result the dollar index rose 0.6%. However Treasury yields reflected different expectations regarding the trajectory of interest rates. The two year yield fell 2 basis points to 0.72% and the ten year yield fell 3 basis points to 1.74%. WTI oil rose 0.5% to $44.55 after rallying higher early in the day. Brent crude oil rose 1.3% to $45.22. Financial shares fell as investors expect the Fed will hold off further on raising interest rates.

The ECB’s QE program will push more US companies to issue debt in the eurozone. This could decrease the amount of bonds that are issued in the US. This decrease in supply should increase the prices of any new issues as well as outstanding bonds. The QE program has pushed down corporate yields considerably and companies are seeking to issue euro denominated debt through a eurozone subsidiary to capitalize on such low borrowing costs. The average yield on the Barclays European corporate bond index has fallen from around 1.5% at the start of the year to just higher than 1.0% now. Starting in June the ECB will purchase e5bn in corporate bonds each month. Last year US companies accounted for 22% of corporate bond issuance in the Eurozone, which was the highest total of any country. This year that number is set to increase. McDonald’s recently issued e2bn in debt. The ten year tenor of that issuance priced at a yield of 0.75%, which is quite lower than the 3.7% it pays on its 10 year US debt.

Low yields around the world are likely to keep yields in the US low. The consensus estimate for the 10 year Treasury yield at the end of 2016 was 2.8% at the start of the year. That has since fallen to 2.15%. Given that yields are currently around 1.75% even 2.15% seems optimistic. Even if the Fed chooses to raise interest rates once or twice this year, record low and negative yields elsewhere in the world will keep a cap on yields in the US. The yields 85% of outstanding global government bonds are lower than yields on the ten year US Treasury, and for the thirty year US Treasury that total is 99.7% according to JP Morgan. As international investors look for yield those factors will suppress US yields. A decrease in net issuance from the Treasury will also decrease supply and put upward pressure on prices. Unless inflation returns in a definitive and convincing way, yields are likely to stay in the current range.

Emerging market bonds have faded somewhat after a strong first quarter. Growth is slowing, deficits are increasing, credit ratings are sliding, however investor demand is still high. This is a dangerous combination for both investors and EM borrowers. Countries and companies may be able to access funding and increase their indebtedness even as revenues and ability to pay those debts decrease. Investors have no choice but to increase risk tolerance, however they are subject to higher losses due to the riskiness of the situation. Pimco has called attention to the “three C’s” that are factors in emerging markets. These include central banks, commodities and China. The main concern relating to central banks is an imminent rate hike in the US that could potentially lead to capital outflows from EM. Commodity prices and demand from China are low putting strain on many EM finances. While the US appears to be taking the slow route to tightening, commodity prices have stabilized. Even though by some metrics risk is increasing, according to the three Cs risks are stabilizing. However monthly inflows have fallen over the last few months and yields seem to have hit a peak. This suggests that the rally EM may have reached the peak.

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Thursday May 5

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