Friday October 14

Stocks rose marginally today even as rates sold off and the dollar strengthened. The S&P 500 rose less than 0.1% 2,132 and the Dow Jones added 0.2% to 18,138. Over the course of the week the S&P 500 was down 1.4% and the Dow was down 1%. Economic data today showed that producer prices rose more than expected, rising 0.7% from last year. Additionally retail sales came in as expected rising 0.6% from the previous month. Sentiment today was driven by comments from Janet Yellen, who attempted to talk up inflation expectations. Yellen suggested that the FOMC might let the economy “overheat” from an inflation standpoint meaning that they might overshoot their target. On this backdrop rates sold off and the yield curve bear steepened. The two year yield fell 2bp to 0.84% and the ten year yield rose 3bp to 1.80%. Over the course of the week the two year and the ten year rose 1 and 8bp respectively. On this backdrop the spread between 2s and 10s bear steepened to 0.96%. The 30 year yield today rose 8bp to 2.56% as a result of Yellen’s statement. In FX markets the US dollar rose against most peers. USD rose 0.8% against EUR to $1.0972. USD rose 0.5% against JPY to Y104.17. USD rose 0.5% against GBP to $1.2188. Oil prices pulled back slightly. WTI fell 0.2% to $50.32 and Brent fell marginally to $52.00. The market for Fed funds futures currently prices in a 66% of higher rates in December.
Banks have been pulling back from cross currency hedging, which in effect is pushing companies to issue debt in whichever currency happens to be cheapest. In theory the cost of issuing a bond in one currency should be the same as the cost of issuing a bond in another, net of hedging costs. This would prevent the arbitrage opportunity of having a funding advantage in one market versus another. However banks as a result of regulations are doing less cross currency swaps which has opened up arbitrage opportunities for issuers. In this way issuers are now able to sell debt in countries with low rates and in some cases they can achieve a funding advantage in doing so. For example since 2011 the amount of euro denominated debt issued by US companies has increased dramatically up to $60bn this year, which is a result of low rates and quantitative easing there. As a result companies have been able to issue debt at significantly lower coupons than if they were to raise rates in the US. A 10 year USD AT&T bond currently yields 3.11% while the equivalent EUR bond yields 0.98%. Taking into account the cross currency basis AT&T has a 41bp funding advantage in Europe.
International banks and investors have been putting money into the US agency MBS market given low yields in their countries. For example San-In Godo Bank in Japan has stopped purchasing JGBs and is in the process of selling a majority of its holdings of those bonds. To replace those assets it will buy nearly $1bn of agency MBS with a yield of around 2.1%. The financial industry at large in Japan has reduced JGB holdings by around 15% year to date. At the same time they have been putting their money into riskier investments such as foreign stocks and bonds in attempt to boost returns. The 10 year JGB has been negative for a significant amount of time which is putting pressure on banks who are domestic focused. MBS are attractive to banks because of the spread they offer as well as the liquidity.
Long bonds in the US were the hardest hit by Yellen’s comments today. Similarly long dated bonds in the UK have also sold off throughout the month, both a result of rising inflation expectations. Yields on 30 year Treasuries have risen 21bp this month. In Europe equivalent maturity gilts are up 25bp and bunds are up 24bp. Some analysts have called into question that this may be the start of a shift in expectations from deflationary to inflationary. Investors who have bought long duration bonds are the most exposed to a selloff if inflation does start to tick up. A fund that invests in TIPS is up 5.2% this year, and will continue to outperform if inflation expectations become more prevalent.
Bill Dudley of the New York Fed said that an interest rate hike was likely at some point before the end of the year, and indicated that subsequent hikes would happen slowly. He said that if the economy performs as expected, he believes that they will raise rates “relatively soon.” According to Dudley the main reason for the increase would be to remove some of the accomodation that is present in the economy today as opposed to slow the expansion. He thinks the economy will grow at a pace between 2 and 2.5%. Typically he is on the dovish end of the spectrum, and he is known to be close with Yellen.
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Friday October 14

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