Wednesday June 14

Markets were mixed today after the FOMC moved ahead with its interest rate hike in spite of lackluster data. The S&P 500 fell 0.1% to 2,437 while the Dow Jones rose 0.2% to 21,374. The KBW Bank index rose 0.1% while utilities added 0.8%. Economic data today showed that headline CPI missed expectations by 0.1% and by falling 0.1% on the month and advancing on the year 1.9%. Core CPI was 1.7% on a yearly basis compared to estimates which called for a 1.9% increase. Additionally data showed that headline retail sales fell 0.3% on the month compared to estimates which called for a 0.1% gain. Retail sales excluding autos fell 0.3% on the month compares to estimates for a 0.2% gain. That data sent rates rallying in the morning, and they increased slightly after the FOMC elected to raise interest rates. The Fed raised the Fed funds rate by 25bp, and maintains on course to hike rates one more time in 2017 before unwinding the balance sheet at the end of the year. The Fed is sticking to its guns that weak inflation is temporary and eventually the tight labor market will have an upward effect on inflation. The Fed’s statement sent the dollar higher since that is more effected by short term rates. Another bearish report for oil showed that crude oil inventories fell 1.7 million barrels last week which was less of a drawdown than expected while gasoline inventories increased by 2.1 million barrels. The 2 year Treasury yield fell 3bp to 1.34%. The 10 year Treasury yield fell 8bp to 2.13%. Accordingly 2yr vs 10yr bull flattened to 0.78%. The dollar was stronger on the day against peers given the Fed’s move. USD rose 0.4% against EUR to $1.1218. USD rose 0.3% against JPY to Y109.60. USD rose 0.2% against GBP to $1.12753. Oil prices had a tough day after the EIA report. WTI fell 3.7% to $44.73. Brent fell 3.5% to $47.02.

As expected the FOMC raised interest rates today to 1-1.25%. The decision to raise interest rates was supported by everyone except Neel Kashkari who dissented from voting. This decision comes even as rates rallied today following weak inflation numbers. Janet Yellen and the rest of the FOMC are of the belief that weak inflation numbers are transitory and due to one off factors such as one time drops in prices of pharmaceuticals and wireless plans. The Fed did lower its core inflation forecast to 1.7% this year but left forecasts for the next two years unchanged. The Fed said that growth was set to pick up in the second quarter compared to the first, and that it still plans to raise interest rates again once in 2017. Also important to note is that the FOMC dropped its statement saying that it was monitoring global developments which suggests the FOMC is eying less risk of a global economic downturn effecting the US recovery. The Fed also outlined its plans to unwind the balance sheet at the end of this year. It will reduce reinvestments of Treasuries and agency MBS in an orderly way. It will establish caps by which it will stop reinvestments in Treasuries in MBS. The caps will gradually increase every three months until reaching $30bn a month for Treasuries and $20bn a month for agency MBS. The Fed did not specify a terminal size of the balance sheet and said that it would learn about the optimal demand for reserves as it unwinds its balance sheet. The Fed did also state that it would leave flexibility to continue reinvestments if the economy materially took a turn for the worst.

The market for leveraged loans is indicative of the high demand for yield in markets right now, and it seems to have become almost too popular of an investment choice. Both the yields on leveraged loans as well as changes in covenant protections are indicative of this trend. Since the start of 2016 spreads on leveraged loans in the US and in Europe have tightened 211bp and 154bp respectively. US leveraged loans now yield 5% and European leveraged loans now yield 4% which is a record low. At the same time covenant protections have deteriorated and the percentage of cov-lite loans has increased dramatically in both markets. In 2006 the percentage of loans that were covenant lite in the US and Europe was just 8.5% and 1.5% respectively. That gave investors more control over the company in the event of deterioration in earnings or certain specified credit metrics. However so far in 2017 the percentage of loans that are covenant lite has increased dramatically to 70% and 73% in the US and Europe respectively. That means that protections for investors have decreased significantly at the same time yields have gone lower as well. The reason for this is high demand for leveraged loans that has turned it to a more issuer friendly market. After two years of outflows retail investors have put money back towards leveraged loans this year. At the same time loans are in favor with institutional investors as well. That is because they offer attractive yields as well as protection from changes in interest rates since most loans float at LIBOR. Data from Preqin shows that dry powder in institutional funds around the world waiting to be invested in loans has increased from around $75bn in 2006 to $200bn currently. Considering that those funds can amplify their capital the amount of pent up demand for leveraged loans is very significant and it seems that barring a serious downturn yields and protections will continue to decrease over time.

The amount of bonds the BoJ is purchasing each month has decreased even as the central bank maintains its aggressive easing policies. This could highlight a benefit of the BoJ’s approach to QE compared to other central banks. Normally central banks specify a certain number of bonds they will buy each month and stick to that target pretty closely. However instead of targeting a specific number of bonds to buy and letting market yields adjust accordingly, the BoJ specified a desired yield level on the 10 year JGB and is adjusting the amount of bonds it buys to meet that goal. The BoJ’s monthly purchases of JGB’s have decreased to Y7.9tn which amounts to around $72bn. While that is still an enormous number it is a decrease from the start of last year when the central bank was buying Y10tn a month. The flexible approach to the amount of bonds it purchases gives the BoJ more flexibility and prevents markets from becoming overly distorted from bond scarcity. That is still somewhat of a problem because the BoJ owns 43% of the JGB’s outstanding. Growth in Japan is recovering however core inflation is just 0.3% due to very low wage growth. That seems to be a recurring problem in countries all around the world.

Wednesday June 14

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