Bonds Cloudy Crystal Ball

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Bonds’ Cloudy Crystal Ball

Bond markets are often held out as being “smarter” than equities; in other words, they are better at reflecting economic reality than stocks. Indeed, yield curve inversion (two year versus ten year) has been a reliable predictor of recessions over the past 50 years.

But fixed income markets aren’t magic. At right, we show five year forward, five year real interest rates derived from the swaps market. We calcu-late the rate by subtracting the five year forward five year inflation swap rate from the five year for-ward five year nominal swap rate. These rates show five year real rates, five years in the future, using implied forwards based on the yield curve. We often here these rates described as the mar-ket’s expectation of long-term growth. But in real-ity, forward rates can be absolutely horrible pre-dictors of future conditions, responding far more frequently to present conditions or monetary poli-cy than to actual indictors of economic growth. At top right, we highlight two large moves in the five year forward five year real rate. In the first instance, actual economic circumstances were bad already and deteriorating; the market was very slow to react, then re-priced violently. In the sec-ond example, there was precisely zero economic catalyst for the move. Instead (third chart), the move higher in real yields over the course of sum-mer 2013 was entirely driven by nominal yield changes; those, in turn, were responding to the end of the taper. June of 2013 was the famed “taper tantrum”. Since then, that risk premium of uncertainty over forward rates has gradually been

priced back out, while the inflation component of real yields has collapsed due to lower spot oil prices. If 5y5y nominal, inflation, or real interest rate forwards were in fact a predictor of long-term growth, these transitory changes in Fed policy or spot commodity prices shouldn’t move them dramatically in short periods of time. But indeed they do. Our key takeaway here: be very, very cautious when some-one drums up fixed income market relationships as predictors of economic strength or weakness. Fixed income markets are smart, but deciphering their signals is not always a straightforward exercise.

5 Year Forward, 5 Year Real Yields: Last Ten Years

5y5y Real Yield Decomposition: Last Ten Years High Frequency Economic Data: Last Ten Years

-15 -10 -5 0 5 10 15 250 300 350 400 450 500 550 600 650 700 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2.98 -0.30 -0.02 1.58 -1.0 -0.5 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 5y5y Nominal Yield

5y5y Inflation Breakeven Yield Oil Decline Crushes 5y5y Breakevens Nominal Risk Premium Priced In Nominal Risk Premium Priced Out

10/10/08 to 12/19/08: -3.29%! 4/26/13 to 7/5/13: +1.60%! Claims soaring (nothing new); loan growth dropping (nothing new)

Loans and claims both firmly on improving trends, but no notable acceleration in improvement.

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Treasury Yields, Prices, and 30 Year Fixed Mortgage Rate

National Average 30 Year Mortgage Rate (%)

30 Year Treasury Future (Price, Roll Adjusted) 30 Year Treasury Bond (Yield, %)

108.2 108.4 108.6 108.8 109.0 109.2 109.4 109.6 109.8 4/1 4/30 5/29 6/26 7/25 8/22 9/22 10/20 11/17 12/16 1/15 2/13 3/16 3.7 3.8 3.9 4.0 4.1 4.2 4.3 4.4 4.5 4.6 3 /2 8 4 /1 0 4/ 23 _5/6 5 /1 9 5 /3 0 6 /1 2 6 /2 5 7 /8 7/ 21 _8/1 8/ 14 8 /2 7 9 /9 9 /2 2 1 0 /3 1 0 /1 6 10 /2 9 11 /1 1 11 /2 4 1 2 /5 1 2 /1 8 1 2 /3 1 1 /1 3 1 /2 6 2/ 6 2/ 19 _3/4 3 /1 7 3 /3 0 200 DMA 0.20 0.30 0.40 0.50 0.60 0.70 0.80 4/1 4/29 5/27 6/24 7/22 8/19 9/16 10/14 11/11 12/9 1/6 2/3 3/3 3/31 200 DMA 50 DMA 115.0 116.0 117.0 118.0 119.0 120.0 121.0 4/1 4/30 5/29 6/26 7/25 8/22 9/22 10/20 11/17 12/16 1/15 2/13 3/16 200 DMA 50 DMA 1.00 1.10 1.20 1.30 1.40 1.50 1.60 1.70 1.80 1.90 4/1 4/29 5/27 6/24 7/22 8/19 9/16 10/14 11/11 12/9 1/6 2/3 3/3 3/31 200 DMA 50 DMA 120.0 122.0 124.0 126.0 128.0 130.0 132.0 4/1 4/30 5/29 6/26 7/25 8/22 9/22 10/20 11/17 12/16 1/15 2/13 3/16 200 DMA 50 DMA 1.60 1.80 2.00 2.20 2.40 2.60 2.80 4/1 4/29 5/27 6/24 7/22 8/19 9/16 10/14 11/11 12/9 1/6 2/3 3/3 3/31 200 DMA 50 DMA 135.0 140.0 145.0 150.0 155.0 160.0 165.0 170.0 175.0 180.0 4/1 4/30 5/29 6/26 7/25 8/22 9/22 10/20 11/17 12/16 1/15 2/13 3/16 200 DMA 50 DMA 2.20 2.40 2.60 2.80 3.00 3.20 3.40 3.60 3.80 4/1 4/29 5/27 6/24 7/22 8/19 9/16 10/14 11/11 12/9 1/6 2/3 3/3 3/31 200 DMA 50 DMA 50 DMA

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Money Markets, ETFs and Trade of the Week

This week’s trade of the week is via the deriva-tives markets. We look to pick up some small yield from the iShares US Real Estate ETF IYR. While IYR is not strictly speaking a fixed income instrument, its low volatility and attractive yield make it more similar to the riskier fixed income spectrum than most US equity sectors. Consider selling a deep out-of-the money put option on IYR, struck at $70, for 24 cents. We like this trade as a way to express our expectation that the FOMC will not hawk rates and will stay held back by weak data through at least their June meeting. On a longer-dated basis, an IYR long has much less promising risk-reward, but holding June 19th expiry puts to expiration garners a credit of 24 cents and can serve as a yield en-hancement on an existing long or a stand-alone way to generate income in Q2. We choose a strike so far out of the money due to historical precedent: during the Taper Tantrum, when fixed income and yield investment risk premi-ums soared, IYR lost 17.71% in a matter of a few weeks. Our trade breaks even 16% below IYR’s current price, requiring a full repeat of 2013’s massive duration selling to lose the premium collected.

Duration continued to perform strong this past week, gaining 69 bps in terms of total return,

while other high-duration instruments

(Treasuries, LQD, BLV) performed well too.

Fid. Cash 0.01 0.000 Fed Funds 0.060 -0.050

Van. Prime 0.01 0.000 O/N Libor 0.120 -0.003

Schwab Cash 0.01 0.000 1M Libor 0.179 0.006

Fid. Munis 0.01 0.000 3M Libor 0.274 0.007

Schwab Govt 0.00 0.000 4 Wk T Bill 0.020 0.005

Fed. Prime 0.01 0.000 3M T Bill 0.020 -0.005

JPM Prime 0.01 0.000 6M T Bill 0.117 0.005

Blkrock Govt 0.00 0.000 1Y T Bill 0.250 0.015

GS MMkt 0.01 0.000 Repo 0.200 0.030

Money Market Rates

Money Market Funds Key Short Term Rates

Yield 5 Day YTD

Ticker Name Price (%) TR (%) TR (%)

AGG Core US Bond Mkt 111.52 2.27 0.27 1.79

BIL 1-3 MoT Bill 45.71 N/A -0.02 -0.07

BIV Vang. Intrmed. 86.36 2.64 0.51 2.67

BKLN Senior Loans 24.15 3.63 0.48 1.41

BLV Vang. Long Term 96.95 3.82 0.51 3.89

BND Tot Bond Mkt 83.46 2.38 0.34 1.96

BOND PIMCO Tot Ret 110.35 1.96 0.30 3.41

BSV Barc. Short Term 80.47 1.30 0.24 0.99

CSJ 1-3 Yr Corp. 105.48 1.03 0.16 0.54

EDV Long Dur. Trsy 131.98 2.27 0.69 7.10

EMB JPM EM Bonds 112.19 4.04 0.21 3.28

FLOT Floating Rate 50.64 0.50 0.08 0.32

HYG iBoxx HY 90.26 5.39 0.28 2.03

IEF 7-10 Yr Bonds 108.72 1.93 0.54 3.07

IEI 3-7 Yr Trsy 124.34 1.37 0.44 2.00

JNK Barc. High Yield 39.06 5.79 0.28 2.62

LQD iBoxx Invest. Grade 121.93 3.24 0.58 2.94

MBB MBS 110.33 1.81 0.20 1.25

PFF Preferreds 39.90 5.28 -0.04 2.52

PGF Financial Preferreds 18.59 5.57 0.16 3.26

PGX Preferred Port. 14.88 5.85 -0.03 2.70

SCPB Barc. Short Term 30.72 1.31 0.22 0.79

SHM Short Term Munis 24.29 0.81 -0.10 0.23

SHV Short Term Trsy 110.28 N/A 0.01 0.02

SHY 1-3 Yr Trsy 84.88 0.52 0.12 0.62

SNLN iBoxx Sen Loan 19.33 3.93 0.05 1.72

STPZ PIMCO 1-5 Yr TIPS 52.01 N/A 0.15 0.54

TIP TIPS 114.24 N/A 0.01 1.99

TLH 10-20 Yr Trsy 139.50 2.07 0.65 3.72

TLT 20+ Yr Trsy 132.06 2.48 0.63 5.52

VCLT Long Term Corp 94.60 4.29 0.38 3.37

VCSH Vang. Short Term 80.15 2.01 0.20 1.12

TBF Short 20+ Yr Trsy 23.67 N/A -0.75 -5.88

TBX Short 7-10 Yr Trsy 29.57 N/A 0.07 -3.05

Key Fixed Income ETFs

iShares US Real Estate ETF (IYR): Last 6 Months

50-DMA

$79.45

$66.76 IYR 6/19/15 67 P Breakeven

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Treasury Yield Curve: Current vs 3 Months Prior, w/ BPs Change

Bunds Yield Curve: Current vs 3 Months Prior, w/ BPs Change

Eurodollar Yield Curve: Current vs 3 Months Prior, w/ BPs Change

Inflation Curve: Current vs 3 Months Prior, w/ BPs Change

Bespoke Global Yield Curve: Current vs 3 Months Prior, w/ BPs Change

+5.66 -15.26 -24.73 -35.75 -34.26 -32.12 -28.02 0 50 100 150 200 250 300

1 Year 2 Year 3 Year 5 Year 7 Year 10 Year 30 Year

4/1/2015 12/30/2014 -11.7 _-15.4 -14.3 -11.6 -18 -78.2 -37.3 -40 -20 0 20 40 60 80 100 120 140 160

4/1/2015 12/30/2014 +3.5 +2.5 -2 -19.5 -26.5 -32.5 -39 -42 -45.5 -46.5 -49.5 0 50 100 150 200 250 3 Mo 6 Mo 9 Mo 12 Mo 15 Mo 18 Mo 21 Mo 24 Mo 27 Mo 30 Mo 33 Mo 4/1/2015 12/30/2014 +131.7 +68 +47.85 +43.81 +20.73 +15.21 -0.49 -50 0 50 100 150 200

4/1/2015 12/30/2014 -1.64 -12.93 -10.74 -6.57 -15.81 -13.76 -9.96 250 270 290 310 330 350 370 390 410 430 450

3/31/2015 1/6/2015

Benchmark Yield Curves

Treasuries continue to grind out risk premium, responding to other global bond markets, weak US data, and lower risk of rapid rate hikes com-press term premiums and reduce yields across the curve. We’ve seen the best performance from the long end the last couple days, while the belly had been the leader over the past weeks.

The Eurodollar strip continues its grind, while the first hike pricing remains the eternal six months away. We expect a hike to come in September based on the current situation—as we have for some months now. Expect April’s FOMC meeting to be a real snoozer; we have two months of data to gauge June hike likelihood, currently low. ECB QE continues to hoover up bonds on

sched-ule and the front end of the German yield curve continues to plumb new depths. The ten year bund is now well below 20 bps with no relief in sight and the result is further and further yield grabbing. It’s equally hard to see a catalyst for higher rates and profitable buying here.

As month-over-month CPI prints have improved (thanks to much slower percentage declines in oil prices) we continue to question risk premiums priced in; while 2015 inflation should be docile at the very least thanks to the strong dollar and weak commodities, housing and services inflation remains exceptionally robust relative to headline.

Global yields remain under pressure as devel-oped market bond yields remain anchored to near zero rates around almost the entire world. Thirty year debt remains extremely “cheap” (high yield) relative to the gentle slope in the five-ten year part of the curve. Short term rates (under three years) are helpfully low for global growth; Europe is turning around and US growth poised to pick up, pressuring FOMC decision making.

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High Yield Corporates Municipal Bonds Mortgage Backed Securities

Emerging Markets 2 Year vs 10 Year

5 Year vs 10 Year

10 Year Italian BTP/German Bund

Municipal Bonds 10 Year Swap

High Yield Corporates

2 Year vs 5 Year 10 Year German Bund Long Dated Treasuries

Treasury Curves (BPs) Spreads (BPs) Total Return Over Past Year (BPs)

65 75 85 95 105 115 125 135 110 130 150 170 190 210 230 250 40 50 60 70 80 90 100 110 100 110 120 130 140 150 160 170 180 190 200 50 55 60 65 70 75 80 85 90 -200 -180 -160 -140 -120 -100 80 100 120 140 160 180 200 -4 0 4 8 12 16 20 24 28 32 36 40 44 48 6 8 10 12 14 16 18 325 375 425 475 525 575 -350 -250 -150 -50 50 150 250 350 0 100 200 300 400 500 600 700 800 900 0 400 800 1200 1600 2000 2400 2800 3200 0 100 200 300 400 500 600 -100 0 100 200 300 400 500 600

Curves, Spreads and Total Returns

Returns on duration remain firmly positive as the longer-dated bonds have recovered much of the performance given up in February and March.

The downtrend in BTP spreads vs bunds remains firmly in place, but the pullback we saw in March has slowed.

High yield spreads are almost entire-ly driven by the Energy sector at this point, but plenty of Energy new issue is hitting the market: over $3 bn last week.

As long as the FOMC is circumspect about the pace of hikes, expect risk premiums to come out of EM.

Treasuries-bunds remains driven by

Treasury yields due to the anchor of ECB bond buying; buying Treasuries vs bunds looks an awful lot like buying Treasury outright 2s5s continues to move

flatter thanks to a lower expected pace of rate hikes once the FOMC does lift Fed Funds off of zero.

Munis traded at a lower yield than Treasuries for a couple days in march, but are now at identical yields. 5s10s looks to be tentatively edging higher.

With the mid-curve slope on a treadmill since the start of 2015, we have a hard time seeing more flattening.

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