Changing Liquidity in the Fixed Income Markets

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by Brad Houle, CFA
Executive Vice President

The bond market is a dealer market with no central exchange. This means that all bond trades are over-the-counter trades whereby market participants trade amongst themselves. By contrast, stocks are traded in a continuous auction market where an investor can get the market price of a stock instantly by seeing where it is trading on the various electronic and physical exchanges. Bond pricing can be more esoteric, particularly for more exotic securities such as some mortgage-backed bonds or high-yield bonds.

The 2008 financial crisis was sparked by speculative mortgage-backed securities which started to fail when homeowners stopped paying their mortgages. Part of the issue was the fact that it was difficult to nearly impossible to value these securities and there was no liquidity for these bonds. The government often regulates in response to the last crisis and this situation is an example of backward looking regulation. As part of the reactive financial market regulation that came out of the financial crisis was that banks are now required to have greater regulatory capital. On the surface this seems like a good idea: banks are required to hold more “safe” assets on their balance sheets like U.S. Treasury bonds to cushion for inevitable bumps in the road. The unintended consequence of this change has made it difficult for large banks to effectively trade fixed income securities. It used to be good business for Wall Street banks to trade bonds with customers. Banks would make a market in bonds and would use their balance sheet to provide liquidity to customers. With onerous capital requirements this business has become difficult and unprofitable for participants. The bond market has gotten much bigger since the financial crisis and much less liquid.

According to the Wall Street Journal, since the 2008 financial crisis the U.S. Corporate bond market has doubled in size to $4.5 trillion dollars. In addition, outstanding U.S. Treasury Bonds trading volumes have fallen 10 percent since 2005 while the size of the market has tripled.

The implication for this change is volatility in the bond market will probably be higher going forward. We have yet to have a real test of bond market liquidity since financial crisis. When interest rates start to climb we will see how resilient the market is when short-term investors in bonds all try to squeeze out the same small door at the same time.

The good news for Ferguson Wellman clients is we largely use individual bonds for clients. This is important because an investor that owns an individual bond can wait out the pricing volatility because at maturity you will get your money back. Participating in panic selling into a volatile or potentially illiquid market is completely voluntary. In the past, we have been able to be opportunistic buyers of bonds sold into illiquid markets. One case in point was the mini-crisis in the municipal bond market when an analyst named Meredith Whitney unwisely used her fifteen minutes of fame on the television program 60 Minutes to incorrectly predict massive defaults in the municipal bond market.

Another silver lining to this potential situation is an advance in technology that could improve liquidity in the fixed income markets. The leading edge of fixed income trading is an electronic bond trading platform that has the potential to revolutionize bond trading. Rather than use a bond dealer intermediary to trade bonds, this platform allows firms like Ferguson Wellman to trade directly with other investment management firms. This concept is in its infancy and Ferguson Wellman is adopting this technology where it can benefit our clients’ portfolios. We are optimistic that wide adoption of this technology can benefit all fixed income investors.

Our Takeaway for the Week

  • A lack of liquidity in the bond market may cause volatility in bond prices to be elevated in the future. Owning individual bonds can allow an investor to ride out any potential storms. Also, we think that an eventual broader adoption of electronic bond trading technology will eventually make markets function more smoothly.

Disclosures

Spinning Wheel

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by Ralph Cole, CFA
Executive Vice President of Research

Spinning Wheel

The strong dollar has been a headwind for S&P earnings so far this year. However, that headwind appears to be dissipating. Having traded at $1.40 less than a year ago, by last month the Euro had plunged to $1.05. The Euro’s 25 percent devaluation has been a positive development for European economies. Paired with quantitative easing, this has led to a rally in European equity markets.

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As confidence has started to build in the Eurozone, we have seen economic growth starting to accelerate. In fact, first quarter GDP in the Eurozone was 1.6 percent, which compares favorably to the meager .2 percent reported  in the U.S. for the first quarter. This change at the margin, with Euro growth outpacing U.S. growth, has led to a strengthening of the Euro relative to the U.S. dollar. As Shawn Narancich stated in our March 13 blog, “the dollar was due for a break after such a parabolic run.” Since mid-March, the Euro has strengthened 8.5 percent relative to its U.S. counterpart. We view this moderation in dollar strength as a positive for U.S. multi-national companies, and we also see it as a healthy indicator for the capital markets. We still believe that the dollar will strengthen against the Euro as the year moves along, but it will be gradual.

Finally

Along with a rally in the Euro, we have seen a rally in interest rates since the end of January. The U.S. 10-year bond yield bottomed at 1.64 percent in January; today it stands at 2.23 percent. Not only have U.S. bond yields risen over that time period, but so have yields in Europe. After bottoming at .08 percent, the German 10-year bund now stands at a .70 percent yield. We have long maintained that higher global yields would result in higher rates here in the U.S. and we believe yields are finally starting to discount expectations of stronger global growth in coming quarters.

 Takeaways for the week:

  • The dollar has taken a pause against the Euro, and we view this as healthy for the global economy
  • Higher yields are reflecting higher growth prospects in the second half of 2015

Disclosures

Krys-Rusoff Appointed to Metro Exposition and Recreation Committee

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Deidra Krys-Rusoff, senior vice president and portfolio manager,  has been appointed to the Metro Exposition and Recreation Commission (MERC).

While new to the MERC, Krys-Rusoff is not new to Metro, having joined the Oregon Zoo Bond Citizens Oversight Committee in 2010, serving as vice chair and chair. MERC works to protect the public investment in three of Metro’s visitor venues: Oregon Convention Center, Portland Expo Center and Portland 5’s Centers for the Arts. Scott Robinson, Metro’s deputy chief operating officer, said Krys-Rusoff was an obvious choice for the position. “Deidra comes from the financial sector. She’s involved in bond markets, which has really helped our oversight committee. She is able to communicate the technical information to the rest of the committee in a way they can understand.”

“Deidra’s commitment to serve our community is very admirable and consistent with the value she brings to our clients and company every day. We are proud of her accomplishments and leadership,” said Jim Rudd, principal and chief executive officer of Ferguson Wellman.

 

Belaboring Labor

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Shawn-00397_cmykby Shawn Narancich, CFA
Executive Vice President of Research

Working for a Living

Investors unnerved by disappointing economic data of late breathed a sigh of relief with the April jobs report, which showed that nonfarm payrolls rebounded to a monthly rate of 223,000 last month. Unemployment dropped again and now stands at 5.4 percent, a rate not too far from the Fed’s definition of the full employment rate of unemployment (somewhere just north of 5 percent.) A “goldilocks” report of sorts that’s neither too hot nor too cold, the April payroll release supports the notion that the Yellen & Co. will likely begin the rate tightening process this fall. As policymakers and investors debate how tight labor markets actually are against a backdrop where the labor force participation rate hovers near its lowest level since the late 1970s, we are increasingly attuned to reported wage rates and the broader employment cost index (ECI). While wage gains remain muted at 2.2 percent in April, the ECI of 2.6 percent released last week demonstrated a notable uptick. When juxtaposed against anecdotal evidence of wage gains at fast food restaurants and retailers, our best guess is that the worm has turned with regard to employment costs this cycle. Because labor accounts for the predominant cost of doing business, the near-zero inflation rates we’ve seen of late appear likely to begin rising. When combined with the recent rebound in oil prices, headline inflation probably rises closer to the Fed’s 2 percent target by year-end.

Spring Forward

In contrast to the encouraging labor report, investors were greeted by a report showing that productivity of the U.S. labor force declined for the second consecutive quarter. While somewhat obscure, the statistic shines a light on the U.S. economy’s weak start to the year. By marrying employment and output statistics, the report tells us that the U.S. economy produced less per each hour worked in the first quarter. The reason productivity is such an important statistic is because when it’s combined with employment costs, it generates what we call unit labor costs. As alluded to above, sustained increases in the cost of labor are a key signpost for inflation, particularly when they translate into rising costs of production on a per unit basis. Just as importantly, unit labor costs determine how profitable companies are and the overall standard of living enjoyed by workers. Another tough winter combined with disruptions from the west coast ports strike put a damper on the U.S. economy in the first quarter, but we believe that an improving labor market, rising disposable incomes, and higher capital spending will engender a rebound of sorts in the second quarter. Commensurately, we would expect productivity to return to positive territory.

Exceeding Expectations

First quarter earnings season is just about finished and, once again, U.S. companies have done a remarkable job of under promising and over delivering.  Compared with expectations of a low single-digit decline in first quarter profits, corporate America is instead delivering earnings that should end up being marginally above levels of a year ago. In particular, while dramatically lower oil prices caused red ink to flow on the income statements of many energy companies, the damage was ameliorated by better downstream refining and marketing results and the quick pace with which oil and gas producers have right-sized their cost structure.

Our Takeaways from the Week

  • A solid April employment report bodes well for better economic times ahead
  • Another encouraging earnings season is just about finished