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BOND STRATEGY
WEEKLY REPORT
Buy The Back-Up In Junk Spreads
March 14, 2017
Periodical Monetary Policy: The Fed will lift rates this week, but will likely leave its median forecast
for three hikes this year unchanged. With inflation still below target the Fed has an incen-
In this Issue:
FF Fed Will Take
tive to take it easy. Curve steepeners, TIPS breakeven wideners and overweight spread
It Slow.......................2 product positions will benefit.
FF Consolidation
Complete?.................4 Duration: The growth outlook is improving and the 10-year Treasury yield could soon move
FF The Value Is Back higher, breaking out of its recent trading range. An already elevated economic surprise
In High-Yield.............5
index should not be a deterrent.
High-Yield: Junk spreads have widened even though default rate indicators continue to
show improvement. With valuations now looking more attractive, we upgrade high-yield
from neutral to overweight.
U.S. election, money markets were How Much Hawkishness Can Markets Take?
% %
FED FUNDS RATE MARKET EXPECTATIONS*:
still only discounting one rate hike YEAR-END 2017
before the end of 2017. The Fed has 2.0 2.0
already raised rates once since then
and the market is now almost priced 1.5 1.5
for another three hikes before year-end
(Chart 1). Encouragingly, financial 1.0 1.0
markets digested the shift up to two
2017 rate hikes without much of a .5 .5
Editorial Board BPs 2/10 NOMINAL TREASURY SLOPE (LS) %
hiccup the yield curve steepened, 10-YEAR TIPS BREAKEVEN INFLATION (RS)
Ryan Swift 2.2
Vice President TIPS breakevens widened and junk 180
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BCA RESEARCH INC. U.S. BOND STRATEGY - WEEKLY REPORT MARCH 14, 2017
As we have written several times,1 with core inflation and TIPS breakevens still below target, the
Fed must ensure that the economic recovery continues. It will therefore be quick to back away from
any nascent hawkishness if financial conditions start to tighten. With markets already showing some
signs of stress, we expect the Fed to err on the side of caution this week. This means the Fed will
lift rates, but also leave the median forecast of three 2017 rate hikes unchanged.
This notion that the Fed should be lifting rates, but only very slowly, is confirmed by our Fed Monitor
(Chart 2). The Fed Monitor is a composite of 32 indicators that track the evolution of U.S. economic
CHART 2
BCA Fed Monitor Suggests A Slow Pace Of Rate Hikes
%
FED FUNDS RATE*: 12-MONTH CHANGE (LS) 4
BCA FED MONITOR** (RS)
5
2
0 0
-5
Barely -2
above
zero -4
0 0
-2 -2
EASIER MONEY
REQUIRED
-4 -4
% %
FED FUNDS RATE*
15 15
10 10
5 5
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
* TARGET FED FUNDS RATE JOINED WITH EFFECTIVE FED FUNDS RATE FOR PERIOD PRIOR TO 1971
**COMPOSITE INDICATOR CONSISTING OF ECONOMIC AND FINANCIAL MARKET VARIABLES
NOTE: SHADING DENOTES PERIODS WHEN THE FED MONITOR IS ABOVE ZERO
1
Please see U.S. Bond Strategy Weekly Report, Inflation: More Fire Than Ice, But Dont Sound The Alarm, dated January 24,
2017, available at usbs.bcaresearch.com
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BCA RESEARCH INC. U.S. BOND STRATEGY - WEEKLY REPORT MARCH 14, 2017
ponent will be necessary for the Fed to deliver on 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016
its current expected path of rate hikes. While the *COMPOSITE INDICATOR CONSISTING OF ECONOMIC AND FINANCIAL
MARKET VARIABLES
Fed has sometimes started to lift rates with the NOTE: SHADING DENOTES FED TIGHTENING CYCLES
While economic growth is accelerating, below-target inflation means that the Fed must continue to nurture
the economic recovery. Investors should position for a steeper curve, wider TIPS breakevens and tighter
credit spreads until inflationary pressures are more pronounced. This means at least until long-maturity
TIPS breakevens reach the 2.4% to 2.5% range and core PCE inflation is firmly anchored around 2%.
Bottom Line: The Fed will lift rates this week, but will likely leave its median forecast for three
hikes this year unchanged. With inflation still below target the Fed has an incentive to take it easy.
Curve steepeners, TIPS breakeven wideners and overweight spread product positions will benefit.
editor@bcaresearch.com www.bcaresearch.com Copyright 2017 BCA Research Inc. All Rights Reserved. Refer to last page for important disclaimer. 3
BCA RESEARCH INC. U.S. BOND STRATEGY - WEEKLY REPORT MARCH 14, 2017
In fact, changes in the 10-year Treasury yield 2012 2013 2014 2015 2016
tend to lead the economic surprise index by * ADVANCED BY 5 WEEKS
**SOURCE: CITIGROUP
several weeks. This means that stagnant yields
during the past few months have already fore-
CHART 5
shadowed a reversal in the surprise index. In
Labor Market Points To Stronger Growth
other words, some mean reversion in economic Ann% Ann%
NON-FARM EMPLOYMENT*:
surprises is already in the price and should not Chg Chg
12-MONTH RATE OF CHANGE
prevent yields from rising in the coming weeks. 2.5 3-MONTH RATE OF CHANGE 2.5
(Annualized)
worked have accelerated suggesting that GDP 2011 2012 2013 2014 2015 2016 2017
growth will be strong in Q1 (Chart 5). *REVISIONS LINED UP TO RELEASE DATE
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BCA RESEARCH INC. U.S. BOND STRATEGY - WEEKLY REPORT MARCH 14, 2017
An already CHART 6
So Do Financial Conditions
elevated %
REAL GDP GROWTH (LS)
economic BCA FED MONITOR*: FINANCIAL CONDITIONS COMPONENT** (RS)
surprise 8
index will
not stop 2
yields from
rising. 4
-2
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
* COMPOSITE INDICATOR CONSISTING OF ECONOMIC AND FINANCIAL MARKET VARIABLES
**SHOWN AS A 12-MONTH CHANGE
Financial conditions are also supportive of a further acceleration in growth. We found that the financial
conditions component of our Fed Monitor provides a strong indication of near-term trends in GDP
growth (Chart 6). This highlights that growth should be strong during the next few months but also
that the Fed must respond to any tightening in financial conditions if it wants growth to remain robust.
Bottom Line: The growth outlook is improving and the 10-year Treasury yield could soon move
higher, breaking out of its recent trading range. An already elevated economic surprise index should
not be a deterrent.
FF Lending standards have rolled over and are now just barely in net tightening territory
2
Please see U.S. Bond Strategy Special Report, Seven Fixed Income Themes For 2017, dated December 20, 2016, available at
usbs.bcaresearch.com
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BCA RESEARCH INC. U.S. BOND STRATEGY - WEEKLY REPORT MARCH 14, 2017
Discover CHART 7
Default Rate Indicators Are Showing Improvement
what you % %
HIGH-YIELD 12-MONTH TRAILING DEFAULT RATE*
can do 12 BCA MODEL** 12
with BCA 8 8
Analytics.
4 4
12 12
10 10
8 8
6 6
0 50
40
-10
40 40
0 0
EASING STANDARDS
Ann% Ann%
INDUSTRIAL PRODUCTION (LS)
Chg Chg
10 TOTAL BUSINESS SALES MINUS INVENTORY****** (RS)
10
0 0
-10
-10
1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
* SOURCE: MOODY'S INVESTORS SERVICE
** BASED ON INDUSTRIAL PRODUCTION, LENDING STANDARDS, NON-FINANCIAL SECTOR PROFIT GROWTH AND INTEREST COVERAGE
*** NONFINANCIAL CORPORATE SECTOR CASH FLOW DIVIDED BY INTEREST EXPENSE
**** SOURCE: INSTITUTE OF SUPPLY MANAGEMENT
***** AVERAGE OF SMALL AND LARGE BUSINESSES, SOURCE: FEDERAL RESERVE
****** SHOWN ADVANCED BY 6 MONTHS, SOURCE: DEPARTMENT OF COMMERCE
*******SOURCE: CHALLENGER, GRAY & CHRISTMAS
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BCA RESEARCH INC. U.S. BOND STRATEGY - WEEKLY REPORT MARCH 14, 2017
The combination of wider junk spreads and an improving default outlook has led to an increase
in our preferred gauge of value for high-yield bonds the default-adjusted spread (Chart 9). The
default-adjusted spread is calculated by subtracting an ex-ante estimate of default losses from the
average spread on the Bloomberg Barclays High-Yield index.
To arrive at an estimate of default losses we use the Moodys baseline forecast for the default rate
and our own forecast for the recovery rate based on the historical relationship between recoveries and
defaults. With the release of Februarys default report, the Moodys baseline default rate forecast fell to
3.14% for the next 12 months. Based on this forecast we estimate that the recovery rate will be 44%.
Combining the default and recovery rate forecasts gives an estimate for default losses of 3.14%
x (1- 0.44) = 176 bps for the next 12 months. Since the average option-adjusted spread of the
3
Please see Commodity & Energy Strategy Weekly Report, Feds Pre-Emptive Hike Will Hit Gold, Not Oil, dated March 9, 2017,
available at ces.bcaresearch.com
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BCA RESEARCH INC. U.S. BOND STRATEGY - WEEKLY REPORT MARCH 14, 2017
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BCA RESEARCH INC. U.S. BOND STRATEGY - WEEKLY REPORT MARCH 14, 2017
adjusted
spread is
between 200 40
12-MONTH EXCESS RETURNS** (%)
positive
12-month
excess 0
returns 81%
of the time.
-20
-40
0 100 200 300 400 500 600 700 800
EX-ANTE DEFAULT-ADJUSTED* SPREAD (BPS)
* OPTION-ADJUSTED SPREAD LESS FORECASTED DEFAULT LOSSES BASED ON MOODY'S BASELINE DEFAULT RATE FORECAST.
** RELATIVE TO A DURATION-MATCHED POSITION IN TREASURY SECURITIES.
SOURCE: BLOOMBERG BARCLAYS INDICES, MOODY'S INVESTORS SERVICE.
TABLE 1
12-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread
HIGH-YIELD 12-MONTH EXCESS RETURN** (%)
% OF EPISODES
90%
# OF WITH POSITIVE
AVERAGE BEST WORST CONFIDENCE
OCCURRENCES EXCESS
INTERVAL
RETURNS
[-200, -150) 0 N/A N/A N/A N/A N/A
[-150, -100) 0 N/A N/A N/A N/A N/A
HIGH-YIELD EX-ANTE DEFAULT-ADJSUTED SPREAD* (BPs)
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BCA RESEARCH INC. U.S. BOND STRATEGY - WEEKLY REPORT MARCH 14, 2017
Discover have a bit further to run. However, given still-low inflation readings, the Fed would eventually be
what you forced to back away from its hawkish rhetoric and support renewed spread tightening. In our view,
can do the main risk to upgrading junk this week is that we are a bit too early.
with BCA Bottom Line: Junk spreads have widened even though default rate indicators continue to show
Analytics. improvement. With valuations now looking more attractive, we upgrade high-yield from neutral to
overweight.
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BCA RESEARCH INC. U.S. BOND STRATEGY - WEEKLY REPORT MARCH 14, 2017
TREASURIES 2
Nominals 1
TIPS 4
SPREAD PRODUCT 4
Corporates 4
High-Yield 3 4
MBS 2
Government-Related 2
Municipals 3
ABS 5
Non-Agency CMBS 2
Agency CMBS 4
* RECOMMENDED PORTFOLIO WEIGHTING RELATIVE TO BENCHMARK.
LEGEND:
1-MAX UNDERWEIGHT 2-UNDERWEIGHT 3-BENCHMARK WEIGHTING
4-OVERWEIGHT 5-MAX OVERWEIGHT
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