Weekly Fund Wrap: Mo' Wages Mo' Problems

by: ADS Analytics

The market performed poorly last week with both bonds and equities selling off aggressively.

We break down the action in Treasury yields.

And we review the price action across the closed-end fund space.

It's like the more money we come across
The more problems we see
What's going on?
What's going on?

The market joined the chorus of Mo' Money Mo' Problems by the The Notorious B.I.G. last week as it struggled to digest the meaning of strong wage growth figures on Friday and its potential knock-on effect on further Fed hikes as well as lower corporate margins.

We plot weekly post-GFC weekly returns from SPDR S&P 500 (NYSEARCA:SPY) and iShares 20+ Year Treasury Bond (NYSEARCA:TLT) in the chart below. This makes it pretty clear that last week's price action was extremely unusual not only by the size of the moves but also by its position in the lower left quadrant of the chart as both bonds and stocks went deeply negative.

For weekly SPY returns below 3% there have been no negative TLT returns in our period sample until last week. The trend line suggests that TLT returns should be closer to 2% given last week's SPY return. This means that long-dated Treasury bonds underperformed the usual market pattern by over 5%.

Perhaps more importantly, the recent price action appears to have decidedly broken the key yield trend line below. Given the outsize role of Treasury yields on the income-producing closed-end fund sector, we discuss what is driving the worst start in the Treasury market since 2009 and where we may go from here.

So, what just happened?

To figure out what is behind the move in yields we need to split Treasury yields into its components. There are several ways of doing that but we prefer the following:

  • Current and future short-term rates
  • Term Premium

The market's view of short-term rates we proxy by the Dec-2019 fed funds futures and the term premium figure is derived from the Fed model, which takes into account the level and shape of the entire yield curve. Although our breakdown collapses a lot of yield curve information into the 2019 fed funds futures, we think it is still qualitatively instructive, even if quantitatively inexact.

We plot the weekly changes in these two components in the chart below.

What the chart tells us is that the rise in 10-year nominal Treasury yields since the beginning of the year has been driven in roughly equal measures by short-term rates and the term premium.

Let's try to break this down a bit further.

Short-term rates

Short-term rates are largely a function of fed funds rates and expectations, plus a Fed premium - which is the difference between what the Fed expects (measured by the median dot plot) and what the market expects (measured by fed funds futures or forward OIS rates). The Fed has been steadfast in its median projection of 3 hikes for 2018 and the market has only recently begun to catch up with this figure. To us, this appears to validate Fed's hawkish stance on inflation and the extension of the hiking cycle despite a long period of relatively muted inflation.

Term Premium

Term premium is a technically complex but intuitively simple concept. It is basically the market's measure of additional compensation required to invest in long-term bonds over rolling over a short-term bond position.

Over the last year or so the term premium has been trading at historically depressed levels. We think this is justified for a number of reasons: greater transparency of the Fed, lower volatility and greater anchoring of inflation expectations and an increase in global FX reserves as a share of GDP.

As it happens the term premium, for largely mysterious reasons, is reasonably correlated to inflation expectations, which is easier to pin down and understand.

Inflation expectations, as measured by the derivatives market, have increased about 10 basis points this year. With actual inflation relatively flat this means that all of this has gone into the inflation risk premium. The 5y inflation risk premium is shown below and is flat relative to current inflation. This means the market is not pricing in any additional premium over and above current inflation for the next 5 years.

So, to summarize, the recent move higher in yields has been driven in roughly equal measures by short-term rates and the term premium. Short-term rates have moved higher on the back of the market converging with the Fed's number of hike expectations - we think largely due to the strong wage growth figure. The term premium has gone up by the rise in the inflation risk premium - again we think as a function of the wage figure but also perhaps by the fact that the inflation risk premium was previously negative.

So where do we go from here?

We will defer to other market pundits as to the direction of fed funds, inflation and nominal yields and will reserve our comments to the more tangible valuation market measures.

  • Fed Risk Premium - over the short term the market has converged with Fed's view on fed funds, however there is still a gap in the longer-term as we show below. This doesn't mean the market is wrong - the Fed has in the past hiked fewer times than it expected initially however if additional inflation pressures show up, yields may need to adjust by a larger amount that what is priced in currently.

  • Inflation Risk Premium - longer-term inflation risk premia are flat against current inflation so, arguably, the market is more fairly priced here. But again, if inflation keeps going up then not only must breakevens rise so will the inflation risk premium.
  • Term Premium - is more fairly priced today than in the recent past but is still below zero. We think that there is good reason for the term premium to stay low however we must admit that the risk from here is asymmetric towards higher term premium and steeper yield curve.

In summary, what we can say here is that nominal yields have converged closer to fair value, however by no means have they overshot it. And when you consider the tendency of market prices to overshoot with the significant technical of the Fed balance sheet run-off and increased Treasury issuance we can very well see bonds weaken considerably for the remainder of the year.

Fund Space

How has last week's weakness affected closed-end funds?

Broadly speaking, except for a few special situations (e.g., healthcare) sectors have performed in line with previous price and equity volatility. Low-vol sectors like loans, investment grade and mortgages had very little NAV impairment while higher-volatility sectors such as equities and commodities sold off more.

We are a little surprised by the preferred sector prices slightly outperforming NAVs (i.e., discounts tightened). We also did not expect the sector NAVs to sell off as much as they did, however the bulk of the NAV impairment was due to the equity weakness on Friday rather than the week-long bond drop, particularly the 5% price drop in the finance sector.

MLPs fared badly with a triple whammy from bond, equity and commodity selloff, however the sector is no stranger to very high volatility.

EM income did surprisingly well, though much of this is due to ongoing dollar weakness and resilient credit spreads.

Taking a wider look across the market

Preferred sector discount is beginning to look attractive

... and the high yield muni sector is already attractive at these levels.

We also like loan and mortgage funds both of which can remain resilient to interest-rate and equity weakness, so long as the latter does not spill over into a recession.

Good Luck!

It's like the more money we come across
The more problems we see

What's going on?
What's going on?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for information purposes only and does not constitute investment advice or an offer or the solicitation of an offer to buy or sell any securities. Past performance is not a guarantee and may not be repeated. Investment strategies are not suitable for everyone and you should always conduct your own research or speak to a financial advisor. Although information in this document has been obtained from sources believed to be reliable, ADS ANALYTICS LLC does not guarantee its accuracy or completeness and accept no liability for any direct or consequential losses arising from its use. ADS ANALYTICS LLC does not provide tax or legal advice. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.