The End Of Operation Twist

While there has been the usual keen market focus on what the FOMC and some of its key members have been saying in the past few weeks, perhaps not enough attention has been paid to what the Fed has been doing.

Operation Twist | The Fed

T he Fed has been removing duration from the bond market at a steady pace. The Fed has added about $200 billion in 10-year equivalents to its balance sheet and will add another $200 billion more before Operation Twist comes to an end in June.

The main effect of the Fed’s maturity extension program has been to support the prices of risk assets through the portfolio channel effect. In doing so, Operation Twist has successfully repeated the rallies generated during QE1 and QE2.

In each of these previous QE episodes, the rally in risk assets was concentrated in the first half of the quantitative easing period and tended to fade away as the program approached an end. Operation Twist may have reached a similar turning point. The end of the program is in sight and there may indeed be some volatility associated with the end of Operation Twist, but we do not expect a major selloff in risk assets as occurred following the end of QE1 and QE2.

In both of these cases, a risk-off phase was ushered in by exogenous shocks unrelated to the Fed’s efforts, specifically, an escalation in financial systemic fears stemming from the European sovereign debt crisis.

It certainly complicates matters that this systemic risk refuses to dissipate completely: Spanish and Italian bond spreads have widened again in the past week as the  government balked at imposing new austerity measures in the face of contracting economic growth.

Operation Twist and U.S. Financial Markets

Domestic U.S. financial spreads have followed Spanish spreads higher, but contagion to U.S. financial markets should be less intense than occurred last year in the event that European stress spikes again.

The Fed | Operation Twist

One reason is that the Fed’s recent stress tests showed that U.S. banks are so well capitalized that they could survive a very nasty economic and financial backdrop. Still, we do not wish to downplay the risks facing U.S. markets. Contagion is very difficult to predict. Moreover, the European Central Bank (ECB) may be slow to react if Spain goes into a tailspin.

Recent economic data confirm that Germany is expanding at a solid pace, while Spain, Italy, Portugal and Greece are mired in recession. With German unemployment at a 20-year low and several healthy wage settlements in the news, it is only a matter of time before the ECB is forced to grapple with the dilemma of policy rates that are too loose for the core and too tight elsewhere.

Nonetheless, our fixed income team still thinks that valuation is relatively attractive in most spread products, especially as one moves down in quality. While there may be a temporary disruption in risk assets with the end of Operation Twist and risks from European sovereign debt flare-ups, the end of previous QE episodes was marked by a sharp deterioration in leading economic indicators. So far this year, these indicators remain largely in an upward trend.

Bottom line: Watch for increased volatility in the bond market as the end of Operation Twist approaches. However, an overweight position is still warranted within U.S. fixed income portfolios.

U.S. Junk Bonds Or Stocks?

Investors seeking a somewhat more conservative cyclical exposure should consider tactically replacing some U.S. equity exposure with high-yield corporate bonds.

Junk Bonds or Stocks

A fter the initial phase of the recovery, the relative performance of high-yield vs. equities has been range-bound, reflecting improving corporate balance sheet health, headwinds to growth and a “search for yield”.

Junk bonds outperformed equities during the two flight-to-quality bouts in 2010 and 2011. High-yield issues of course also declined in absolute return terms, but were generally less volatile and experienced relatively modest sell-offs. In total return terms, high-yield bonds fell only by one-third of the amount that equities did in the 2010 selloff episode, and declined 50% less than equities did in 2011.

While there has recently been some concern expressed in the financial press about the high level of gross issuance in the corporate bond universe, most (if not all) of this activity represents refinancing by firms. Refinancing alone should not put upward pressure on spreads. Net corporate bond issuance over the past year has essentially been flat according to Flow of Funds data, and while these results cannot be broken down by credit quality, it is unlikely that the story is materially different for high-yield than for investment-grade issuers.

Our base case view is that equities will outperform junk by a modest amount this year. Nonetheless, junk bonds stand to decline by less in the event that euro area contagion returns to global financial markets. The recent equity rally has presented investors with an opportunity to take partial profits and rotate into a less volatile, but still cyclically exposed asset class.

Searching For Yield In Faraway Places

Global bond investors seeking yield are still currently better served by U.S. high yield corporate bonds on average than EM sovereigns.

Emerging Market Sovereign Spreads | High Yield

E merging market U.S. dollar-denominated sovereign (EM) debt is a viable alternative to satisfy investors’ search for yield in the ongoing low interest rate environment.

EM bonds are an out-of-benchmark credit play that on average offer more than 300 bps of yield pick-up relative to U.S. Treasurys and about a 150 bps advantage over U.S. investment grade credit. Although pockets of value in EM markets exist, our Global Fixed Income Strategy service prefers the risk-reward profile of the U.S. high yield sector for developed market global bond investors.

In the long term, benefits from holding EM debt within a global developed market bond portfolio include diversification and potential spread compression due to improving credit quality. However, in the current environment, most EM sovereign debt does not offer enough advantages over comparable quality U.S. corporate credit to merit a significant position.

Since the beginning of this year, market optimism and the “risk-on” trade have pushed credit spreads tighter in general. We expect this trend to continue at a much slower pace going forward. EM bonds have outperformed U.S. high yield bonds since the beginning of the year, but the former are particularly vulnerable to event risks and to a shift in sentiment.

That said, for investors that are seeking yield in EM sovereign markets, countries that benefit from higher oil prices offer the best relative prospects and are a potential hedge in the event of a supply-driven oil price shock.

Fed Raises The Bar

The bar for additional Fed stimulus has been set a little higher.

Fed Stimulus | Operation Twist Ending

T he FOMC Minutes from mid-March were less dovish than investors expected. Policymakers left the door open to more stimulus, but noted that only a “couple” of members – rather than the more expansive “few” mentioned in the previous Minutes – saw the need for more stimulus even in the absence of a renewed growth slowdown. The Fed staff also revised down their estimate of the amount of economic slack and revised up slightly the inflation outlook in light of a smaller output gap and higher energy prices. One could argue that the fact that the Fed does not see the need for additional stimulus as a positive factor for the equity market, but some investors were hoping that stocks would enjoy both trend-like economic growth and another liquidity injection.

We are not surprised by the FOMC’s tone, and do not expect Operation Twist to be extended past June unless there is a sudden softening in job creation, a drop in inflation expectations or a sharp tightening in financial conditions.

Late in 2012, policymakers may consider more stimulus ahead of the possibly large fiscal contraction in store for 2013. However, there are too many election uncertainties to base monetary policy decisions this year on what might happen with fiscal policy next year. The Fed will probably wait and watch for signs that fiscal tightening is undermining the jobs recovery before taking action.

Bottom line: The Fed is in no hurry to change its 2014 ‘forward guidance’, but will be in wait-and-see mode in the absence of a deterioration in the economic and financial backdrop.

LTROs Were A Hit, But…

The ECB’s credit injections helped provide much needed liquidity, but money supply data suggest that the LTROs have done little to improve private sector lending.

LTRO Europe | Spanish Banks | Italian Banks

E uropean money supply data showed an uptick in M3 to an annual growth rate of 2.8% following several months of decline at the end of 2011. M3 has struggled to climb despite the rapid expansion of the monetary base since the middle of last year. It takes about six months for credit to translate into spending, so the loss of momentum for M3 suggests the economy may not get a boost from the ECB’s credit injections (December and February LTROs) until at least late this year.

The December LTROs have not translated into expanded lending to the private sector. In aggregate, lending to households and firms has shrunk quite sharply.

Spanish and Italian banks both bought around €20 billion of their own sovereign bonds in January and February, which supported their sovereign spreads. Simultaneously, however, Spanish banks have slashed lending to the private sector. Italian banks have been less stingy since the recession so growth headwinds in Italy are milder than in Spain. We remain concerned about Spanish banks’ provisioning for non-performing loans, their capitalization needs and their exposure to Portugal. Having narrowed following the announcement of the LTROs in December, Spanish bank CDS spreads have widened in recent weeks.

Bottom line: There are lingering risks in Europe, including the need for growth in the face of austerity, bank recapitalization and deleveraging and contagion from Portugal. It is much too soon for the ECB to be hinting at withdrawing its extraordinary measures.