Indexology^® Blog

Fed a Small Step Closer to Raising rates

Today’s FOMC statement published after the meeting is more upbeat than the last one in discussing the labor markets and the inflation outlook.  The FOMC noted “solid gains and a lower unemployment rate” and that the “likelihood of inflation running persistently below 2 percent has diminished somewhat” despite lower oil prices.  In announcing the end of QE, the statement noted “substantial improvements in the outlook for the labor market since” QE began.

The balance in the FOMC may be shifting at the same time. There was one dissent from Narayana Kocherlakota of the Minneapolis Fed arguing for a more dovish position than the Committee took. At the previous meeting in mid-September there were two dissents arguing for a more hawkish position and quicker action for higher interest rates.

The full minutes of the previous FOMC meeting included a discussion of Fed operating procedures and how they would raise interest rates in the face of some $3 trillion-plus of excess reserves. The summary statement from that meeting mentioned concerns about removing policy accommodation.  This time the lack of any mention of operating procedures suggests that the FOMC is confident that it can raise interest rates when the time is right.

None of this points to a precipitous move to boost interest rates quickly. However, the Fed recognizes – and the apparently the FOMC acknowledges to itself – that the policy target on unemployment is close at hand and the trend in core inflation is shifting towards 2%.   Markets and investors will begin to react.  Forecasts of when the Fed might move and what the Fed Funds rate might be at the end of 2015 will be revised to the hawkish side.

The CME Group FedWatch, based on trading in 30 days Fed Funds Futures Contracts, reveals that the probability of a rate hike by next June is above 50-50.   The chart below was captured at 3:50 PM Eastern on October 29^th. See the Fed Funds Probability tool here.

The senior bank loan or leverage loan market as measured by the S&P/LSTA U.S. Leveraged Loan 100 Index ticked up last week as the index has returned +0.10% month-to-date and 1.56% year-to-date.  Last week’s price action of the secondary loan market assisted the index in clawing back against a month-to-date loss from the beginning of the week of -0.51%.  Much of last week’s leveraged loan positive return accompanied a 3.2% rally in equities (S&P 500) and a 0.8% high-yield bond rally as measured by the S&P U.S. Issued High Yield Corporate Bond Index.  Also aiding in last week’s increase in demand for loans was the fact that new-issue launches have slowed to a trickle.

Currently the 10-year Treasury is yielding 2.25%, 2 basis points lower than Friday’s close of 2.27% for the S&P/BGCantor Current 10 Year U.S. Treasury Index.  If the markets are concerned of news from this week’s FOMC Meeting announcements, they haven’t shown it.  To date the more speculative indices S&P/LSTA U.S. Leveraged Loan 100 Index, S&P U.S. Issued High Yield Corporate Bond Index and S&P Municipal Bond High Yield Index are returning 0.10%, 1.11% and a just slightly negative number of -0.16%, respectively.

Market sentiment can change quickly though and if news from the FOMC does undermine the current risk-on environment; leveraged loans could be the least volatile in price.  Compared to the municipal high yield’s 7.35 year duration and the U.S. Issued High Yield’s duration of 4.86%, the weekly reviewed leverage loan index will be least effected to the change in rates.

Following in suit with the colors of the trees, investor sentiment appears to be cycling. While the market may not be trading high-yield junk for investment-grade positions as quickly as New Yorkers are trading in their flip-flops and shorts for scarves and umbrellas last week, market demand has shifted in October. The S&P/BGCantor U.S. Treasury Bond Index, which tracks over USD 7 trillion of outstanding treasury debt, responded to October’s equity volatility with investors moving toward quality. Wednesday, Oct. 15, 2014, risk adverse demand drove up the price of T-bonds; bringing yields down to the lowest end-of-day close in over a year, at 0.92% (see Exhibit 1). The shift in tide was not lost on the municipal bond market.

Thus far, 2014 has seen investors clamoring for yields in a low interest and low supply muni market. High-yield munis have outperformed their investment-grade counterparts. Bonds from the Tobacco Master Settlement Agreement of 1998, tracked by the S&P Municipal Bond Tobacco Index have performed outstandingly this year, up 13.36% YTD. However, up to this point of Q3 2014, high-yielding tobacco bonds have remained flat, at 0.03% (see Exhibit 2).

The S&P Municipal Bond High Yield Index, with a 12.69% return YTD, saw returns go the other way in October, down 0.25% for the month after a mild rebound. A similar trend occurred with the S&P Municipal Yield Index, down 12.04% YTD and down 0.05% MTD, although not as dramatically. The S&P Municipal Yield Index implements a weighted investment strategy based on blended quality (see Exhibit3). The S&P Municipal Bond Investment Grade Index only returned 8.18% YTD, yet saw a jump of 0.61% in October.

The S&P 500 has recovered from the drop off from the week of Oct. 13, 2014, and the sun came out this weekend, however the market is far from a consensus on what the future will hold. The municipal bond market has many variables to consider, along with a multitude of viewpoints. On November 5, 2014, S&P Dow Jones Indices will be hosting their annual Municipal Bond Forum live online and in New York. Industry leaders from top Wall Street firms will be debating the central issues and solutions facing both the economy and municipal bond market. For more information, please attend our Third Annual Municipal Bond Forum—Rising Rates? How to Deal With “Maybe”.  The event will also be live streamed.

By my reading, the recent tone in the investment press and blogosphere has been decidedly, shall we say, anti-active.  Index-based investing has won, active has lost, time for stock pickers and portfolios managers to find new careers.  It’s over.

One of the sharper summations of the zeitgeist comes by way of a recent post from The Banker’s Umbrella.  The author takes a sardonic jab at the life of an equity fund manager:  track the index, naively over/under weight a few names, sit back and collect a performance-be-damned paycheck.  Yes, it’s harsh and perhaps the passive-aggressive (sorry, couldn’t help myself) tack warrants a flag for unnecessary roughness.  But underlying the jab are real trends supported by real research.

Perhaps the most succinct example of that research is William F. Sharpe’s “Arithmetic of Active Management,” which says the average active dollar, after costs, must underperform the average passive dollar.  The proof case for Sharpe’s work is S&P Dow Jones’ regularly-published SPIVA research.  SPIVA demonstrates that the majority of active managers underperform their benchmarks, especially over longer time periods.  SPIVA’s companion piece, the Persistence Scorecard, shows that it’s nigh impossible for any manager to remain among the top performing segment over time.

Trends can shift and it is possible that the anti-active wave may one day swing back to a more favorable view of professional asset managers.  Regardless of prevailing sentiments, however, there remain sound reasons for the superiority of index investing.

Unlike Treasuries and investment grade corporates, the high yield market as measured by the S&P U.S. Issued High Yield Corporate Bond Index touch a low point for yield earlier in the month at a 5.87% on October 6^th.  This market was in the process of selling off and had a yield of 6.51% on October 15^th, up 65 basis points from the 6^th and 38-basis point higher than the 6.13% start to the month.   High yield’s reaction posts October 15th was “risk on” as yields since then moved 60 basis points lower to a current level of 5.91%.  Month-to-date the total return of the index is 1.09% and for the year has returned 4.66%.

After having dropped to a low of 2.13% on October 15^th, the yield of the U.S. 10-year as measured by the S&P/BGCantor Current 10 Year U.S. Treasury Bond Index has risen by 14 basis points to its current 2.28%.  Year-to-date yields are 75 basis points lower than the start of the year.  Though 2.13% is the lowest point for 2014, it is not the lowest for the index which was 1.39% back on July 25^th of 2012.  If the trend is your friend, then expect lower yields in the near future.  If however you think next week’s FOMC meeting will be the event that turns the tides then now would be the inversion point.

Like Treasuries, the yield of the S&P U.S. Issued Investment Grade Corporate Bond Index (2.77%) is 14-basis point higher than the 15^th of the month.  At mid-month, the year-to-date total return of investment grade corporates was at 8.02% but has dropped down to its current 7.03% with the slight move up in yield.  The index is still comparable in return to recent years past, which have ended the year up above 8% except for 2013 in which the index spend most of the year in negative territory.

Source: S&P Dow Jones Indices, 10/23/2014