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Food Price Inflation and El Nino Possibility

High Yield Gives Up Ground To Investment Grade

Fed Policy and Congress: Janet Yellen Speaks

How Did The Chinese Bonds Perform in 1H 2014?

Weighing In: Reaching Your Goal Weight

Food Price Inflation and El Nino Possibility

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Bluford Putnam

Managing Director and Chief Economist

CME Group

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Food price inflation is increasing sharply in the US. Only last December 2013, food prices were just 1.05% higher than the previous December. As of May 2014, food price inflation was running at 2.46% (year over year) and possibly heading above 4% by late 2014 or early 2015. Now, the Federal Reserve (Fed) prefers to target core inflation, which leaves out the volatile food and energy sectors. When food inflation is rising along with incremental increases in core inflation, however, the Fed can be expected to take this into consideration. Further, if the incremental increases in core inflation come along at the same time as the unemployment rate declines below 6%, which we expect to happen in the second half of 2014, then the probabilities increase for the Fed to raise its target federal funds rate sooner rather than later in 2015.

Higher food prices in the US are primarily related to the droughts in the vegetable and fruit growing areas of California as well as the livestock regions around north Texas and southern and western Oklahoma. And, even as we monitor the drought in California, it is important to note that there are signs over the equatorial Pacific Ocean of the warmer than usual water temperatures that have the potential to give rise to an El Niño event. If, and this is by no means a certainty yet, an El Niño event develops, then the impact on weather patterns around the world can be quite striking, yet with many of the effects coming with a lag. The direct impact of warmer water is more evaporation and then more precipitation, depending on where the winds blow. And because El Niño events are associated with oscillations in air pressure patterns, wind and jet stream track shifts can drive where the rain (or snow) falls and where it does not. If an El Niño event occurs, we would expect more rain in Ecuador and Peru, southern Brazil and northern Argentina, but less rain in Australia.

The impact on the US tends to come with a little longer time lag and eventually may involve a stronger storm track across the southern parts of the US and less stormy and milder winters in the northern sections of the country. The California drought could be eased in the process, but with a greater probability of quite severe weather. Hurricane formation is impacted by the shifting wind patterns, which can lessen the ability of the storms to develop off the west coast of Africa in the tropical Atlantic. Hurricanes may still form, as Arthur did in early July, in the warm waters southeast of Florida and in the Caribbean Islands. What El Niño events underscore is how connected world weather patterns are, which emphasizes the global nature of agricultural markets.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

High Yield Gives Up Ground To Investment Grade

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Kevin Horan

Director, Fixed Income Indices

S&P Dow Jones Indices

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After having risen 19 basis points the first week of July, the yield on the S&P/BGCantor Current 10 Year U.S. Treasury Bond Index dropped 20 basis points from the July 3rd 2.72% to its current 2.52%, offsetting the initial increase.  The move up in yield to start July was the largest weekly jump since last August (8/16/2013), while last week’s rally moving yields downward was the largest weekly move in yield since a 31 basis point rally back on June 1st of 2012.  Last week also brought news that the Fed plans to end its tapering activity by October of this year.

Not quite out of the news headlines yet, Puerto Rican municipal bond yields are at 8.13%, right where they began the week, as measured by the S&P Municipal Bond Puerto Rico Index.  Performance of this index year-to-date has returned 0.43% after being as high as 10.65% on May 30th.  Performance for the month the index is down -5.2%.  The yield of the broader S&P Municipal Bond Index also remained unchanged on the week at a 2.67% though unlike Puerto Rico, the broad index is returning 5.59% year-to-date.

Investment grade bonds as measured by the S&P U.S. Issued Investment Grade Corporate Bond Index turned it up a notch as the index’s yield tightened by 9 basis points on the week to a 2.76%.  Year-to-date this index is now returning more than its high yield counterpart with a year-to-date return of 5.68%.  Last week’s performance added 0.81%, more than enough to offset the prior week’s negative 0.61% that started July.

As mentioned, the S&P U.S. Issued High Yield Corporate Bond Index has returned 5.38% year-to-date.  Last week the index gave up 0.12% for total return after a relatively flat prior week and a string of positive weekly performance since March of this year.  While the yield of the investment grade index moved down by 9 basis points last week, the yield of the high yield index moved the same 9 basis points but upward to a 5.04%.

Continuing to yield 4.34%, the S&P/LSTA U.S. Leveraged Loan 100 Index has returned +0.08% month-to-date while the similar credit of high yield was down -0.15%.  Year-to-date the senior loan index has returned 2.56%.

The S&P U.S. Preferred Stock Index’stotal return is up 0.55% on the month while equities as measured by the S&P 500®are returning a very close 0.45%.  Year-to-date total return performance is not even close as preferreds are outperforming the equity markets returning a total return of 11.64% compared to the equity markets total return of 7.62%

There are no Monday economic releases for this week, but the rest of the calendar should pack a punch.  As the strength of the recovery is still in question, Tuesday’s release of the Empire Manufacturing Survey (17 expected, 19.28 prior) along with the June month-over-month Advance Retail Sales (0.6%exp., 0.3% prior) should shed some insight to the debate.  The June Import Price Index (0.4% exp) is also set to be released for Tuesday.  MBA Mortgage Applications (1.9% prior) along with June’s PPI (Producer Price Index (0.2% exp., -0.2% prior) and Industrial Production (0.3% exp., 0.6% prior) will make for a busy Wednesday.  After the “hump-day”, Housing Starts (1020k exp.), Initial Jobless Claims (310k exp., 304k prior) and the Philadelphia Fed Business Outlook (16 vs. 17.8 prior) will follow.  The week will close with the release of both the University of Michigan Confidence number (83 exp. vs. 82.5 prior) and the Conference Board of U.S. Leading Index which is expected to be unchanged from its prior release at a 0.5%.  The Leading Index gives an indication of the future state of the economy.

Source: S&P Dow Jones Indices, Data as of 7/11/2014, Leveraged Loan data as of 7/13/2014.

 

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Fed Policy and Congress: Janet Yellen Speaks

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David Blitzer

Managing Director and Chairman of the Index Committee

S&P Dow Jones Indices

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Fed Chair Janet Yellen testifies on Tuesday and Wednesday this week to House and Senate Committees as part of the Fed’s mid-year report on monetary policy.  Last week’s release of the FOMC minutes from the June 17-18 meeting set the stage for this week’s testimony and questions.   The big question — when will the Fed begin raising interest rates – won’t get an answer from Mrs. Yellen.  The consensus guess is mid-2015; since the release of the minutes and the May employment report many analysts have moved their dates closer to now.

Other questions were answered and will probably be debated.  While the current round of quantitative easing and bond buying will end in October, the Fed will continue to reinvest funds from coupon interest and maturing bonds until sometime after they begin raising interest rates.  Yes, the Fed noted the recent uptick in some inflation measures which occasioned a lot of discussion among bloggers, and no, it is not worried about inflation and won’t respond with higher interest rates out of fears of inflation.

After some ups and down last week, the stock market will be listening with care.  Given the FOMC minutes and the recent tone of Fed comments, the testimony shouldn’t send stocks into a tailspin.  Comments on the economy will be neutral at best and won’t encourage any buying or upward revisions of earnings estimates.  Old-line monetarists who worry a lot about inflation may be even more worried given Janet Yellen’s earlier comments on inflation.   The wild card in the Q&A sessions in both the House and the Senate could be comments by a minority who want to hobble the Fed by forcing it to follow arbitrary policy rules or build a wall between interest rate policy and all bank regulation.  Some in Congress are jealous of the Fed’s policy-making power or don’t wish to recognize the crucial and successful role it played during the financial crisis. Remarks about the Fed’s structure will only heighten uncertainty about future monetary policy.

Most of the questions from representatives and senators are likely to focus on the economy and recovery, but a few may get wonkish and discuss how, not when, the Fed will raise interest rates.  One of the long running complaints about quantitative easing is that it flooded the banking system with excess reserves. Initially some feared that all that money would create inflation; it hasn’t. Now the question will be how to raise interest rates when it is impossible to drain enough excess reserves to create upward pressure on the fed funds rate.  The FOMC minutes covered this issue., The Fed will continue to pay interest on excess reserves (IOER) and this rate will be a key policy tool going forward, Second, the Fed will establish an overnight reverse repurchase facility to supplement the IOER and drain reserves for brief time periods.

The FOMC did note one challenge it will face, both with Congress and the markets.  With new policy tools, it will need to explain and educate both sets of constituents about what it is doing and how things will work.  This week’s testimony may be an early signal of this education effort.

Stay tuned this week for the testimony and what it all means.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

How Did The Chinese Bonds Perform in 1H 2014?

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Michele Leung

Director, Fixed Income Indices

S&P Dow Jones Indices

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As the Chinese bond market rapidly expands, reaching almost CNY 30 trillion, it has gained an increasing amount of attention from global investors.  Tracked by the S&P China Bond Index, the total return of the CNY-denominated bonds rose 5.7% in the 1H of 2014.

While the risk of default put downward pressure to the Chinese corporates in the beginning of year, the sentiment improved as the government strives to roll out financial reforms and promote growth. The S&P China Corporate Bond Index managed to retreat from the lows and delivered a total return of 5.98%, which outperformed the S&P China Government Bond Index in the same period. Please see Exhibit 1 below.

While both Chinese government and corporate bonds traded tighter, the yield of the S&P China Corporate Bond Index tightened by 91bps to 5.56%, as of June 30, 2014. Notably, the yields of the sector level indices – S&P China Services Bond Index and S&P China Utilities Bond Index tightened by 1.08% and 1.14% respectively.

The Chinese government continues to support the economy while carrying out financial and capital market reforms.  For example, the China Banking Regulatory Commission (CBRC) recently announced changes in the calculation of the Loan to Deposit Ratio (LDR). The ratio is adjusted by exempting certain loans (i.e. backed by financial bonds) and including Negotiable Certificate of Deposits (NCDs) and certain offshore deposits.

Separately, the regulatory support for offshore RMB business also accelerated, three offshore RMB clearing banks were established in London, Frankfurt and Seoul, while Paris and Luxembourg are the next potential candidates.

Exhibit 1: Total Return Performance of the S&P China Bond Index 

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Source: S&P Dow Jones Indices.  Data as of June 30, 2014.  Charts are provided for illustrative purposes.  Past performance is not a guarantee of future results.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Weighing In: Reaching Your Goal Weight

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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“Weighing In:” will be a series of posts comparing and contrasting the impact of different weighting schemes within commodity indices. The series will be the first to feature our two headline indices, the equally weighted Dow Jones Commodity Index (DJCI) and the world production weighted S&P GSCI.  The purpose of the series is to help you reach your portfolio goals by understanding the effect of weighting inside commodity indices. We will kick off with a description of the difference between the two major weighting schemes, and in subsequent discussions will analyze the historical behaviors of each of the indices.

Both the DJCI and S&P GSCI have the same methodologies with the exception of the weighting schemes and the rebalance periods back to their respective target weights. The resulting index compositions differ dramatically. See below for a comparative snapshot of weights as of July 9, 2014:

Source: S&P Dow Jones Indices.
Source: S&P Dow Jones Indices.

Notice the significant difference in the weights, especially in energy where the DJCI has 33.8% and the S&P GSCI has an energy weight of 72.1%. Also notice the relatively low weight in the S&P GSCI of metals at 9.6% versus 35.5% in the DJCI, and lower agriculture and livestock weight 18.2% in the S&P GSCI versus 30.7% weight in the DJCI.

Why is this?

Again, It is from the different weighting methods between the indices. The DJCI is an equally weighted index where step one is to liquidity weight each commodity by a 5 year average of total dollar value traded. Next the commodities are grouped into components by their physical similarities and correlations to apply caps to further diversify. The caps are applied so that no more than one component is greater than 32% and no subsequent component is greater than 17%. This is done in an interative process until the requirement is filled. Last the sectors are limited to 33% each and this is rebalanced quarterly.  The goal is to incorporate diversification and liquidity as the intrinsic characteristics of the index.

The S&P GSCI is a world production weighted index where the goal is to reflect the relative significance of each of the constituent commodities to the world economy, while preserving the tradability of the index by limiting eligible contracts to those with adequate liquidity.

With respect to each Designated Contract, a Contract Production Weight (CPW) is calculated based on world production and trading volume. The final CPWs are rounded to seven digits of precision.

The calculation of the CPWs of the Designated Contracts involves a four-step process: (1) determination of the World Production Quantity (WPQ) of each S&P GSCI Commodity, (2) determination of the World Production Average (WPA) of each S&P GSCI Commodity over the WPQ Period, (3) calculation of the CPW based on the Contract’s percentage of the relevant Total Quantity Traded (TQT), and (4) certain adjustments to the CPWs.

World Production Quantity (WPQ)

The WPQ of each S&P GSCI Commodity is equal to the total world production of the S&P GSCI Commodity over the WPQ Period.

The use of the five-year WPQ Period (and the averaging of that five-year period to determine the WPAs) is intended to mitigate the effect of any aberrational years with respect to the production of a particular commodity.  For example, if a given commodity is produced primarily in one part of the world that suffers damage from hurricanes or earthquakes in a particular year, resulting in curtailed production levels, the use of that year’s production figures might not accurately reflect the significance of the commodity to the world economy.  Commodity production in a particular year may also be higher or lower than would normally be the case as a result of general production cycles, supply and demand cycles, or worldwide economic conditions.  Measuring production levels over a five-year period should generally smooth out any such aberrational years.

The definition of the WPQ Period imposes a delay of approximately one-and-one-half (1 ½) years between the end of the WPQ Period and the end of the relevant Annual Calculation Period.  This delay is because world production statistics are often incomplete and subject to revision after their original publication.  Imposing a delay on the WPQ Period generally enhances their accuracy and reliability.

The WPQ Period is defined as the most recent five-year period for which complete world production data is available for all S&P GSCI Commodities from sources determined by S&P Indices to be reasonably accurate and reliable. This procedure is intended to assure that the same WPQ Period is used for all S&P GSCI Commodities, which allows comparisons between production figures to be made without taking into account temporary aberrations in different time periods.

World Production Average (WPA)

The WPA is simply the average annual production amount of the S&P GSCI Commodity based on the WPQ over a five-year period.

Contract Production Weight (CPW)

In calculating the CPW of each Designated Contract on a particular S&P GSCI Commodity, the WPA of such Commodity is allocated to those Designated Contracts that can best support liquidity. 

With respect to each Designated Contract, the CPW is equal to the Percentage TQT for such Contract multiplied by the WPA of the underlying S&P GSCI Commodity (after any necessary conversion made for purposes of the calculation) and divided by 1,000,000.

The simpler of the two is the equally weighted DJCI. However, both indices are used as asset class representations in order to fulfill different portfolio goals.  The most popular reasons investors use commodity indices are for diversification and inflation protection, so we will evaluate the historical effectiveness of both indices in these roles. Additionally, we may explore how well each of the indices fills requirements of other motivations behind commodity allocations such as liquidity, emerging markets exposure, or hedging against rising interest rates.

 

The posts on this blog are opinions, not advice. Please read our Disclaimers.