The average spread in the Morningstar Corporate Bond Index rallied more than 12 basis points last Thursday to +143. This rally was in response to Federal Reserve chairman Ben Bernanke's assertion that he expected the Fed would continue its highly accommodative policy for the foreseeable future.
While the media hype sent the markets higher, we don't think there is any substantive change in his policy stance since the Q&A session following the Federal Open Market Committee meeting June 19. We think Bernanke has been crystal clear that the Fed would begin to taper asset purchases as early as this autumn and end all purchases by next summer if the economy and the unemployment rate develop as the Federal Open Market Committee expects. According to the meeting minutes, it appears that the opinion to begin tapering the asset-purchase programme sooner rather than later is gaining traction as "several members judged that a reduction in asset purchases would likely soon be warranted." In addition to the strength or weakness of economic and unemployment metrics in the second half of this year, technical factors in the bond market may force the Fed's hand to begin tapering. The government's monthly deficit has been declining as a result of increased tax revenue, reduced spending increases from sequestration, and dividend payments from Fannie Mae and Freddie Mac. As such, the Treasury will not need to issue as much debt in the second half of this year and there will be less debt issued for the Fed to monetise. Considering that the Fed already owns a substantial amount of long-dated Treasuries, it will become increasingly difficult for the Fed to source bonds, causing even greater problems in the Treasury repo market.
The Fed has left itself a way to get out of tapering in the second half of this year--if the economy does not progress as it forecasts. In conjunction with the FOMC's statement June 19, the Fed released its updated economic projections. The increased forecasts surprised Bob Johnson, Morningstar's director of economic analysis, who wrote, "I suppose the only real surprise is that the Fed outlook for the economy is remarkably more bullish--too much so, in my mind. Its forecast for 2013 [US] GDP growth is 2.3%-2.5% compared with my forecast of 2.0%-2.25%. For 2014 it is even more bullish, estimating 3.0%-3.5% growth compared with my forecast of 2.0%-2.5%. The Fed also lowered its inflation forecast and significantly lowered its expectations for the unemployment rate, one of the announced key drivers of Fed policy."
Forecasts for Global Economic Growth Continue to Deteriorate
The International Monetary Fund reduced its forecast for global GDP growth to 3.1% from 3.3% last April and cut its projections for economic growth in the emerging market to 5.0% from 5.3%. Supporting the IMF's reduced projections, China released a greater-than-expected drop in June exports of 3.1% due to weak global demand. This drop comes on top of a soft 1% growth rate last year. Recent comments from several Chinese government officials appear to be trying to talk down the markets' expectations for second-quarter GDP. Consensus estimates call for 7.5% year-over-year growth in the second quarter, slower than the 7.7% in the first quarter and 7.9% in the fourth quarter of 2012. However, many economists are revisiting their assumptions as it appears that Chinese policymakers may be more tolerant of slower growth in the near term in order to wring out speculative excesses in the real estate market. Considering China is the second-largest economy in the world, slowing growth will have a domino effect across the globe, especially in the resource-rich nations that have supported their own economies by exporting raw materials to feed China's ravenous appetite.
ECB Holds Short-Term Rates Low; Evaluating Other Monetary Programmes
The European Central Bank held its short-term lending rate at 0.5% in July, indicating that it would keep rates low for an extended period. The ECB also wouldn't rule out extending a new round of loans to the banking system if growth weakens or liquidity tightens. In an interview last week, ECB board member Joerg Asmussen from Germany remarked that the ECB may keep its short-term rate low beyond 12 months. When even the Germans (who are culturally opposed to even a hint of inflation) are advocating extended low rates, you know easy money policies are here to stay. We continue to think that the ECB is evaluating other economic support measures such as securitised small-business loan pools or asset purchases, but that it is holding these potential programmes in reserve in case the debt crisis returns in Europe. For now, so long as yields on the peripheral sovereign bonds and credit spreads for the banking system remain contained, the ECB will be content to use language to prod economic recovery as opposed to instituting new monetary programmes.
New Issue Market Testing the Waters
A few issuers came out of the woodwork to access the bond market last week, but for the most part, it was relatively quiet in the new issue market. New issue concessions indicated in the whisper numbers started off at attractive levels around 20-25 basis points, but tightened to 10-20 basis points in official price talk and tightened further to 5-15 basis points by the time the deals were launched.
Assuming the 10-year Treasury stays range-bound and credit spreads hold their gains, we expect the volume in the new issue market should pick back up. Based on the market volatility since the FOMC meeting, we suspect there is a strong backlog of issuers that have held back and are waiting for calmer waters. Considering there are only two and a half weeks until the seasonal August slowdown in the corporate bond market, we expect those issuers that have held off, along with the typical new issue volume, may make for a couple of busy weeks.
