Corporate Bond Spreads – The Daily Tearsheet

Morning Report: Negative yielding corporate debt.

Vital Statistics:

	Last	Change
S&P futures	3020	5.35
Oil (WTI)	60.39	0.19
10 year government bond yield		2.11%
30 year fixed rate mortgage		4.13%

Stocks are higher as we kick off earnings season. Bonds and MBS are up.

The upcoming week will be dominated by bank earnings. The economic data is unlikely to be market-moving, however we will get some real-estate related data with housing starts and homebuilder sentiment. We will also get retail sales, industrial production and capacity utilization.

Citigroup reported earnings this morning that beat Street estimates. Mortgage banking revenues were down 2% QOQ and down 9% YOY.

Manufacturing activity in New York State rebounded last month, climbing out of negative territory. New Orders were flat, shipments improved, while employment hit the lowest level in 3 years.

Europe is used to negative yields on sovereign debt, with the German Bund yielding -29 basis points. In other words, you are paying 105.25 to get back 100 in 10 years, along with some interest. That is strange enough, in of itself, but how about this? Corporate bonds trading with negative yields. Don’t believe it? US jar maker Ball Corp, maker of the mason jar, trades at a yield of -20 basis points and matures in 18 months. Why would any investor buy that? Because the principal hit will be less than deposit rates of -40 basis points or 18 month German paper yielding -70 basis points. It is a fascinating study of the law of unintended consequences. The whole point of negative interest rates is to push investors to get out of safe haven sovereign debt and take some risk – specifically lending money to businesses that need it. The whole point of this exercise is to increase the amount of credit in the system in order to fuel economic growth. However, instead of providing financing to nascent businesses who could be the growth drivers of tomorrow, they are lending money to a company that makes jars (hardly emerging technology) instead.

A portfolio manager at Janus Capital explained it as follows: “A bond like Ball Corp’s is “a safe place to hang out,” [Janus Capital Portfolio Manager Tim] Winstone said. “And just because something is negative yielding, that doesn’t mean it can’t get more negative yielding.” In other words, we are in greater fool territory. Fun fact: around 2% of the European junk bond market trades at negative yields. In fact, Winstone says that about 24% of the European investment grade market trades at negative yields. It isn’t entirely irrational – money managers are making a bet on further central bank stimulus and are positioning themselves to reap capital gains on negative yielding paper, which means they could end up making a positive return despite a negative yield headwind.

John Maynard Keynes once advocated inflation as the “euthanasia of the rentier class.” In reality it may turn out that negative interest rates will do the job. Fascinating times we live in.

Morning Report: Blowout jobs report

Vital Statistics:

	Last	Change
S&P futures	2752	12.25
Eurostoxx index	364.42	2.24
Oil (WTI)	63.42	-0.46
10 year government bond yield		3.18%
30 year fixed rate mortgage		4.89%

Stocks are higher this morning after a strong employment report. Bonds and MBS are down.

Jobs report data dump:

Nonfarm payrolls up 250,000
Unemployment rate 3.7%
Average hourly earnings up 3.1%
Labor force participation rate 62.9%
Employment-Population ratio 60.6%

Overall, an exceptionally strong report, with nothing to dislike. Strong wage growth, increasing labor utilization rates, low unemployment. Simply put, this is a blowout jobs report, the best we have seen in years.

The sell-off in the stock market was beginning to push the Fed Funds futures towards the dovish direction, but this report pretty much ended that. While we will get one more job report before the December FOMC meeting, it is looking like we are going to see another 25 basis points.

Productivity increased 2.2% in the third quarter, which was a deceleration from the 2.9% we saw in Q2. Unit labor costs rose 1.2%. We are seeing rising compensation costs (up 3.5%) while output is also up. Rising comp costs are much higher than the inflation rate, and while it is easy to focus solely on wages, the cost of an employee is more than just wages – it includes benefits and other regulatory costs as well.

Construction spending was flat in August and rose 7.2% YOY. Residential construction rose 0.5% MOM and 4.9% YOY. Office and lodging rose smartly on a YOY basis. Interestingly, education building is still going strong, just as the tail end of the Millennial generation is graduating. You would think colleges would figure out how to compete on price, but for the moment they are competing on amenities and infrastructure. Which is partly why college is so expensive. There is going to be a reckoning, IMO when a demographic dearth of students meets falling affordability driven by rising interest rates.

Manufacturing slowed somewhat last month according to the ISM Manufacturing Survey, however it remains robust, despite what is going on with trade. That said, many of the comments from survey participants noted that prices are rising, partially driven by tariffs. Supply lines are stretched and more firms are running at capacity. That said, the higher anecdotal capacity utilization isn’t translating into the numbers, at least not compared to historical norms:

Rising interest rates have pulled back corporate bond issuance. Corporate bond issuance is often the canary in the coal mine for the economy and therefore bears watching. Many companies tapped the markets during the ZIRP years to refinance pre-crisis debt and the fund stock buybacks, so perhaps the comparisons aren’t really all that valid. Investor appetite is waning, however that may be due to the fact that shorter duration paper is beginning to earn a return, so funds are getting defensive with the Fed in tightening mode. So far we aren’t seeing a material widening of credit spreads. Still, in the summer of 2007, a few leveraged buyouts were unable to sell the paper from M&A deals, and the buyside went on a buyer’s strike against structured products. At the time, nobody had any idea what it would turn into.

Morning Report: Empire State Outlook dims

Vital Statistics:

	Last	Change
S&P futures	2802	-1
Eurostoxx index	383.92	-1.14
Oil (WTI)	69.81	-1.2
10 Year Government Bond Yield		2.84%
30 Year fixed rate mortgage		4.50%

Markets are flattish as earnings season gets into full swing. Bonds and MBS are flat.

Oil is dropping after US Treasury Secretary Steve Mnuchin said the US could waive some Iranian oil sanctions.

Bank of America reported decent earnings this morning. This is a big week for earnings, with about 200 major companies reporting. The early part of reporting season is generally dominated by the banks.

Jerome Powell will testify in front of Congress on Tuesday and Wednesday. Generally these events don’t yield much in the way of useful info – they are mainly for the benefit of politicians who want to draw attention to some issue that may or may not relate to monetary policy. Expect a lot of questions regarding how a trade war and income inequality will affect growth from Democrats, and expect a lot of questions regarding regulation from Republicans. The prepared remarks are here.

Retail Sales rose 0.5% in June, which was in line with expectations. Ex-autos and gas they rose 0.3% while the control group was flat. May numbers were revised upward. The control group was below expectations, but with the May revisions offset that. Discretionary items (clothing, sporting goods, department stores) declined, which building materials and furnishings rose.

Business Inventories rose 0.4% in May. The inventory-to-sales ratio is down to 1.34 from 1.39 last year.

Business activity in New York State exhibited continued strength in June, according to the New York Fed’s Empire State Manufacturing Survey. While the current conditions index exhibited strength, the outlook has slipped. The survey doesn’t say whether this is being driven by a potential trade war or something else. Planned capital expenditures (a proxy for expansion plans) decreased.

The Atlanta Fed took up their Q2 GDP estimate to 3.9%. Morgan Stanley warns that we are seeing a bit of a sugar rush in the economy courtesy of trade tensions. As companies worry about a potential trade war, they stockpile raw materials and other inputs. This gooses the inventory numbers which makes the current quarter look particularly strong. The problem is that you get a double whammy if the trade war materializes. Activity will drop, and that inventory will be liquidated, both of which will reduce GDP growth. Even if a trade war doesn’t happen, uncertainty could cause companies to pull in their horns. FWIW, I am skeptical of the “uncertainty” argument. Regulatory “uncertainty” out of DC generally causes companies to be cautious. The rest of the clatter is just noise. Certainly investors (judging by the S&P 500) aren’t worried.

One stat to watch: Corporate bond spreads. We are seeing a slight widening in some of the junkier investment grade debt. Baa spreads increased to 200 basis points from 165 in February. While spreads are still tight relative to historic levels, this is something to watch. Years of financial repression have given issuers the upper hand with regards to covenants and some of those chickens will come home to roost in the next recession.