After the wrenching correction of the last two weeks, both the equities and fixed-income markets have earned themselves a well-deserved respite. Not surprisingly, investors and the financial media are now starting to re-focus on the dramatic interest rate spike and its potentially dampening effect on the economy.
As a case in point, the Wall Street Journal reported that, for the week ended Thursday, the 30-year fixed-rate mortgage averaged 4.46%, up 53 basis points from 3.93% the previous week (the largest weekly increase since the week ended April 17, 1987) and up 80 basis points from a year ago. Such a rate rise should put a dent into refinancing activities. In the short term, however, the spike in mortgage rates may actually spur more potential homebuyers into action out of fear of missing out on the highest level of home affordability in a decade.
Market observers also point to gold’s continuing decline as an indicator of receding inflation fears. Gold prices reached a three-year low this week as selling pressure from gold ETFs overwhelm purchases by central banks worldwide.
Thus, at least for a few days, global financial markets can rest easy on the belief that higher rates will slow down the economy just enough to keep the Fed engaged for quite a while longer, particularly when there is nary a hint of inflation anywhere in the system.
The next major hurdle for both stocks and bonds will be, of course, the June employment report, scheduled for release right after the holiday. The timing of the ADP payrolls report on July 3rd and the actual June employment report on July 5th may make investors too queasy to really enjoy their holiday barbeques.
On the muni side, our prediction for a market bounce by week’s end turned out to be too conservative. We didn’t have to wait until quarter-end after all. Monday’s selling paroxysm created such compelling relative value in the tax-exempt market that by Tuesday, market participants had to reverse course and start buying again. Although it started with crossover buyers looking to capitalize on attractive cross-market ratios, individual investors apparently provided the catalyst for the turnaround, enticed as they were by the possibility of buying 5.00% coupons at par again. According to The Bond Buyer, retail platforms such as BondDesk saw record buy volume this week, even as bid-wanted lists from institutional investors were flooding the market.
As a result, the market rallied back on Wednesday by 20 to 23 basis points in longer-term maturities, the sharpest one-day rebound in munis since the 2008 crisis. Yesterday saw more follow-through action with another drop in yields of about 8 basis points or so.
Curiously, this market turnaround occurred while mutual fund outflows continued to set new records. According to Lipper, for the week ending June 26th, weekly reporting long term muni funds experienced a stunning $2.8 billion in outflows. Their high yield counterparts saw $1.2 billion in redemptions. In fact, the combined $4 billion in outflows represented a historical record since Lipper started keeping track in 1992.
Where does the market go from here?
The continuing redemption flows probably just represented a lagged reaction on the part of mutual fund shareholders. However, one cannot help but wonder if there was a larger “disintermediation” phenomenon at work here. After all, it would’ve made sense for a fund investor to cash out of his or her muni fund, where valuations and dividends may not have caught up to real-time trading levels – given the speed and severity of the correction – and redeploy funds into individual bonds with the precise characteristics he or she needs at much cheaper levels. While this is pure conjecture at this point, we believe it is something worth keeping an eye on, going forward.
Where does the market go from here? We view the last 50 basis points of muni underperformance versus Treasuries as primarily a “liquidity event”, so there may still be room for further relative performance improvement. However, note our emphasis on “relative:” muni performance from here on will still depend on a stable Treasury market. Should volatility return to the fixed-income markets as a result of say, much stronger economic data, municipals may not hold their ground for long.
It is also possible that a further rebound in munis will be seen as a selling opportunity from those traders who got caught with significant inventory this time around. If history is any indication, the price lows reached on Tuesday may be retested at least once more this year and they have to hold before a bottom can truly be established.
One of the key beneficiaries of the market bounce had to be the State of Illinois’ $1.3 billion G.O. issue. Even in the depths of the selloff, the initial price talk of +180 basis points over AAA, which worked out to a 5.95% yield for the 25 year maturity, was already an attractive relative value. No wonder it ended up more than 6 times oversubscribed by the time it was released. Once the rally got going, the deal benefited from both lower absolute yields and slightly tighter credit spreads. In the end, Illinois’ cost of capital ended up at 5.65% for its long-term maturity, for a spread of +160 versus AAA.
Needless to say, the deal was a “success” only in a relative sense, as the spread was still wider than the 145 basis points the state paid for its previous G.O. issue back in April. Absolute yield levels have also risen sharply since, so the cost to Illinois taxpayers, attributable to the state legislature’s failure to pass pension reform, was quite real.
In next Tuesday’s column, we’ll attempt to draw some conclusions from this week’s market debacle and subsequent rebound.
Disclaimer: The opinions and statements expressed in this column are solely those of the author and Axios Advisors, who are solely responsible for the accuracy and completeness of this column. This column does not reflect the position or views of RICIC, LLC or MuniNetGuide.
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