U.S. equities whipsawed back and forth yesterday, closing in negative territory, albeit better than the lows of the day. After opening significantly higher on solid earnings report, the Dow, Nasdaq, and S&P 500 all retraced lower into the afternoon on fears that the economy continues to risk double dip. For the day, the Dow actually traded in a volatile 200 point range ultimately closing down 30 points for the day. The afternoon push higher was somewhat impressive, but hasn’t carried forward to today as futures are pointing to a weaker opening. There is a tremendous tug of war occurring between solid earnings, in which 70%+ of reporting companies have beat expectations, versus a softening in economic data. This trend will most likely continue and keep stocks range bound. From a technical perspective, 1115 looks like the important resistance level to the upside on the SP 500 (closed yesterday at 1101.53), that if breached could propel the market higher. After closing at 1115 on Monday, the market failed to sustain that level and has tested it twice this week only to move lower. On the other hand, 1090 is the critical support level to the downside that could ignite another sell-off if we trade below that level. If I was a stock market guru, which I’m not, I would consider getting long stocks if we move above 1115 and consider selling if we move below 1090. Hopefully we hit 1115!
On the treasury front, the theme remains the same. Yields move slightly higher when stocks rally, while yields fall more severely when stocks sell-off. After the 2-year treasury hit .66% on Monday, it is now trading around .55%, an 11 basis point move in three days. Similarly, the 10-year treasury yield is back down to 2.94% after touching 3.06% earlier this week. The failure of rates to move higher as stocks rally is a telling sign that the outlook for economic growth is subdued (As an aside, we will get a look at 2nd qtr GDP this morning at 8:30 , which is expected to come in at 2.6%). It is even more telling in the face of significant new issue treasury auctions this week, which obviously all went well. Clearly deflation is a primary concern and it is very interesting what Fed Bank of St. Louis President James Bullard said in a research piece yesterday, “The U.S. is closer to a Japanese-style outcome today than at any time in recent history. A better policy response to a negative shock is to expand the quantitative easing program through the purchase of treasury securities.” Again, there is no question that the Fed is keenly concerned about the potential for deflation, as entering a deflationary cycle is an extremely difficult environment to reverse…….just ask Japan!
In regards to the capital markets, a combination of lower treasury yields and tightening spreads has once again freed up credit for corporations and municipalities seeking to issue debt. Absolute yields, particularly for investment grade issues, are falling to record lows. As an example, U.S. Bancorp (USB) issued new 5-year bonds at a 2.45% yield, one of the lowest ever paid by a bank. Muni yields, both tax-exempt and taxable, also continue to fall across the curve particularly for the cleaner credits, while mortgage backed security (mbs) prices hit record highs once again yesterday. The lower financing costs should enable issuers a better ability to manage budgets and balance sheets going forward, creating significant profit opportunities for them down the road.
On the fixed income front, declining yields are making it more and more difficult to find attractive assets. The reality is that lack of robust loan demand coupled with massive amounts of excess liquidity are chasing investment yields lower as banks, insurance companies, asset managers, etc are searching for yields. Consider the possibility for deflation and yields could remain low for some time. With that rosy outlook as the backdrop, we continue to recommend opportunistically rebalancing the portfolio. Consider taking gains within the mbs portfolio, particularly on structures that exhibit erratic and accelerating cash flows (smaller pools, arms, higher coupon collateral, etc). Why not sell a bond at a premium today rather than get taken out at par as prepayments accelerate. Consider selectively unwinding suspect municipal credits ( i.e.: California, Illinois, Michigan, etc), while bids are strong. Also consider selectively adding cleaner muni credits to the portfolio. While absolute yields have declined, relative spreads to treasuries are historically attractive and, specific to banks, longer duration munis provide an excellent vehicle for a loan surrogate strategy. We also like one time call one time step callable agencies as a defensive play against rising rates and selectively playing in corporates continues to be a place to generate some alpha returns.