Municipal Fixed Income Weekly

June 23, 2017


Municipal Fixed Income Weekly

June 23, 2017


Key Themes for the Upcoming Week

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  • Wilmington Trust Investment Advisors' economics team authored an epilogue to the 14 June Federal Open Market Committee (FOMC) meeting: Fed speakers were busy with comments on the economic outlook this past week. Dallas Fed President Robert Kaplan (an FOMC voter, neutral bias) supported the FOMC's last rate hike at the June meeting, but would now like to see confirmation in data that weakness in inflation was transitory before raising rates. He also said “muted” 10-year yields suggest expectations for sluggish economic growth, and “I want to take that into account.” More on the economy and the FOMC in the first section of this edition.
  • On balance, momentum appears to be in favor of a robust municipal market going into next week. The yield curve was steady throughout the past five trading days and while the first week of summer's trading began with a traditionally sluggish start, trailing 5-day volume concluded at $55.945 billion, slightly better than the $53.144 billion 6-month average.
  • Considering both supply and demand, it seems to us that a shortage of new issuance appears to be a stronger force than the positive, but relatively feeble demand as measured by mutual fund flows. Should the year-over-year deficit of new supply persist, and negative news remains absent from the headlines, we believe demand will slowly march forward in similar fashion as it has thus far in 2017. We remain constructive on the investment grade municipal market for the near term.
  • Core Narrative: the municipal bond market seemed to stall last week. While trailing 5-day volume finished at about $55.945 billion, $9.873 billion higher than last week's $46.071 billion in par value, the yield curve was practically directionless, ending stronger by 1bp on the long end. In view of the current supply-demand equilibrium, it seems to us that a scarcity of new issuance gives the impression of being a stronger force than demand. We believe demand will hang on for the time being. As such, we remain constructive on the investment grade municipal market for the near term.
The Economy and the Fed
As a backdrop to last week's domestic fixed income market performance, Wilmington Trust Investment Advisors' economics team, led by chief economist Luke Tilley, authored an epilogue to the 14 June Federal Open Market Committee's decision to raise its Fed Funds rate target range to 1.00%-1.25%, from 0.75%-1.00%:

Fed speakers were busy with comments on the economic outlook this [past] week. Dallas Fed President Robert Kaplan (an FOMC voter, neutral bias) supported the FOMC's last rate hike at the June meeting, but would now like to see confirmation in data that weakness in inflation was transitory before raising rates. He also said “muted” 10-year yields suggest expectations for sluggish economic growth, and “I want to take that into account.” Chicago Fed President Evans (voter, dovish bias) suggested that “we could wait until the end of the year” to hike rates, as he would like to see if the softness in inflation abates. In our view, this is a bit of a surprise that he is even mentioning hiking given that he is usually dovish. In addition, he mentioned that he is wondering if there is something “more global, more technological that's taking place that we don't quite have our arms around very well.” He also said “I think we are at the point where we can make a decision to start reducing the balance sheet at any time.” Minneapolis Fed President Kashkari (voter, dovish), who opposed the rate hike last week, said it was a mistake to raise rates with inflation so far below target, and would want to see inflation pick up before supporting another rate hike. St. Louis Fed President James Bullard (non-voter, dovish), said that the Fed should begin shrinking its balance sheet “sooner rather than later,” but thinks the projection to raise the Fed Funds rate to 3% over the next two and a half years is “unnecessarily aggressive,” and while being open to the idea that inflation was caused by transitory factors, is worried that it is more broad based with 10-year Treasury yields so low and oil prices falling.

Yield Curve
This past week had a rather light economic calendar, and domestic fixed income markets remained in a narrow trading range for the first three trading days. The 10-year U.S. Treasury (UST) note began Monday drawing a 2.144% yield. Then, shortly after the open it briefly dipped to 2.137%. By late afternoon, it moved up its intra-day high of 2.191%, and closed U.S. trading at 2.188%. The Municipal Securities Rulemaking Board (MSRB) reported that a mere $7.697 billion of par value in municipal bonds traded (Fig. 51) and the high-grade curve was unmoved with the exceptions of the 5- and 7-year maturities, which both skirted higher by 1 basis point (bp).

On Tuesday morning, the Current Account Balance printed -$116.8 billion, above the -$123.8 billion survey consensus, but below the revised -$114.0 billion for the previous quarter. Luke Tilley noted that, “The Current Account deficit increased to 2.5% of GDP from 2.4 percent in Q42016. Goods exports increased $13.2 billion to $383.7 billion, mostly reflecting increases in exports of industrial supplies and materials, and in exports of automotive vehicles, parts, and engines.” The UST market seemed to be largely unaffected by the report, and the 10-year note managed to rally a few basis points to finish the day at 2.157%. Municipal volume picked up a little on Tuesday having transacted $9.445 billion in par value, a bit more lively than Monday, but still below the trailing 6-month average of $10.507 billion. Similar to Monday's action, the high-grade municipal curve was untouched for the day, excepting the 5-, 6-, and 7-year points which were stronger by 1bp.

The first day of summer brought Existing Home Sales for the month of May, printing 5.62 million, slightly better than the 5.55 million in the consensus survey and a 1.1% month-over-month increase from the prior print of 5.57 million. Total housing inventory at the end of May rose 2.1% to 1.96 million existing homes available for sale, but is still 8.4% lower than a year ago (2.14 million) and has fallen year-over-year for twenty-four consecutive months. The benchmark 10-year UST managed to rattle around within only a few basis points range, and ended the day drawing a 2.156% yield. The ICE AAA Municipal Yield Curve was once again intact apart from the 7- to 13-year portion of the curve, which strengthened by 1bp.

On Thursday, Initial Jobless Claims came in at 241 thousand, and on Friday, the New Home Sales report printed +2.9% month-over-month for May. By the end of the week, the benchmark 10-year UST was trading at a 2.142% yield, down about 1bp from the previous Friday's close of 2.151%. The ICE AAA Municipal Yield Curve managed to finish the past five trading days unchanged in the scope of the 6-month to the 5-year maturity, as well as the 14- and 15-year points. All other spots were lower by just 1bp.

The Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index yield reset 6bps higher at 0.870% (Fig. 3). That 7-day rate is elevated for the second consecutive week after having fallen six of the past nine weeks, and the topmost figure since 19 April, when it hit a multi-year peak of 0.920%

Ignoring the 6-month spot, last week's change in tax-exempt rates flattened the ICE AAA Municipal Yield Curve by 1bp, front to back, shrinking the difference between the 1- and 30-year yields to 184bps, from 185bps the previous Friday (Fig. 6). At 184bps, the high-grade municipal yield curve is the flattest it has been in 180 days, 59bps lower than its maximum print for that period on 13 March (Fig. 7). The spread between the 2- and 10-year contracted by 1bp, and closed at 90bps on Friday, also the flattest that portion of the curve has been in the past six months (Figs. 8 and 9).

On balance, momentum appears to be in favor of a robust municipal market going in to next week. The yield curve was steady throughout the past five trading days and while the first week of summer's trading began with a traditionally sluggish start, trailing 5-day volume concluded at $55.945 billion, slightly better than the $53.144 billion 6-month average.

Municipal-to-US Treasury (M/UST) Yield Ratios
The UST curve twisted last week, as the 6-month point declined by 2.3bps and the 1-year maturity fell by 0.7bps (Fig. 5). The 2-year UST note's yield edged higher by 2.6bps and the 5-year increased by 1.4bps. Beyond the 7-year point, the UST curve was lower by between roughly 1 and 6bps. With municipal yields unchanged in the short portion of the curve, and lower by 1bp beyond the 7-year point, M/UST ratios were mixed, but mostly altered by simply a small extent. The 1-year M/UST grew 0.418 ratios on the week, to close at 71.066%, while the 2-year M/UST fell by 1.407 ratios to end Friday at 71.375%, down from the prior print of 72.782% (Fig. 21). The 5-year M/UST finished at 71.144%, declining by 0.571 ratios from the previous week's 71.715%, and the 10-year M/UST subtracted a mere 0.021 ratios to close the past five trading days at 86.754% versus the earlier print of 86.775% on the 16th of June. Finally, the largest proportional change was the 30-year M/UST, which ended 1.842 ratios above last week's figure, to finish at 98.675%.

AA Municipal-to-AA Corporate (AAM/AAC) Yield Ratios
Yield ratios for AA municipal bond and senior unsecured AA corporate bonds were also mixed last week. The 1-year AAM/AAC closed the week at 55.735%, 1.127 ratios lower than the preceding Friday's 56.863% (Fig. 28). The 2-year measure inched lower by 0.327 ratios to end the last five trading days at 56.892%. The 5-year printed 59.265%, an increase of only 0.021 ratios from the prior week's 59.243% on the 16th of June, and the 10-year was practically unchanged, printing up 0.094 ratios at 64.678%. The 30-year AAM/AAC added 0.862 ratios to last week's 80.423%, to close on Friday at 81.285%.

Market performance
Municipal market performance was slightly positive last week, with returns for all the indices on which we report ending on dry ground. For the first time in three weeks the S&P Municipal Bond Index produced a positive total return, printing +0.097% (Fig. 35). Still, six of the past eight weeks have generated upbeat performance, and for the first twenty-five weeks of 2017, that broad-based market benchmark has produced +3.705%. The Intermediate, Short-Intermediate, and Short indices closed the week with total returns of +0.062%, +0.040%, and +0.027%, in that order. The California and New York indices finished in the black with performances of +0.110% and +0.103%, respectively. The S&P Municipal Bond Puerto Rico Index handed out a +0.655% total return, the strongest showing in the eight weeks since the five trading days ending the 28th of April, when that benchmark generated +0.678%. The Commonwealth has supplied widely varying weekly returns, both positive and negative. Nevertheless, the island's woes persist, and the S&P Municipal Bond Puerto Rico Index suffers year-to-date performance of -3.479%.

Supply and demand
New issuance for the approaching five trading days should come in a touch light at $6.554 billion, compared to last week's year-to-date record of $11.202 billion (Fig. 49). As of Friday's close, year-to-date municipal bond issuance stood at $185.763 billion, a $31.557 billion or 14.521% shortfall compared to the same period ending 24 June 2016, when supply stood at $217.320 billion. Last week's outsized issuance managed to narrow the year-over-year deficit in supply to a small extent. Nevertheless, 2017's dearth of new municipal deals has probably functioned as a support to prices, keeping yields somewhat suppressed. In January, we forecasted a 10% decline in supply for 2017 against last year's $455 billion in new issuance. While to-date supply is currently 14.521% behind last year, we stand by our $400 billion estimate for 2017. We believe the year-over-year shortage will continue to serve as a constructive contribution to municipal market performance.

Rotating to demand, on Wednesday, the Investment Company Institute (ICI) reported $487 million of net flows into municipal bond funds for the preceding five trading days ending 14 June (Fig. 50). The most recent account was rather scrawny to middling for the most recent string of inflows since the beginning of the year. In fact, as of Wednesday, the 12-week moving average stood at a positive $545 million. In our view, the latest succession of flows is halfhearted contrasted to, for example almost one year ago, when the 12-week moving average on 27 July 2016 stood at a positive $1.550 billion. As we have mentioned in recent issues of this publication, we remain concerned that the positive trend is tenuous. All the same, twenty-two of the twenty-four weeks reported so far in 2017 have seen net inflows, with investors ploughing $10.992 billion of capital into municipal bond mutual funds.

On Thursday, the New York Federal Reserve reported that primary dealer firms' municipal bond positions increased by about $1.573 billion versus the previous week. The most recent report of $20.437 billion for the five trading days ending the 14th of June was materially higher than the prior $18.864 billion reported for the 7th of June (Fig. 52). Primary dealers' largest positions still reside in maturities beyond 10 years with that category representing 56% of their collective municipal bond holdings, followed by variable rate demand notes (VRDNs), which represent about 20%.

Considering both supply and demand, it seems to us that a shortage of new issuance appears to be a stronger force than the positive, but relatively feeble demand as measured by mutual fund flows. Should the year-over-year deficit of new supply persist, and negative news remains absent from the headlines, we believe demand will slowly march forward in similar fashion as it has thus far in 2017. We remain constructive on the investment grade municipal market for the near term.

Market Sentiment
On Friday, the sell-side recorded a less optimistic outlook for the tax-exempt bond market over the near-term horizon and moved unambiguously into the neutral zone. For the 1-week view, Thomson Reuters Municipal Market Data noted that traders eliminated their collective bullish view, taking that category to nil, the first time to print 0% since the 02 June survey (Fig. 53). The neutral group jumped 38% to 67%, up from 29% the prior week. The bearish crowd declined by 10%, printing 33% for the one-week outlook.

Looking out 1-2 months, traders scored 0% under the bullish banner for the second week in a row (Fig. 54). The neutral division slipped by 4 percentage points to 83%, only a slim drop from 87% in the previous survey. The bearish class printed 17%, up from 13% on the 16th of June.

Taking a quick look at the next week, buy-side attitudes drifted away from the being at all bullish. Portfolio managers failed to show up in the bullish category for the 1-week outlook the first time in four weeks, down from 20% in the last review (Fig. 55). The neutral group rose to 75%, while the bearish set edged higher to 25%, up from 20% on the 16th of June.

Buy-side investors became completely neutral for the 1-2 months horizon, as 100% of contributors scored in that category, the first time for such an occurrence in over two years (Fig. 56).

The most recent assessment had 83% of dealers describing their inventories as light, while 17% scored in the heavy category (Fig. 57). Dealers have registered their inventories as heavy only eleven times in the past two years. The most recent positive score prior to last Friday's reading occurred five weeks ago on the 19th of May; that number was 17%, as well. No participants labeled their positions as medium.

Core Narrative
The municipal bond market seemed to stall last week. While trailing 5-day volume finished at about $55.945 billion, $9.873 billion higher than last week's $46.071 billion in par value, the yield curve was practically directionless, ending stronger by 1bp on the long end. In view of the current supply-demand equilibrium, it seems to us that a scarcity of new issuance gives the impression of being a stronger force than demand. Should the year-over-year insufficiency of new supply keep on, and if negative news remains absent from the headlines, we believe demand will hang on for the time being. As such, we remain constructive on the investment grade municipal market for the near term.





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