Municipal Fixed Income Weekly

June 8, 2018


Municipal Fixed Income Weekly

June 8, 2018


Key Themes for the Upcoming Week

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  • An unusually strong bid at the front of the high-grade municipal curve sent yields tumbling out to the 5-year maturity. Levels beyond that position drifted higher, drawing closer to US Treasury (UST) interest rate movements. The ICE AAA Municipal Yield Curve was stronger by a full 14 basis points (bps) at the 6-month spot, and by 13bps at the 1-year point.
  • As we conjectured in this publication last week, the rally that seemed to stall the prior Wednesday, proved rather fleeting, at least from the intermediate portion of the curve and longer. This past week, most of the upward shift in yields took place on Wednesday. Then, on both Thursday and Friday the high-grade curve remained unperturbed with the exception of a few spots, most notably at the front where strength persisted. Nevertheless, with calm setting in, we think it likely the tax-exempt municipal market could get off quiet start next week.
  • The ICI reported positive mutual fund inflows of $316 million. Despite the most recent account, we remain troubled by the tepid current. We still think retail demand is somewhat unsubstantiated and may wane in the face of lasting negative market performance. Looking forward to the twenty-third ICI Municipal Bond Mutual Fund Flows report for 2018, the next one on the 13th of June, will cover the five trading days ending on 06 June, when the S&P Municipal Bond Index generated a -0.123% return. That performance may have shaken municipal bond investors over that same time frame, and we could see weaker, perhaps even negative net flows in next week's report.
  • Core narrative: the market took a break on Thursday and Friday after mid-week softening. The past five trading sessions seemed to be the retracement, at least in part, of the strength emanating from the news coming out of Italy and Spain a fortnight ago. Nonetheless, the tax-exempt municipal bond market settled into a two-day quiet by the end of the week. We suspect the next couple days will begin with a somewhat calm tone.
The Economy and the Fed
We thank chief economist Luke Tilley, economist Rhea Thomas, and the rest of Wilmington Trust's economics team for lending perspective and weighing in on a few selected highlights from the past week.

US Markets:
Data was solid last week. The ISM Non-Manufacturing Index rebounded in April after dips in the previous two months (+1.8 points to 58.6), holding at elevated levels and continuing to indicate expansion in the services sector, despite comments citing uncertainty around tariffs. The Prices Paid Index edged up to an 8-month high. The JOLTS Job Openings and Labor Turnover Survey continued to highlight a robust labor market in April. Job Openings jumped by more than expected to a new cycle high, with the rate at 4.3%. The Hires Rate edged up one tenth to 3.8%, while the Quits Rate held steady at a cycle high at 2.3%. The trade deficit narrowed by more than expected in April to -$46.2 billion, driven by higher exports, of petroleum goods in particular, while imports edged lower. This suggests support for 2Q GDP growth from net trade. The Atlanta Fed GDPNow forecast ticked down 4.6% from 4.8% at the end of last week.

International Developed:
Eurozone data was sluggish this week on the hard data front. Eurozone Retail Sales showed a tepid +0.1% month-over-month (m/m) gain in April. While Core Retail Sales (Ex-Food and Fuel) were firmer at +1.7% on a year-over-year (y/y) basis, the gain was a recovery after previous months of softness, with gains on a three-month basis flat. German Factory Orders and Industrial Production were both weaker than expected in April, suggesting a soft print for Eurozone-wide Industrial Production this week. These softer data suggest that growth momentum has not picked up at the start of the second quarter. UK Services PMI was stronger than expected, suggesting some increase in growth momentum after soft growth in 1Q.

Emerging Markets:
China's Export Value Growth held steady in May, rising by 12.6% y/y, with demand holding up from other emerging markets, and a rebound in export growth to the U.S. (+11.6% y/y). On a three-month basis, momentum has been slowing though. While global growth still remains solid, ongoing trade tensions could weigh on exports going forward. Import Growth jumped +26.0% y/y reflecting robust domestic demand and higher commodity prices.

Week Ahead:
US CPI Consensus Forecasts look for a +2.8% y/y (+0.2% m/m) reading for the headline, and +2.2% y/y (+0.2% m/m) for Core, as the impact of energy prices feed through. Given the Fed's mention of the inflation target being “symmetric” we expect that the FOMC will tolerate higher inflation in the near term, and we expect CPI to settle lower at the end of 2018. We do not expect the Fed to change the trajectory of its rate hikes if CPI comes out as expected.

Retail Sales will also be a focus. After a solid start to the second quarter with April retail sales +0.3% m/m, consensus forecasts look for a +0.4% m/m reading in May, which would suggest that the consumer continues to be supported by a strong labor market and tax cuts. Eurozone Industrial Production is expected to show a decline in April, with consensus looking for a -0.5% m/m reading, after Germany, Spain, and the Netherlands all showed declines at the country level, though these may be offset somewhat by more muted softness in France and Italy, and a strong gain in Ireland. This would suggest slower growth momentum going into the second quarter.

Yield Curve
An unusually strong bid at the front of the high-grade municipal curve sent yields tumbling out to the 5-year maturity. They drifted higher beyond that position, drawing closer to US Treasury (UST) interest rate movements. The ICE AAA Municipal Yield Curve was stronger by a full 14 basis points (bps) at the 6-month spot, and by 13bps at the 1-year point (Figs. 1 & 2). The 2- and 3-year maturities trimmed 5 and 4bps from their yields, respectively, while the 5-year declined by 1bp. The yield at the 7-year spot finished the week 3bps higher, as the 10- and 15-year maturities both closed the past five trading days higher by 4bps. The 30-year moved up by 6bps, to end the week drawing a 2.960% yield.

On Wednesday, the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index yield dropped 1bp to print a 1.050% yield (Fig. 8). That cut represents the seventh nonstop week that benchmark rate fell, for a total decline of 76bps since it reached its multiyear high of 1.810% on 18 April.

Beyond the 6-month point, last week's activity steepened the ICE AAA Municipal Yield Curve by an extraordinary 19bps, top to bottom. The difference between the 1- and 30-year yields expanded to 147bps, compared to 128 bps the preceding week (Fig. 1). The ICE AAA Municipal Yield Curve has steepened 36bps thus far in 2018. Still, while the curve is at its sharpest slope over the past thirty days, it is 0.43 standard deviations below its 158.88bp 1-year trailing daily average (Figs. 11 and 12).

Observing the ICE AAA Municipal Yield Curve from a different angle, at 2.440%, the 10-year maturity provides 82% of the interest rate at the 30-year point, whereas on 08 June 2017, that same spot provided just 69% of the long high-grade rate. The 15-year delivers 90% of the 30-year's yield, 1% less than the previous Friday's close.

As we conjectured in this publication last week, the rally that seemed to stall the prior Wednesday, proved rather fleeting, at least from the intermediate portion of the curve and longer. As for this past week, most of the upward shift in yields took place on Wednesday. Then, on both Thursday and Friday the high-grade curve remained unperturbed with the exception of a few spots, most notably at the front where strength persisted. Nevertheless, with calm setting in, we think it likely the tax-exempt municipal market could get off quiet start.

Municipal-to-US Treasury (M/UST) Yield Ratios
While UST interest rates moved higher across the entire term structure, high-grade tax-exempt municipal bond activity was mixed, with yields inside of the 5-year point moving lower and all points at 6-years and beyond drifting higher (Fig. 10). Inside the 15-year maturity, however, UST yield changes outpaced those of high-grade municipal bonds. Beyond that point we saw the converse, with the ICE AAA Municipal Yield Curve outdoing USTs to the upside.

Overall, M/UST ratios moved lower at four of six reference points, making high-grade municipal bonds comparatively less attractive. The 6-month M/UST fell by a mammoth 7.185 ratios, to finish the week at 66.730%, compared with the prior print of 73.915% (Figure 25). The 1-year M/UST moved lower at 66.459%, a 6.449 ratio decline from the previous week's 72.907%. In a far more muted move, the 2-year M/UST subtracted 2.788 ratios, to close the last five trading sessions at 67.600%. The 5-year M/UST was lower by 1.330 ratios to finish the week at 71.583%, down from the prior Friday's 72.913%. Over the same 1-week period, the 10-year M/UST edged slightly higher to 82.937%, a rise of 0.150 ratios from the earlier print of 82.787% on the 1st of June. Lastly, the 30-year M/UST ended with a 0.741 ratio increase from the prior week's 95.176%, to finish at 95.917%. We present a more complete view of the one-year historical AAA Municipal-to-US Treasury yield ratios in Figures 26-32 on pages 22-24.

AA Municipal-to-AA Corporate (AAM/AAC) Yield Ratios
In like manner, municipal bonds in the Aa/AA ratings category became less attractive relative to their senior unsecured corporate counterparts at most points inside of the 10-year maturity. Friday's close saw the 6-month AAM/AAC finish the previous five trading days at 62.096%, lower by 5.082 ratios from 67.178% on the 1st of June (Fig. 33). The 1-year AAM/AAC decreased by 5.322 ratios, closing the week at 61.627%, down from the preceding Friday's 66.949%. The 2-year AAM/AAC moved lower by 1.984 ratios, to complete the last five sessions at 66.471%. The 5-year fell to 66.826%, a decrease of 0.098 ratios from the prior week's 66.924% on the 1st of June.

The 10-year printed a 0.717 ratio upturn to close the week at 66.713%. Finally, the 30-year AAM/AAC glided higher by 1.459 ratios from the previous week's 76.851%, to finish Friday at 78.310%. We present a more complete view of the one-year historical AA Municipal-to-AA Corporate yield ratios in Figures 34-40 on pages 25-27.

Market Performance
The strength at the short end of the term structure was more than sufficient to offset by the upward drift in the intermediate and long segments, as the S&P Municipal Bond Index's average yield remained practically unchanged edging a mere 0.011% lower. The broad market index delivered an almost flat -0.043% total return over the past five trading sessions, bringing its year-to-date figure to -0.302% (Fig. 42). The Intermediate Index also ended the week in the red, delivering -0.008%, while the Short Intermediate and Short indices closed on dry ground, generating +0.106%, and +0.162%, in that order. The High Yield Index also finished the week on an upbeat, producing a total return of +0.205% whereas the High Yield Excluding Puerto Rico finished at -0.007%. The S&P Municipal Bond California Index turned in a -0.060% return, while the New York Index produced a -0.054% performance for the week. Once again, the best return of the indices on which report was the S&P Municipal Bond Puerto Rico Index, bringing the fourteenth straight week of positive performance. The Commonwealth's benchmark delivered a +1.989% total return, the third highest ranking week for that index over the past fifty-two, carrying its year-to-date figure to +16.680%.

Looking at the S&P Municipal Bond Index by sector, returns were mixed, as Prerefunded/Escrowed-to-Maturity bonds scored the highest with a +0.135% total return, while Tobacco Settlement ranked a close second with +0.096% (Fig. 45). Of the twenty-four sectors in that broad market benchmark, Higher Education came in at the bottom turning in a -0.122% total return.

Looking at states and territories, Puerto Rico finished the week at the top, printing a healthy +1.989% performance (Figs. 41 & 46). But with a 0.640% index weight, the Commonwealth contributed a paltry +1.3bps to the Municipal Bond Index's overall total return. As we mentioned on these pages last week, we routinely see outsized returns - both positive and negative - from the unincorporated organized US territories. On the other hand, California, New York, Texas, and Florida represent a combined weight of 43.200% and contributed a total of -2.5bps to last week's performance.

Supply and demand
The new issue slate for the upcoming week stands at $5.148 billion and follows last week's year-to-date high watermark of $9.614 billion (Fig. 58). The current schedule is about $4.465 billion lower that the last one and $698 million below the $5.846 billion 12-week moving average. Total year-to-date issuance stood at $137.936 billion as of Friday's close. That number compares with $173.490 billion for the same period for 2017, a 20.493% shortfall. The recent quickening of new deals will likely decelerate during the summer months, but is expected to resume in the autumn. We still stand by our initial forecast of $350 billion in total supply for 2018, a 20% decline from 2017.

Turning to demand, the Investment Company Institute (ICI) reported net positive flows for the fourth consecutive week. On 06 June, the most recent Wednesday-to-Wednesday record for the week ending on the 30th of May showed positive inflows of $316 million (Fig. 59). Despite the most recent account, we remain troubled by the tepid current. We still think retail demand is somewhat unsubstantiated and may wane in the face of lasting negative market performance.

Looking forward to the twenty-third ICI Municipal Bond Mutual Fund Flows report for 2018, the next one on the 13th of June, will cover the five trading days ending on 06 June, when the S&P Municipal Bond Index generated a -0.123% return. That performance may have shaken municipal bond investors over that same time frame, and we could see weaker, perhaps even negative net flows in next week's report. Nevertheless, as of Wednesday, investors have added a net total of $9.819 billion into municipal bond funds thus far this year, with only seven of the twenty-two weeks reported so far in 2018 producing negative net flows.

The New York Federal Reserve reported that primary dealer firms expanded their collective municipal bond positions for the second succeeding week. On Wednesday the latest account showed that dealers increased their holdings by $2.038 billion versus the previous report (Fig. 61). The balance totaling $23.213 billion for the five trading days ending the 30th of May was up from $21.175 billion reported for the 23rd of May.

Market Sentiment
On Friday, Thomson Reuters Municipal Market Data reported that 33% of dealer firms in their survey were bearish for their 1-week outlooks, a drop from 57% a week ago (Fig. 62). The neutral group spiked to 67%, compared to the prior report's 29% in that category. Dealers who described themselves as bullish over the upcoming week scored nil compared to last week's 14%. Dealer sentiment was exactly allocated the same for the 1-2 month outlook as it was for the 1-week view (Fig. 63). Please see Figures 64 through 66 for additional survey information pertaining to the buyside sentiment and dealer inventories.

Core Narrative
The market took a break on Thursday and Friday after mid-week softening. The past five trading sessions seemed to be the retracement, at least in part, of the strength emanating from the news coming out of Italy and Spain a fortnight ago. Nonetheless, the tax-exempt municipal bond market settled into a two-day quiet by the end of the week. We suspect the next couple days will begin with a somewhat calm tone.





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