Wednesday, December 12, 2012

Moody's on the 5y5y Forward Breakeven Inflation Rate vs. Treasury Yield Disconnect, High Yield Bonds

According to a chart released by Moody's in their November 29, 2012 Weekly Market Outlook, there is a huge gap between the 10-year Treasury Yield and 5-year 5-year Forward Breakeven Inflation Rate. And they've been diverging since late 2011. So the rates vs. inflation battle should start to get interesting again. Inflation expectations were at 2.91% at the end of November; but, according to Zero Hedge today (pre-FOMC statement), the 5y5y Forward Breakeven Inflation Rate just hit 3.08%, "the highest level in 17 months."

The charts below are from Moody's November 29 Weekly Market Outlook ("Not Only the Fiscal Cliff Threatens Defaults"). They also made an interesting call on high yield bonds and interest rate risk.

Source: Moody's
Event risk has trumped inflation compensation
Treasury rates are not currently providing adequate compensation for projected future inflation. Negative near-term views about the economic outlook provoked both stimulatory measures and risk aversion by investors, holding down bond yields. Expectations for annual inflation of 2.91% as measured by the 5-year 5-year forward rate far exceed the current 1.63% yield on 10-year Treasury notes (Figure 1). Favored by the Federal Reserve, this measure of expected inflation uses Treasury and TIPS rates to estimate annual inflation for the period five to 10 years ahead, with the most recent values corresponding to years 2017 through 2022. The increasing disconnect between inflation expectations and interest rates has seen the 5-year 5-year forward rate rise from last year’s low of 2.02%, while the 10-year Treasury yield dropped from last year’s high of 3.75%.

Here is their view on high yield corporate debt vs. investment grade corporate debt (chart = High Yield Spread % vs. Benchmark Treasury Yield):

Source: Moody's
"In contrast to investment grade bonds, the elevated spreads on high yield debt provide natural protection against interest rate risk."

"The potential for high yield spreads to narrow next year is assisted by a mild outlook for defaults"

"Positive developments that decrease economic uncertainty next year could narrow spreads as rates rise, leading higher-risk, high yield debt to a relatively positive outcome next year."

Read the full report at Moodys.com for free (or was free) here: http://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBC_147847

Some opinions: Since the pricing of risk is being distorted by the Federal Reserve's QE programs, it is interesting to watch credit market participants try to game the Fed's next move and the future direction of yield spreads, inflation expectations, and economic growth during a depression propped up by government bailouts and central bank balance sheets. The Federal Reserve has been buying trillions of agency mortgage-backed securities and Treasury bonds since 2008 to lower interest rates and boost employment. The Fed Funds rate is already at 0%, so quantitative easing (QE) is just being used as another tool to lower interest rates. This in turn backstopped home prices, boosted stock prices, and tightened credit spreads since 2009. Now the scary part is the too-big-to-fail bailed out banks and the Federal Reserve are still behind the wheel of the credit and interest rate markets. Remember former Fed Chairman Alan Greenspan's interest rate "conundrum" in 2005? And it seems like every type of investor is being forced to take on more risk with cash yielding 0%, or they are leveraging the current rate environment for extra returns (mREITs for example).

So what happens next? Do Treasury yields start to rise as the economy improves and/or inflation expectations rise? Or does a third deflationary wave send "risk assets" lower again during this historic deleveraging cycle with sovereign debt crises, currency wars, and balance sheet recessions worldwide. Here is a chart of Total Credit Market Debt/U.S. GDP.

source: St. Louis Fed

And there are currently $494 trillion OTC interest rate contracts outstanding as of June 2012 (via Bank for International Settlements)!

"Key developments in the first half of 2012:
  • Total notional amounts outstanding of OTC derivatives amounted to $639 trillion at end-June 2012, down 1% from end-2011. The appreciation of the US dollar against key currencies between end-2011 and end-June 2012 contributed to the decline by reducing the US dollar value of contracts denominated in euros in particular. Interest rate contracts fell slightly to $494 trillion. Credit derivatives notional amounts also declined, to $27 trillion. In contrast, foreign exchange contracts outstanding rose to $67 trillion.
  • Gross market values, which measure the cost of replacing existing contracts, dropped by 7% to $25 trillion. Gross credit exposures, which measure reporting dealers' exposure after taking account of legally enforceable netting agreements, fell to $3.7 trillion."

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