Week of February 26, 2024

Dec Mullarkey, CFA , Managing Director, Investment Strategy and Asset Allocation

The U.S. Federal Reserve’s favorite gauge of inflation, core personal consumption expenditures (PCE), hit this week. The January reading held few surprises. It came in right in line with expectations. Away from that we also got an update on U.S. personal income, which was higher than expected. However, digging into the numbers showed outsized wage increases were not the main driver – it was more about stronger than expected dividend gains.????

None of this is likely to change the Fed’s view that inflation is retreating at a measured pace. In turn, these conditions allow the central bank to remain patient and wait to accumulate more evidence that inflation is well corralled before cutting rates. Recent comments from Fed officials and their meeting notes from January also confirm they are united on holding back for now.??

After all, the economy is showing firm growth as inflation eases – essential ingredients for a soft landing. And given the strength of the labor market, the Fed is emboldened to hold rates high for longer. The Fed’s forecast is for three rate cuts this year, with market pricing generally in agreement and leaning toward the Fed’s June meeting as the kickoff for the first cut.?

Sources: Bloomberg, Financial Times, 2024.

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Linda Kong Ting, CFA , Senior Director and Credit Analyst, Asset Management

Could the “Basel III Endgame” actually be what’s saving banks from the commercial real estate crisis? As outlandish as it sounds, it may well be so, but only for banks of at least Category IV and above (a minimum of US$100 billion in assets). Banks have unsurprisingly chafed at the prospect of the new capital rules under Basel III, as these would both raise the cost of doing business and reduce competitiveness compared to European peers, but have still begun to prepare for the new regime even as they push hard for changes to the proposed new regulations. As a consequence, the “RWA diet,” or program to reduce risk-weighted assets, that many midsize and large U.S. banks have imposed to prepare for the new rules has essentially prevented them from leaning further into commercial real estate lending, The RWA diet has even prompted some banks to sell portfolios of commercial real estate loans.

Meanwhile, across the pond in Sweden some banks have reportedly extended loans at higher loan-to-value ratios on various commercial properties, despite property valuation declines that rival the troubled office markets in Germany and New York.

As credit investors we are usually relatively sanguine about bank regulation, but this one seems to have come with some unexpectedly salubrious, albeit unintended, consequences. That stated, such an impact also suggests that there is further potential risk lurking in the smallest regional banks, who do not have Basel III to discourage them from doubling down, and potentially in other areas of the alternative lending space, where valuation marks may be more fluid than for heavily regulated banks.

Source: Bank of America, 2024.

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John Bichajian III, CFA , Managing Director, Derivatives & Quantitative Strategy

Last week we flagged how market observers could compare changes in the implied volatility level of out-of-the-money puts relative to the implied volatility level of out-of-the-money calls (a.k.a., the skew) to assess investor sentiment toward the underlying security or index.

Derivatives pricing can also be used by market participants to glean insights into general market volatility expectations when there is an event that is likely to impact a single name equity (an earnings announcement for example) or even a broad index like the S&P 500 Index.

As an illustration, we can look at the pricing of a one-week straddle (i.e., being long of both a put and a call with the same strike price and expiry) and calculate the current volatility expectations for the major U.S. indices in anticipation of the non-farm payroll report, which will be released on March 8.

Due to the higher-than-anticipated consumer price inflation prints to start 2024, as well as to the ongoing tightness in the U.S. labor market, one could think the payroll report next Friday has taken on greater importance for Fed members trying to determine how much longer the Federal Funds Rate should remain in ultra-restrictive territory.

According to our analysis of the one-week straddle for the S&P 500 Index, it appears market participants are not anticipating significant volatility around the payroll numbers despite the above-mentioned strong inflation and employment prints.

Source: Bloomberg, 2024.

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John Fekete , Managing Director and Head of Capital Markets, Crescent Capital Group

High yield bond issuance has?surged?in February, pushing year-to-date supply to US$58 billion, a 70% increase compared to the same period last year. Positive investor sentiment and strong demand for quality paper has been supported by the resiliency of the U.S. economy, bringing borrowers and investors back into the market. Primary issuance in February has reached US$27 billion, up 86% over last year’s total and the busiest February for new issue activity in three years.?

Strong investor demand could be seen in the oversubscription for most new bond offerings, nearly all from seasoned issuers with credit ratings of BB or B. Given the benign default outlook, in our view investors are also warming up to CCC-rated bonds. This riskiest part of the high yield bond market has generated month-to-date returns significantly in excess of entire U.S. high yield bond market, according to the ICE BofA US High Yield Index. We believe high yield bonds and syndicated loans are in a rare position, with yields high enough to attract capital while low enough to facilitate refinancing. There appear to be limited near-term macro headwinds facing fixed income. Credit fundamentals remain positive, with solid growth and loosening financial conditions.

Source: Bloomberg, 2024.

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Market insights are based on individual portfolio manager opinions and market observations. These are observations only and are not intended to provide specific financial, tax, investment, insurance, legal or accounting advice and should not be relied upon and does not?constitute a specific offer to buy and/or sell securities, insurance or investment services. Investors should consult with their professional advisors before acting upon any information posted here. It is not possible to invest directly in an index.

The use of derivatives may expose the portfolio to risks that differ, and may be possibly greater than, the risks that would be generally associated with investing in fixed income assets. These risks include, but are not limited to: i) the lack of availability of a liquid market at the time that the portfolio may want to unwind a derivative contract; ii) the possibility that the portfolio may not be able to realize value from any derivatives contract if the contract counterparty cannot fulfill its obligations under the contract; and iii) the possibility that the portfolio could experience a loss of all or part of any margin, cash or securities, on deposit with that counterparty if that counterparty goes bankrupt. There is the possibility of deterioration in the functioning or liquidity of the market for derivative instruments which may decrease the value of the derivatives instruments, thereby decreasing the value of the portfolio. Under certain circumstances, the portfolio may be unable to close out derivative contracts in a timely manner or realize values that reflect the fair market values of those investments. The posting of derivative collateral and margin could result in liquidity demands for the portfolio. The portfolio will need to hold ample eligible collateral and margin to satisfy collateral requirements. Derivative contracts may include the use of leverage. Derivative collateral may not be sufficient to close out the portfolio’s obligations under its derivative contracts.

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