Merrill Lynch Research looking for the trifecta of better data and higher rates and wider spreads in June.
Via Merrill Lynch Research:
- June Gloom. The combination of data inspired rate hiking risks, heavy supply volumes, elevated dealer inventories and lack of retail inflows means that we are set up for more indigestion and another month of upward pressure on interest rates and widening pressures for credit spreads in June. Mitigating that to some extent would be a better than expected outcome on the Greece situation, depending on the amount of incremental rates risk created by such scenario. We remain underweight high grade credit.
- Data deluge. Next week we are getting bombarded with important new economic data releases including inflation and spending, manufacturing and services, construction and employment. Thus if the economy is bouncing back, as expected and evident in data such as durable goods and housing starts, that should become clear next week. Hence we expect credit spreads to remain positively correlated with short term Treasury yields in June, whereas the correlation with back end rates depends more on Greece.
- Bond deluge. At the same time the new issue market should heat up after the holiday shortened week, as the approaching Fed liftoff and more challenging market conditions continue to create incentives for front loading supply that was planned for later in the year. While we expect the dollar volume of supply to decrease significantly in June to $70-110bn from the record $151.8bn issued in May, we think the month of June still comes in above market expectations – especially as issuance is likely front loaded during the first three weeks of the month. It begins with $25-30bn the first week of June.
- Elevated inventories. Record supply volumes have created an overhang of elevated dealer inventories. While it is not unusual to see such pattern, usually subsequent periods of more muted supply volumes allow dealers to de-risk. However, this time the market appears sufficiently saturated with bonds that dealer inventories remain high ahead of a busy month of June.
- Lack of retail inflows … but foreign demand is strong. The reset higher in interest rates has reduced bond fund NAVs enough for retail inflows to more or less disappear. Offsetting the lack of retail demand to some extent is the fact that foreign demand for US corporate bonds remains strong. While the official data on foreign net purchases of US corporate bonds is reported on a very lagged basis only, from our conversations with investors and recent overseas travel we sense that at least demand from Asia is accelerating a bit.
- Back-end spread curve flattener is for 2H. While we have been thinking that the catalyst for the 10s/30s spread curve to begin flattening is an increase in long term interest rates to about 2.3% on the 10-year – which would create mutual fund/ETF outflows that impact the 10-year sector – the recent increase in the duration in new issue supply has us reluctant to think June is the month where the flattening starts. (Page 6)