Via Merrill Lynch Research:
- Full on bonds. Not surprisingly after another record breaking month in the primary market (July=$129bn) the high grade bond market feels satiated with paper. We see this as secondary credit spreads continue to widen, new issue concessions increase, although there was some month-end buying in July it seemed slow to pick up, and the CDS-cash basis turns more negative. What this market needs is a break – either in the form of a slowdown in supply volumes or some healthy inflows. We expect two more somewhat busy weeks in the primary market before investors head to the beach for total August volumes of $60bn. Unless interest stabilize at lower levels and prompt retail inflows our continued underweight stance on high grade credit will work.
- ECI vs. PCE. Judged by the reaction in the rates market the disappointing 2Q Employment Cost Index (ECI) of just +0.2% vs. +0.6% expected has the potential to generate a rebound in retail inflows as a representative HG ETF rose about 1/2pt on the same day. Recall that the recovering ECI was the lone bright spot on the US inflation front. However, we would not pay too much attention to one number – especially as this one seems a poor reflection of the generally very strong labor market. Moreover, the Fed‘s preferred inflation gauge – PCE – rebounded nicely in 2Q.
- Accelerating M&A activity. M&A volumes are clearly accelerating as we estimate $404bn in July for North America – the fourth busiest on record (since 2003) – after June at $415bn had nearly tied July last year for the busiest month ever. In fact all five months March-Jul this year individually rank in the all-time top-8 busiest months. M&A volumes are heavy because the equity market continues a historically rare pattern of fairly consistently rewarding acquiring companies for takeovers. Unless that changes we can expect more M&A and, while conditions in the high grade primary market permit, that leads to supply. (Page 7)
- Remain in curve flatteners. High grade spread curve performance in July was characterized by weakness in the belly of the curve (10-year), as with the lack of retail inflows there are few natural buyers of the 10-year sector. We estimate that 5s/10s spread curves steepened by 8bps in July, while 10s/30s flattened 2bps. Our outlook for a flatter 10s/30s spread curve is intimately related to our underweight stance on HG, as we expect retail outflows and eventually increasing buying in the long end by yield sensitive investors. We expect the 5s/10s curve to flatten as well, as the front end has most “tourist” money and rising short term interest rates into the Fed‘s rate hiking cycle lead to re-accelerating outflows there. The big risk to our curve call is that long term interest rates stabilize at lower levels – in which case retail inflows will lead to outperformance in the 10-year sector and a steeper 10s/30s curve. The risk to a 5s/10s flattener is that long rates go up while the front end remains anchored. (Page 18)
- Retrench in standard tranches. We recommend that investors sell non-standard maturities issued this year (7-year, 20-year, etc.) and move into the on-the-runs, as off-the-runs stand to underperform significantly as we head into the rate hiking cycle and liquidity suffers. (Page 19)