Sailing into Brexit's uncharted waters, the UK economy is largely shipshape; High-yield energy bonds reflect uncertainty over crude oil prices; TIPS yields reflect falling inflation expectations in the shadow of the FOMC's latest report.
Unknowns abound in the ongoing battle of Brexit; but the UK economy appears resilient if somewhat shaky.
With unemployment at a 40-year low of just over 4%1 and consumer inflation at a relatively benign 1.8%, the UK economy is sailing into uncharted waters in relatively good shape, if not fully provisioned for the uncertain voyage ahead.
Inflation-adjusted GDP grew at a 1.3% annualized rate in Q4, a notable slowdown from the 3.1% rate of Q4 2014. For the moment, however, it is outpacing growth in the rest of the European Union and continues to avoid recession.
What’s more, the Citi Economic Surprise Index for the UK signaled2 that economic data overall is coming in better than analyst expectations as well.
Chart courtesy of Brandywine Global. Source: Bloomberg, as of 3/19/2019. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
On the rise: U.S. HY Energy Spreads
With crude prices moving from strength to strength in 2019 – WTI (West Texas Intermediate) crude oil touched $59.50 on March 19 – it would make sense that the spreads for high-yield energy debt to fall, since higher prices mean better financial conditions for this sector. But spreads for high-yield energy vs. HY overall3 are on the rise since early February of this year, with the difference moving up strongly, from 137 bps to 173 basis points (bps).
One explanation could be that the breakeven price for crude is above current levels, and this sector of the market doesn't believe WTI prices will continue to rise. A second, less benign explanation, would be a buyers' strike over energy high yield debt due to overall rate uncertainty for the rest of 2019.
On the slide: US Treasury TIPS yields
As inflation continues to moderate and the Fed's inability to raise it grows increasingly evident, inflation-indexed assets are reflecting the change in sentiment. Since December 2018, the yields for five-year TIPS have fallen from 1.1308% on December 20, 2018, to 0.5586% on March 19, 2019.
TIPS yields are one market-based barometer of inflation expectations; other more commonly followed measures include the breakeven inflation rates derived from TIPS yields, which are currently in the range of 1.8% to 1.9%, and the Fed's internal break-even rate, which as of March 15, 2019 came in at 1.932%. All these figures will be watched closely in the wake of the FOMC meeting ending March 20, after which the FOMC's own forecasts of rates, the well-known dot plots, will be revealed.
All data Source: Bloomberg as of March 19, 2019 unless otherwise specified.
1 As of the end of 2018; annualized rate as of Jan 31,2019.
2 Source: Bloomberg, as of March 19, 2019.
3 Source: Bloomberg, March 19, 2019. Indexes: Bloomberg Barclays HY Energy Yield-to-Worst, minus Bloomberg Barclays HY Yield-to-Worst.
The Citigroup Economic Surprise Indices are objective and quantitative measures of economic news defined as weighted historical standard deviations of data surprises (actual releases vs Bloomberg survey median). A positive reading of the Economic Surprise Index suggests that economic releases have on balance been beating consensus. The indices are calculated daily in a rolling three-month window. The weights of economic indicators are derived from relative high-frequency spot FX impacts of 1 standard deviation data surprises. The indices also employ a time decay function to replicate the limited memory of markets.
West Texas Intermediate (WTI), also known as Texas light sweet, is a grade of crude oil used as a benchmark in oil pricing. This grade is described as light because of its relatively low density, and sweet because of its low sulfur content. It is the underlying commodity of Chicago Mercantile Exchange's oil futures contracts.
A basis point is one one-hundredth (1/100, or 0.01) of one percent.
U.S. Treasury inflation protected securities (TIPS) are a special type of Treasury note or bond that offers protection from inflation. Like other Treasuries, an inflation-indexed security pays interest six months and pays the principal when the security matures. The difference is that the coupon payments and underlying principal are automatically increased to compensate for inflation as measured by the CPI. Also referred to as “Treasury inflation-indexed securities.”
The Federal Open Market Committee (FOMC) is a policy-making body of the Federal Reserve System (Fed), which is responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
A spread is the difference in yield between two different types of fixed income securities with similar maturities or other characteristics.