Top of the Street: Inflation frustrates the Fed, corporate credit keeps cranking, cracks in the auto market, rising leverage in mortgage lending

The list of things that might reset interest rates remains short. So corporate credit keeps performing. Cracks show up in auto lending. Leverage rises in mortgage lending. Contributions from GS, JPM, S&P and Milepost.

Markets: Inflation frustrates the Fed
Low readings on inflation may slow the Fed’s efforts to raise short-term interest rates, but conviction that inflation will remain low could hold down long-term rates and create a surprisingly flat yield curve ahead. The yield premium that investors charge to hold long-term bonds has dropped steadily since 2009 as the Fed has built its $4.2 trillion portfolio of Treasury debt and MBS. As the Fed starts to unwind that portfolio, falling expectations and tightening consensus around growth and inflation could swamp the reversal of QE.  A 1% decrease in the Fed balance sheet as a share of GDP should add 2-3 bp to long-term bond yields, according to Goldman Sachs. But a 1 percentage point decrease in inflation expectations should cut the 10-year yield premium by 40 bp. And a 10 bp tightening in the dispersion of economists’ forecasts of inflation – a measure of strengthening consensus – could cut the term premium by another 15-30 bp. “As long as there is widespread agreement among forecasters that inflation will be low and stable, as it is now,” the analysts write, “the rise in the term premium should be a gradual one.” See Goldman Sachs, Global Markets Analyst: Macro Drivers of the Bond Term Premium, 4 Aug 2017. (GS, Milepost).

Markets: But the Fed goes marching on
Steady growth and a tight labor market should keep the Fed hiking roughly each quarter from December through 2019, according to Goldman Sachs, despite low inflation. The bank’s analysts point to 1999-2000 when the labor market tightened but inflation still ran below 2%. The Fed kept hiking until the unemployment rate stabilized in Apr 2000, and then hiked one last time in May. That Fed apparently was trying to get ahead of a large overshoot in employment, which, in the past, has reliably forecast a recession. The bank’s analysts don’t mention that a recession nevertheless followed in May-Nov 2001. They do note that a change in Fed leadership and political noise in Washington could slow hikes, knocking the Fed off its once-a-quarter pace. See Goldman Sachs, US Views: A Bigger Overshoot, 6 Aug 2017. (GS, Milepost).

Markets/economy: Corporate credit keeps cranking
The market in corporate debt keeps charging ahead, with spreads and issuance both strong. Spreads on investment-grade debt are within a few basis points of their tightest levels since the 2008 financial crisis, and new issuance this year is tracking toward a strong $1.15 trillion. Low rates and good earnings growth continue supporting the market. Revenues grew by 5.5% YoY in the second quarter, at least among S&P 500 companies outside the energy sector reporting so far, with nominal GDP up 3.7%. JPMorgan sees good performance in corporate credit continuing, although it lays out some risks: the end to QE in the US and Europe, political conflict, slowing US growth, disappointment on tax and other regulatory reforms, another drop in energy prices and more. See JPMorgan, US Fixed Income Markets Weekly: Corporates, 4 Aug 2017. (JPM, Milepost).

Markets/economy: Cracks in the auto market
The Hertz rental car company has become the latest sign of stress in corners of the auto business. The company last week canceled an offer to redeem bonds due in 2019, sending its equity down last week more than 30% at one point and pushing spreads on its credit default swaps and ABS wider. Analysts speculated that the company may need cash to support auto lease ABS deals, which make assumptions about where loans coming off leases might be resold in the used car market. With a wave of cars coming off of leases this year, General Motors has predicted that the priced of used cars in its leasing portfolio will decline by 7%. Hertz may need cash to manage its losses. “We believe rental car ABS spreads have more downside risk than up,” writes JPMorgan analysts, “as any negative corporate headlines from Hertz and the auto industry will continue to have outsized impact on sentiment.” See JPMorgan, US Fixed Income Markets Weekly: Asset-Backed Securities, 4 Aug 2017. (JPM, Milepost).

Markets: Leverage rises in US mortgage lending
Leverage has made a comeback in US mortgage lending, according to Standard & Poors. Loans with down-payments of less than 10% now account for 40% of all purchase originations, the rating agency writes, citing data from BKFS Mortgage Monitor Report. A quarter of Fannie Mae and Freddie Mac lending in 2016 and early 2017 involved low down-payments as the enterprises took market share away from FHA/VA lending. The share of low down-payment lending marks a 7-year high, according to BKFS. Unlike similar loans made before the 2008 financial crisis, the recent batch has an average credit score 50 points higher and has a fixed- rather than adjustable rate, making them safer. (S&P, Milepost).