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Lift off, we have lift off!

Jeff_PantagesThe Federal Reserve hiked short term rates 25 basis points on Wednesday to a 0.25-0.50% range. It’s the first hike in nine years. More rate increases are expected in 2016, however the Fed expects a “gradual” tightening path. Bonds sold off a touch and stocks rallied on the immediate news, as it was a well-advertised move.

In her press conference, Janet Yellen emphasized that the hike was only 0.25%.  The Fed will be watching and carefully monitoring, and future rate hike decisions going forward will be “data dependent.” Yadda, yadda, yadda. Some have characterized this Fed policy as “dovish tightening.” Bottom line, they are going to take it slow.

By the way, fed funds futures are suggesting fed funds at 0.75 to 1.00% at year-end 2016. However, the Fed’s “dot plot” forecast is closer to 1.375%. So the market thinks the Fed will NOT raise rates as much as it forecasts.

By week’s end equities were fretting over the plunge in oil. WTI traded down through $35 – a seven year low.

S&P 500 stocks closed at 2,006 for the week, down 0.3%. Global stock markets were generally up a bit or flat over the week. Meanwhile, bond yields rose a touch with the two year Treasury yielding just under 1% and the ten year Treasury at 2.20% at the close on Friday.

The bipartisan deal on the FY 2016 federal spending and tax extender legislation is now finalized. It makes a number of temporary tax breaks permanent. This reduces uncertainty and it’s good for the markets. The President will most likely sign it.

The budget deal also lifts the ban on oil exports so U.S. producers now have access to the global markets. The spread between Brent and WTI is so narrow that this change is not likely to have much impact on global prices, but it will provide a source of diversification for European and Japanese consumers.

The High Yield (HY) bond market looks likely to post its first annual loss since the financial crisis. It’s down 4.5% YTD through December 11. The spread vs. Treasuries on ML’s high yield energy bond index is now 12%. Ex-energy, the ML HY index is +6% versus Treasuries (i.e. not suggestive of panic as the long run average spread since 1990 is about 5.6%).

Oil companies are really hurting and driving HY credit spreads wider. The rig count has been cut by two thirds so the current oil glut is on its way to reversing over time. Still, the futures markets expect oil below $60 until 2020. Fitch estimates defaults at 4.5% for HY bonds, up from 3.3% over the past 12 months. For the energy sector, forecasted defaults are closer to 11% next year.

Liquidity in the HY market is questionable; witness Third Avenue, which barred withdrawals and is in the process of liquidating its distressed debt mutual fund. Note this is a very illiquid fund with over 50% the assets unrated and 28% CCC rated – it’s much riskier than the average HY fund. (It’s not even clear why it was structured as a mutual fund with daily liquidity. It was just asking for trouble.)

Other indicators of stress – swap spreads, gold, etc. – are not flashing red. So far, HY is more of a liquidity driven event and is not systemic or contagious to other asset classes. A lot of bad news is priced into the HY market at this juncture.

WSJ:  “Natural gas prices plunged to a 14 year low, as the warmest start to winter on record in the U.S. saps demand for heating fuel and deals another blow to struggling energy companies.” On an inflation adjusted basis, it’s the lowest natural gas prices have been since 1992. Bonds issued by Chesapeake Energy, the second largest natural gas producer in the U.S., are trading close to 30 cents on the dollar.

Inflation in the U.S. was unchanged in November, which puts the YoY gain at +0.5%. The core CPI rose +0.2%, which translates into a 2.0% YoY gain.   At the start of the year, the core CPI was rising at a pace around 1.6%. It looks like core inflation is gradually accelerating.

The EYE is going to take the next two weeks off. The Pantages family is heading down to San Diego for a New Year’s family get-together. We’ll be at the Holiday Bowl watching Wisconsin trounce USC!

Have a Merry Christmas and a Happy New Year everyone!

Jeff Pantages, CFA®
Chief Investment Officer

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