Flattening U.S. Treasury yield curve is a near-term risk, but the curve could steepen later this year on signs of rising inflation.
Policy decisions in Washington continue to be a central theme in the bond market this year. In general, the outlook for government debt and fixed income has become less straightforward than usual as a result of its entanglement with economic policy decisions being made in Washington. If the current threat of tariffs on Chinese goods fails to lead to meaningful re-negotiation of U.S.- Chinese trade policy, it raises the specter of retaliation beyond the arena of raw materials and finished goods flows between countries.
For example, China could choose to decrease its purchase of U.S. Treasury debt. In February, Chinese holdings of Treasuries rose to $1.18 trillion, accounting for 8% of U.S. government debt outstanding. Assuming other buyers do not step forward, Treasury yields could be pushed higher if Chinese buying dissipates.
Treasuries, however, are already losing a major buyer. While Treasury auctions have been well-subscribed this year, the Fed is on track to reduce its balance sheet this year. The retreat of the Fed as a major buyer of U.S. debt means that other buyers will need to fill the gap. This would especially be the case given that the federal budget deficit could grow if tax cuts do not create higher growth in the economy and the expected increase in revenue from a larger tax base (which could be used to offset tax cuts and expected increases in government spending) fails to materialize. Moreover, as interest rates rise, higher interest payments on Treasury debt will also expand the federal government’s debt load.
In addition to the demand scenario changing, issuance of new Treasury debt has been increasing. However, there is some expectation that near term Treasury supply may be somewhat restrained by increased tax revenues resulting from the repatriation of corporate cash reserves held overseas prior to the 2017 Tax Cuts and Jobs Act.
President Trump’s intent is that the tax base will grow more than expected as the economy continues to grow, aided by reduced tax rates. In addition, if the repatriation of corporate dollars to the U.S. turns out to be greater than anticipated, it could produce even more tax revenue that could help keep the federal budget deficit down -- even in the midst of increasing government spending.
In the meantime, the lesson to keep in mind is “Don’t fight the Fed.” Interest rates continue to drift higher. If the federal funds rate reaches 2% by the end of 2018, expect the yield on the 2-year Treasury Note to be around 2.5%. The yield curve should continue to flatten in the near term, but may steepen later in the year if inflation has taken hold.
On the other hand, yields on Treasuries, at least on the longer end of the yield curve, are being restrained by yields in Europe and Japan where the rate environment is much tamer and where central banks have begun to reduce quantitative easing, but are not yet considering raising rates. For example, at the end of March the US 10-year note yielded 2.78%, the German 10-year note yielded 0.50%, and the Japanese 10-year yielded 0.04%. The disparity between U.S. and foreign rates should continue to attract foreign buyers into the U.S. bond market, which will help hold U.S. yields in check.
Credit spreads on corporate bonds started to tighten around Thanksgiving and that tightening continued into the first quarter. By the end of January, spreads were tighter than they had been since early 2007, but they have since widened to levels last seen in September. The band in which credit spreads are moving remains narrow, however, with the Barclays Corporate Bond Index starting 2018 with spreads 95 basis points over Treasuries, tightening to 85 basis points by late January, and widening to 105 basis points by late March.
One factor that has kept spreads fairly tight is comparatively light supply so far this year -- roughly 15% below what had been issued in the first three months of 2017. By late March, just over $300 billion of new corporate bonds had priced with more than one-eighth of those coming from a single deal by CVS, the third largest deal on record. Lack of new supply should keep a lid on spread levels in the near term.
Credit spreads on high-yield bonds have held reasonably well relative to investment grade credit spreads. High yield spreads typically track moves in equities, where volatility has increased lately. The lower the credit quality, the greater the impact any selloff or rally in the broader stock market usually has on spread levels. Strong fundamentals have helped high-yield spreads stay tight, off their widest levels for the year reached in early February but not quite back to the multi-year tights seen in January.
The likely reason that investment-grade bonds may be performing worse than high-yield bonds this year is the former ran the farthest, with spreads getting very tight at the end of January before widening when volatility returned to the equity market. In addition, because high-grade corporate bonds are a more liquid market, they are the easiest to sell when in need of liquidity.
Municipal bonds are off to their worst start since 2005, with the Merrill Lynch 1-10 Year A+ Index down 57 basis points. This is only the third time that municipals have been negative in the first quarter since 1997.
New tax rules handed down by Congress and investor concerns about rising interest rates appeared to be leading causes of the weakened demand for state and local government debt during the quarter.
The expectation was that issuance of municipals in 2018 would drop sharply due to the Tax Cuts and Jobs Act making future pre-refunded bonds no longer eligible for tax exemption. This would reduce supply and help support prices. However, the tax plan also gave insurance companies, banks, and other corporations a tax break, so they have not needed to buy as many municipals as they had been buying previously.
Selling from banks and insurance companies has increased upward pressure on yields, exacerbated by continued Fed rate hikes. Banks and insurance companies have not only reduced their municipal bond purchases, they have also been selling municipal bonds, putting additional downward pressure on prices. Currently, banks and insurance companies represent 30% of ownership in the municipal market.
Yields are hitting levels that have started to attract buyers in the past, with 5-year triple A-rated general obligation municipal bonds sitting just above 2% and 10-year triple A-rated general obligation bonds at 2.5%. A lot of money has been sitting on the sidelines as investors wait to see what will happen with the Fed’s tightening moves, the economy, and supply in the market.
During the first quarter of 2018, the spread between 2-year and 10-year munis widened from 42 basis points to 77 basis points.
BBVA Compass is maintaining a short to neutral duration in municipal portfolios for now. During the first quarter of 2018, the spread between 2-year and 10-year municipal bonds widened from 42 basis points to 77 basis points. Once the selling by banks and insurance firms has run its course, spreads may tighten and municipal bonds should perform better on supply dips or when seasonal demand picks up during the summer months. The yield trend is higher, but will be at a slower pace than for taxable bonds.
Our taxable portfolios are currently slightly short the benchmark duration and overweight corporate credits as the Federal Reserve is expected to continue raising interest rates in 2018 and the economy is expected to continue its solid growth trend. Risks to this position would be a slowdown in the economy, volatility in the equity markets and risk assets, potential international trade disputes, and seemingly omnipresent geopolitical risks.
BBVA Compass is the trade name for Compass Bank, Member FDIC, and a member of the BBVA Group. Securities products are NOT deposits, are NOT FDIC insured, are NOT bank guaranteed, may LOSE value and are NOT insured by any federal government agency.
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