With Both Hands on the Wheel, Fed Eyes Economy and Inflation
US interest rates rose in the third quarter of 2018. All points on the yield curve inside five years set year- to-date highs in the last week of September, with yields longer than five years just under year-to-date highs. The US 2-year note began 2018 at 1.89% and closed on September 30 at 2.82%, an increase of 93 basis points. The US 10-year note began 2018 at 2.41% and closed on September 30 at 3.06%, an increase of 65 basis points. The larger increase in 2-year note yields has flattened the yield curve between 2 and 10 years to 24 basis points from 52 basis points at the beginning of 2018.
The increase in yields has been a byproduct of the continued increases in short term interest rates engineered by the Federal Reserve in response to the strong domestic economy and a small but steady increase in inflation. The US economy grew above 4.0% in the second quarter of 2018, indicators on the manufacturing and service sectors hit multi-year highs, and monthly employment gains remain solid. All of the Fed’s preferred measures of inflation were at or above the Fed’s target of 2.0% at the end of September.
At the central bank’s September 26 meeting, the Federal Reserve raised the overnight lending rate by 0.25% to 2.00%. This was the third 0.25% increase in 2018. The Fed also indicated that, all else equal, another 0.25% increase is likely at the December 19 meeting.
Investment grade corporate issuance increased in September after a light summer. Year-to-date supply lies just short of $900 billion for the year, which is still nearly 20 percent below last year’s record pace. With the lighter supply, demand remains strong. New deals have generally been 3-4 times oversubscribed when they price, which pushes spreads about 15-20 basis points tighter from the initial whisper number to where the deals are actually priced.
Credit spreads in the secondary market ended the second quarter at year-to-date wide levels primarily due to trade tariff concerns. As those concerns waned, the economy maintained its strength, supply remained light and spreads tightened significantly throughout the quarter. The Barclay’s Investment Grade Index sat at a wide of +124 basis points at the end of the second quarter and has tightened in nearly 20 basis points to +106. This is still a bit wider than the +95 we started 2018 with and the year-to-date tights of +85 reached back in January, but we look to be heading back in that direction. Last year we saw spreads grind tighter in the fourth quarter as supply diminished and we expect the same to happen again
The high yield sector saw an even larger tightening in spreads throughout the third quarter as spreads settled just a few basis points off of not only year-to-date tights, but tights in spreads that go back over a decade. High yield supply so far this year has been the lightest since 2009 and default rates continue to steadily decline, contributing to the tightening in credit spreads. Estimates project that default rates should continue to decline by around 25 percent between now and the end of next summer according to Moody’s. If that is the case, we could see high yield credit spreads tighten even further over the next few months.
Going forward, the bond market will be focused on economic growth, inflation, the Federal Reserve, and events in Washington. If the economy and inflation continue at their current pace, the Federal Reserve indicated at its September 26 meeting that members were evenly split between 2, 3, or 4 increases of 0.25% in the overnight lending rate in 2019. Events in Washington could also throw the market a curveball with major trade negotiations underway and the mid- term elections in early November.
For the remainder of 2018, the most likely scenario is for interest rates to drift gradually higher amidst stable to tighter credit spreads. This scenario would be a result of continued solid economic growth, the gradual pace of fed tightening, the continued slow but steady rise in inflation, and a calming of the trade tensions with our trading partners.
Interest rates could head lower and credit spreads widen if there is a major selloff in the equity markets, the mid-term elections produce an outcome the markets aren’t expecting, or trade tensions escalate and hurt economic growth. And, as always, some unforeseen surprise event generally brings in safe haven buying into the US bond market resulting in lower interest rates.
The municipal market made a pivotal turn in the third quarter as rates moved higher. July and August saw lower municipal yields driven by steady investor demand, negative net new issue supply, and strong fundamentals from tax collections. Seasonal demand from the reinvestment of cash flows and maturities compressed credit spreads to expensive levels as buyers were sent scrambling to fill orders. This led to the B of A ML 1-10-year AAA-A Municipal index posting returns of 0.35% and 0.05% for July and August, respectively.
September proved to be the key month. Stronger economic numbers pushed Treasury yields higher and municipal yields followed. During the month of September, the 3-year AAA General Obligation scale rose 22 basis points to 2.03%, a level not seen since October 2009. At the same time, the 10-year AAA General Obligation scale moved 14 basis points higher to 2.58%. The B of A ML 1-10-year AAA-A Municipal index posted a -0.46% total return for September, the worst monthly return year-to-date. Waning investor demand, negative fund flows, and increasing yields made investors somewhat reluctant to enter the market. Investor sentiment “I can buy it cheaper next month” started to sideline buyers by the end of the quarter.
Investors are looking for clues that the September downturn will continue. New issue supply is expected to increase as October is often one of the busiest months for debt sales. Increased supply coupled with weaker investor sentiment for bonds could add upward pressure to municipal bond yields. While supply may increase in the short-run, interpolated year-to-date supply numbers for 2018 are expected to be below numbers seen in the last few years. The current trend is for rates to move higher through the end of the year. However, higher yields along with restricted net new issue supply could keep investors engaged and volatility low during the fourth quarter of 2018.
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Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), BofA Merrill Lynch U.S. Treasuries 1-10 years, BofA Merrill Lynch U.S. Agencies 1-10 years, BofA Merrill Lynch U.S. Corporates 1-10 years A-AAA, BofA Merrill Lynch U.S. Municipals 1-10 years A-AAA, Russell Top 200 Index, Russell 1000 Index, Russell Midcap Index, Russell 2500 Index, Russell 2000 Index, Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).