U.S. Treasury, Fed Coordination, and Inflation Will Determine the Shape of the Yield Curve.
When the year began, it appeared obvious that Treasury yields would work their way higher as the result of rate hikes by the Federal Reserve and burgeoning inflation. The Fed has held up its end of the bargain by hiking the Fed Funds Rate twice, with the most recent hike occurring in June. As a result, the yield on the Two-Year Treasury has moved from 1.92% on December 31st to 2.54% on June 30th. Inflation has been more of a mixed bag. Personal consumption expenditure (PCE) inflation has indeed moved higher with the May reading at 2.0%, on top of the Fed’s intended target. However, given the very low level of unemployment (4.0% in June), one might have expected inflation to be more robust as higher wages push their way through the system. So far, the reaction of the long end of the yield curve to inflation has been muted. The yield on the 10-Year Treasury reached as high as 3.11% on May 17 but ended the quarter at 2.87% as trade war fears began to be perceived as a restraint on economic growth and would be inflation. Given that the rise in short-term yields outpaced the rise in long-term yields, the yield curve between 2 and 10 years flattened from 52 basis points to 33 basis points over the course of the first half of the year.
At least to this point, all indications are that the Fed will stick to its plan to hike the Fed Funds Rate by 25 basis points in September and another 25 basis points in December. New Fed Chairman Powell is perceived to be a bit more “hawkish” than former Fed Chairman Yellen in that he may be less likely to react (i.e., soften intended tightening) whenever the equity market or economy hits a speed bump, especially as long as payroll gains remain strong. The only thing that might knock the Fed off its game at this point is if the trade war drags on and the economic data begins to wither as a result.
The notion of the yield curve inverting (short-term yields higher than long-term yields) has gotten more attention lately as the curve has continued to flatten. Inverted yield curves have historically been precursors to recession, but things could be different this time around given the still very low level of interest rates, even after multiple rate increases over the past year. If the yield on the 10-Year Treasury ends 2018 at or above 3.25% as BBVA Research expects, then there is a reasonable chance that yield curve flattening winds down around current levels. There are also circumstances which could actually cause the curve to begin steepening. For example, the Fed has stated that it is willing to take a “symmetrical approach” to inflation whereby it is willing to allow PCE inflation to get as high as 2.3%-2.5% without tightening policy more than already projected. If true, then the yield curve would most likely steepen with higher inflation given that the Fed remains on its expected path. Finally, while trade wars are universally considered to be a drag on domestic and foreign economic growth, higher tariffs, all things equal, would mean higher inflation and, in turn, a steeper yield curve.
While an inverted curve may or may not come to fruition, ballooning federal budget deficits are potentially a bigger threat in the long term. Recently enacted tax cuts and fiscal spending have indeed boosted the economy, but the price paid for that growth, at least in the near term, is a higher budget deficit which leads to more borrowing by the Treasury by way of increased debt sales. Increased Treasury supply without increased demand means higher interest rates, all things equal, especially if foreign governments (e.g., China) decide that the most effective way to retaliate against tariffs imposed by the U.S. is to reduce their purchases of U.S. Treasury debt.
Credit ratings on investment-grade corporate bonds are at a low ebb, with bonds rated BBB now representing 48.6% of the investment-grade universe. Nevertheless, credit spreads remain quite tight thanks mostly to incredibly strong earnings and cash flows from corporate America. Investment grade credit spreads began the year at 95 basis points, were at 110 basis points at the end of the first quarter, and are now at 123 basis points. Spreads have widened recently over fears that a trade war would slow economic growth and ultimately reduce corporate earnings and balance sheet strength. Should the trade war turn out to be just another negotiating tactic from the President (see Art of the Deal) and trade differences are negotiated amicably, then credit spreads are likely to tighten again. Spreads could tighten regardless if second quarter earnings turn out to be as strong as many expect.
While credit spreads have widened a bit of late, reduced supply has helped restrain spread widening. New-issue corporate bond supply so far in 2018 is running 15% to 20% below last year’s pace. At that rate, supply in 2018 will be the lightest in five years. Lower corporate tax rates combined with strong organic earnings growth are likely benefitting corporations such that they do not need to borrow as much.
Also, stronger earnings and cash flows mean corporations have a better ability to increase dividend payments without borrowing. Fundamentally speaking, higher interest rates mean the cost of debt is higher, making debt issuance less compelling.
Going forward, we still like corporate bonds versus Treasuries for multiple reasons. First, the yield grab continues whereby investors reach for as much yield as possible in the low yield environment. Second, despite recent spread widening, default rates remain very low, even for high yield debt. Default rates hit highs of over 14% during the financial crisis and more recently have steadily declined from around 5.5% at the beginning of 2017 to around 3.7% currently, according to Moody’s Capital Market Research. Finally, we believe that, at least in the near term, the additional yield earned on corporate bonds is more than enough to make up for capital losses (depreciation) that could result from credit spread widening and cause corporate bonds, over the course of the year, to underperform Treasuries.
While high quality bonds remain an ideal safe haven in times of trouble in the equity market, given that interest rates are generally on the rise in 2018, bonds are not expected to render much, if any, positive return. However, if there is one pocket of the bond market that has a chance to do so, it is in tax-exempt municipal bonds, especially tax exempt bonds issued in states with high income tax rates like New York, California, and New Jersey.
So far in 2018, munis are outperforming thanks to improving credit quality, strong domestic growth, and sharply reduced supply. Credit quality has improved on the heels of increased state and local tax revenues from sales tax, income tax, and ad valorem tax (higher property values) as well as stronger earnings from corporations issuing industrial revenue bonds. Economic prosperity has brought increased travel which helps airport authority bonds and even toll road debt. As in the corporate bond market, municipal bond supply is down sharply (around 23%) in 2018, resulting in a scarcity premium, especially for debt issued in high tax states where investors can no longer deduct state taxes on their federal tax returns.
According to Sean Carney at Blackrock, recent new-issue investment grade municipal bond deals have been four times oversubscribed and high yield (junk) deals have been 10 times oversubscribed. Demand is so strong that there is little distinction among investment grade credits. Fiscally weaker issuers are trading at similar spreads to stronger issuers, making municipal bonds look more generic than at any time in recent history. Almost all investment-grade debt issued in California is trading at yields below the AAA GO scale. While such strong relative performance is good for now, it is not expected to last because yields on California debt will eventually be driven so low that investors determine they can earn more net after tax yield on bonds issued in other states. At that point, the trend reverses and California debt comes back to more realistic yields. The rally in California debt is particularly interesting since it comprises the largest percentage of tax exempt bond indices.
At least for the third quarter, we expect the strong relative performance of the tax exempt bond market relative to the taxable bond market to continue. July and August are peak months for coupon and principal payments on municipal debt and investors will be scouring the market for more tax exempt bonds in which to invest the cash.
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