Head - Fixed Income Strategy
May 15, 2017
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Potential US tax reforms would put upward pressure on US long rates.
Long-term US Treasury rates remain range-bound, as investors waver between rising expectations of potential fiscal expansion and uncertainty over the magnitude and timing. Despite 10-year yields fluctuating 20 basis points (bp) over the last month, levels are largely unchanged. Still, long-duration has outperformed year-to-date with 30-year US Treasury debt gaining 2.8%, versus 0.3% for 2-year maturities.
We still expect US tax reform later this year, which will likely drive long-term Treasury rates higher. However, political contention could delay Congress from passing President Trump’s policy goals. This could allow markets to focus on other macro drivers, such as foreign elections or daily economic reports. Indeed, US economic surprise indices have fallen sharply as employment, inflation and personal consumption reports for the first quarter have come in below consensus. Seasonal weakness is likely responsible, although may work as a ceiling on long-dated yields in the near-term.
Fiscal and economic fatigue is also noticeable when looking at Commodity Futures Trading Commission data. After short positions on 10-year US Treasury debt reached a historic high in February, speculative trading had completely reversed. As of the end of April, net positions now imply that speculators have become the most bullish on long-term rates since before the financial crisis. While we don’t believe speculators are positioning for a similar event, we advise clients to be aware of extreme positioning as it could exacerbate market movement if they are wrong.
On the other hand, short rates are not likely to wait for US policy to be resolved. Unlike the long-end, short-term Treasury yields are higher on the year and likely to rise further. Despite the Federal Reserve keeping short-term rates unchanged at its 3 May meeting, expectations have risen for further tightening. With Fed Chairwoman Yellen expressing that recent disappointing first-quarterly economic data was “likely to be transitory”, futures markets now imply a 100% likelihood of a 25bp rate hike at its 14 June meeting. While this may appear too high, in our view, we still expect the Fed to hike short-term policy rates two more times this year.
US government agency mortgage-backed pass-through securities (MBS) have outperformed US Treasury debt year-to-date (+0.9% vs. +1.0%). However, concerns over the potential tapering of bond reinvestment by the Federal Reserve has weighed on MBS spreads, tightening the relationship versus high quality US corporate bonds. Indeed, spreads on US MBS now look quite attractive versus US investment grade corporates, especially when considering the wide differential in credit quality.
In regard to the Fed’s $4.4 trillion bond portfolio, our base-case is for an announcement to taper balance sheet reinvestments at year-end. That said, we can only speculate over the magnitude of the taper, and if they would include both MBS and UST debt. A tapering of MBS reinvestment would likely be negative for spreads, as the Fed owns 27% of the entire agency pass-through market and buys roughly 15% of gross issuance each month.
That said, US banks have increased their holdings of US MBS by 30% over the last 3 years, as regulatory reforms pushed up the demand for high quality assets. Elevated cash balances might suggest banks could opportunistically add to their MBS holdings if valuations cheapened, thus supporting prices.
Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer’s credit rating, or creditworthiness, causes a bond’s price to decline. High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made.