Head - Fixed Income Strategy
June 12, 2017
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Yields have fallen – and prices have risen – of late as hopes of fiscal reform have faded.
US Treasury (UST) rates are being constrained by a combination of relatively weaker economic data, US political indecision. With investor confidence over proposed fiscal reforms fading, long term (LT) yields are trending lower, leading to further long-duration outperformance. Year-to-date, 10-year and 30-year Treasury benchmarks have gained 3.2% and 5.9%, respectively. For context, broad US investment grade aggregate indices (duration 5.5) have gained 2.5% this year.
Without any agreement on health or tax reforms, summer seasonality effects could continue to weigh on LT yields over the coming months. Looking at the last 25 years, the third quarter is typically the worst performing quarter for risk assets (See June North America Charts We Are Watching). Conversely, high quality fixed income – like UST – tends to outperform. Already following the seasonal pattern, economic surprise indices are falling, with data reports repeatedly missing economist expectations. Most recently, the non-farm payroll report for May fell short of consensus, helping push 10-year Treasury yields to their lowest level this year.
Debates over the debt-ceiling are also likely to intensify, as the Treasury Department has already been using special measures in order to keep below the current limit. The Congressional Budget Office (CBO) has estimated these measures will be exhausted sometime this fall. We expect the ceiling to ultimately be raised, though coming to a compromise won’t likely be easy and could be a catalyst to push volatility higher later this year.
On the other hand, short-term UST yields have not retraced. Despite weaker economic data, the Federal Reserve is still likely to hike policy rates 25 basis points at their 14 June committee meeting. This has kept 2-year Treasury yields near their post-crisis highs, while also pushing up the costs for US dollar funding. Indeed, 3-month LIBOR continues its year-long ascent, breaking through 1.2% last month.
Beyond the June meeting, we think it’s quite plausible for the Fed to carry out an additional rate hike later this year. This should flatten the yield curve further and push LIBOR rates higher still. This is why we continue to recommend investors to hedge their floating-rate liabilities or identify assets which adjust to rising LIBOR rates (i.e. US bank loans). Of course, the timing of additional tightening could be delayed if global volatility spikes or inflation concerns resurface. Indeed, core consumer prices have been declining for the last several months, and the Fed’s main inflation gauge is still running below its 2.0% mandate.
Later this year we are likely to hear an announcement regarding the Feds plans over balance sheet normalization. Recent minutes from May’s FOMC meeting alluded to a “gradual and predictable” approach to their reinvestment policy. As such, we think the tapering of reinvestments is unlikely to have a significant impact on the level of Treasury yields in its early stages. However, once reinvestment is fully phased out, the ability to fund additional run-off may weigh on yields as the public is forced to digest additional new supply.
As highlighted in CPB’s 2017 Mid-Year Outlook, higher LT rates still remains our main risk this year. A Republican-led government should eventually agree on tax reform at some point, which will reshape the US growth outlook. To be sure, fiscal expansion is likely the only way LT yields rise meaningfully. Without reform, low inflation and limited high yield options elsewhere in the developed world, will likely keep the demand for US assets high and yields low. Therefore we maintain our neutral duration view in fixed income portfolios.