Head - Fixed Income Strategy
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Despite solid fundamentals and rising inflation, long-dated US Treasury yields remain challenged.
The economic environment for the US remains robust. Unemployment is below 4.0%, 2Q GDP growth is trending above 4.0% and core inflation has reached the Federal Reserve’s 2.0% mandate. Even an August report on US manufacturing jumped to its highest level since 2004, showing that domestic demand remains healthy. However, despite the supportive economic environment, 10-year Treasury yields have been challenged to meaningfully breakout above 3.0%.
There is a long line of culprits which can easily be blamed for containing long-term US rates. First and foremost, US conflicts over trade have provoked investor anxiety. Though informal agreements on new trade deals with Mexico and the European Union have been announced, other clashes with Canada and China remain unsettled. While this has failed to hamper US equity markets from reaching new highs, European stocks have fallen 4% on the year, while emerging markets have lost around 10% (Chinese stock markets have dropped ~20%).
Trade wars are also coinciding with weaker non-US growth, as global PMI’s (Purchasing Managers’ Index) continue to show relative weakness. Also, political and economic volatility in several emerging markets (i.e., Turkey, Argentina, South Africa), has created skepticism over the entire EM asset class. This has driven risk aversion flows into the safety of US Treasury debt, which still happens to be one of the highest yielding (and most liquid) developed bond markets in the world.
November’s US mid-term elections should also be considered. In the months leading into midterms, higher quality bonds tend to outperform lower quality bonds. Though that’s not guaranteed to be the case this year (considering the strength of US credit markets), Treasury debt may attract flows if polls foresee political uncertainty. Indeed, according to prognosticators at FiveThirtyEight, there is a 75% probability that Democrats take the House in November.
Though difficult to quantify, US pension funds may also be playing a role suppressing long-term yields. Since the change in US tax law, corporations have been incentivized to make voluntary contributions by September 15. Indeed, contributions can be deducted from income tax returns (being filed for 2017) at the previous 35% corporate tax rate. Moreover, funding rates among the top 100 pension funds have reached a 10-year high of 93.4%. This will likely encourage portfolio managers to shift allocations from equity to fixed income to reduce risk. This is meaningful, when you consider that pension funds are large buyers of long-dated fixed income, in an effort to match longer-term liabilities.
The aforementioned market dynamics are unlikely to be resolved over the near term. However, economic surprises in the Eurozone have been moving higher since June. If global growth concerns abate, and trade wars are resolved, we should expect long-dated UST yields to become more representative of US fundamentals. Also, with the ECB ending balance sheet expansion in 2019, the Fed reducing theirs, and the Bank of Japan contemplating their own QE program, this could add additional pressure on long-end rates. As such, while we remain allocated to the entire US yield curve, we favor the higher yields (and lower interest rate sensitivity) in short and intermediate maturities. Indeed, 5-year yields are only 15bp less than 10yr yields.
The short-end of the US curve remains in the control of the Federal Reserve. Markets are fully discounting a 25 basis point (bp) rate hike on September 26, while futures have moved up to nearly 80% probability for an additional hike in December. With the Fed expected to follow its projected path toward neutral, the market will need to close this gap. This will likely push short-term Treasury rates higher (including LIBOR rates), and the yield curve flatter. We still expect at least one more rate hike in 2018, followed by at least three more in 2019.
The yield difference between 2-year and 10-year Treasury yields breached 20bp for the first time since 2007. In our view, this has largely been driven by the aforementioned dynamics holding down the long-end of the yield curve. If trade wars fade, some flatness could reverse. Nevertheless, subsequent (and expected) policy tightening will eventually put the shape of the yield curve back on its journey toward inversion in 2019.