The UST curve continues to flatten. At the time of this writing, the benchmark 2-year to 10-year UST curve stood at 109.66 basis points. This is the flattest the benchmark UST curve has been, since Election Day 2016. As I have written for months; policy risks to the markets were skewed asymmetrically to the downside. So much optimism was priced in that policy follow-through was likely to result in a small bump in long-term UST yields. However, failure to launch on policies could send long rates plunging. Add to this weak oil prices, which should blunt inflation pressures, and lower long-term rates is a logical result.
However, policy disappointment has turned a bear flattener, one in which rates rise, but more so on the short end of the curve, into a kind of bull flattener, resulting from a price rally on the long end of the curve. Bear and bull flatteners tell different stories. A bear flattener indicates rising inflation and, possibly, stronger economic growth. As a result, the Fed becomes more vigilant. A bull flattener usually results from a flight to safety or, as is currently occurring, a ratcheting back of growth and inflation expectations. Contrary to popular investment strategy trends, it is critical that investors, advisors and strategists know why markets are doing what they are doing.
At present, the bond market is reflecting scaled-back improvements to the U.S. economy.
One of the better barometers of risk are credit spreads (risk premia) in the high yield bond market. According to BAML data, the aggregate spreads between B-rated high yield bonds and UST benchmarks have widened by just over 30 basis points, since reaching their recent narrows at the beginning of the month. Meanwhile, the yield of the 10-year UST note, which was at 2.39% at the beginning of March 2017, has fallen to just 2.37%, at the time of this writing. This scenario, in which credit spreads widen and junk debt prices fall while UST prices rise, usually represents increased stress in the bond market, or is a sign of policy disappointment. At present, it is the latter which appears to be the cause of spread widening. Again, this speaks to the asymmetric risks to the downside from fiscal policy efforts.
In my opinion, we are likely to see tax cuts (at least on the corporate side), regulatory reforms and infrastructure spending by the end of 2018 (not a typo). However, the finished products will probably be scaled back by 25% to 50% from the lofty goals originally set by the Trump administration and/or predicted by optimistic strategists and economists. As such, risk asset prices probably resume rising, with the possible exception of high yield debt, which was the product of a bit of irrational exuberance, in my opinion. I believe that the 10-year UST note will end the year under 3.00%, perhaps well under 3.00%.
If tax policy reforms are scaled back, we might see little relief on the individual side. Corporate tax reform seems to be a greater priority of GOP members of Congress, at the present time. Any individual tax relief is likely to be moderate, in my opinion, basically done to say “we did something.” This bodes well for municipal bonds which, in my view, should retain their tax-free status, even in the highest brackets.
About Thomas Byrne
Thomas Byrne brings nearly 30 years of financial services experience to Wealth Strategies & Management LLC. He served as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.