As much as I am tired of discussing the yield curve, new comments and theories appear each day. Some defy logic. Others are humorous. A few make sense.
Crazy Little Thing Called Rates
The theory that makes the most sense to me is:
The UST curve is flattening because inflation and economic growth are now believed to be more tepid than the lofty expectations many market participants had built in, post-election. This is not to say that the economy will not improve and/or inflation will not run hotter than it did, in 2016. However, GDP surging over 3.0% seems unlikely, in the near future, and inflation pressures may have peaked in the first-quarter of 2017, at least for now. Why the downgrading of economic growth and inflation expectations? Market participants and strategists now expect more modest efforts in the areas of tax reform, regulatory reforms and trade policy.
This explains the long end of the curve. The Fed’s desire to hike two or three more times in 2017 is responsible for higher yields on the short end of the curve. It is my belief that, as long as Core PCE is within 50 basis points, on either side, of 2.00%, the Fed will raise the Fed Funds Rate steadily, but gradually. As raising the Fed Funds Rate is traditionally seen as anti-inflationary, bond market participants are likely to flatten the yield curve, with the majority of UST yield increases coming on the short end of the yield curve. Several Fed officials have recently hinted that the Fed could begin shrinking the size of its balance sheet, as soon as late 2017. This has the curve Steepening Set (the group that expects a steeper curve) pointing to balance sheet shrinkage as a reason for a steeper yield curve. Not so fast, Sparky.
For one, the focus of the Fed’s balance sheet reduction, at least initially, appears to be its mortgage-backed securities holdings. By reducing its MBS holdings, the Fed would have little, if any, impact on long-term UST yields, but it could impact 30-year mortgage rates significantly. Remember, the Fed decided to purchase MBS to prevent the spread between mortgage rates and benchmark UST rates from widening. If the Fed sold its MBS on the market, it could force up MBS yields and thus, mortgage rates, unless/until yield-hungry investors were lured into MBS by higher yields.
Any impact to benchmark UST rates from the reduction of MBS holdings would likely come from MBS traders hedging their positions. As higher MBS/mortgage rates would tend to cause MBS average lives to extend, MBS traders could purchase the 10-year UST note to hedge positions.
Structural demand for yield could play a part in where long-term yields ultimately move. It is no secret that, by purchasing longer-term bonds, the Fed has squeezed-out some investors from USTs and has pushed them out on the risk spectrum. If the Fed began to reduce it’s holding of U.S. Treasuries, particularly by actively selling assets rather than by allowing them to mature and run off, the likely rise of long-term rates would probably draw capital back in on the risk spectrum. This would probably cap the rise of long-term UST yields and could drive them back down. This is precisely what happened after the 2013 Taper Tantrum.
We must also consider that bulk of the Fed’s long-term bond holdings have maturities of less than ten years. The average maturity of the Fed’s balance sheet is about six years. As such, it is not surprising the that 5-year to 10-year UST curve often experiences the most severe curve flattening, of all the benchmark curves, when the Fed talks about shrinking its balance sheet.
Another consideration, which is often overlooked, is that when the Fed shrinks its balance sheet, it is (at least theoretically), removing stimulus from the economy. Thus, after an initial steepening due to bond market supply and demand phenomena, the yield curve could begin to re-flatten as the bond market prices in lower inflation potential from less accommodative policies. Pundits and Fed officials may discount this scenario, believing that monetary policy conditions would still be accommodative. However, physics teaches that deceleration is acceleration in the opposite direction. As such, I believe that reducing stimulus should cause the bond market to respond in a manner reflecting tighter financial conditions, even if monetary policy conditions remain “accommodative.”
Remember, when the Fed launched QE1 and QE2, the yield curve steepened because monetary policy accommodation, whether it is traditional or extraordinary, is considered pro-inflationary. This is why the Fed began “Operation Twist,” in June 2011. By swapping short-term holdings (two years and in) for longer-term holdings (three-years and out), the Fed was hoping to hold-down/push-down long-term rates. As yields on the long end of the yield curve have risen dramatically, since last summer (126 basis points from trough to peak), much of the potential rise on the long end of the UST curve may have already happened.
Much of the rise of yields on the long end of the UST curve has come as the result of short positions taken by speculators and total return bond managers who assumed that, with a Republican President, a Republican House and a Republican Senate, fiscal policy reforms and stimulus would breeze through the legislative process. This totally and, in my opinion, irresponsibly ignored the ideological differences between the President and GOP members of Congress and among GOP Congresspeople, as well. In my opinion, these short-sellers where seeing just what they wanted to see. As reality set in, short positions were covered, thereby driving down long-term rates. A 10-year TIPS/10-year UST breakeven below 2.00 (1.97, at the time of this writing) is also sending the message that U.S. inflation may be less of a threat than previously thought.
The bond market is truly a global market. As such, it is difficult for U.S. Treasury yields to completely decouple from their major counterparts. German sovereign debt yields, on both the long and short ends of the yield curve, have trended lower, in recent weeks. After rising to -0.699% on 3/28/17, from a recent low of -0.946% on 2/24/17, 2-year German sovereign debt yields have fallen back to about -0.790%. The 10-year German bund yield has fallen to 0.252% (at the time of this writing) after cresting at 0.485%, on 3/8/17. Some of this is probably due to the upcoming French elections, renewed trouble in Greece and the potential of a populace victory in Italy, in 2018. However, I believe some of the decline of German sovereign rates is because the European recovery could prove transitory as the benefits from a weakening euro currency fade.
Does this mean I favor piling capital on the long end of the yield curve, at the present time? I don’t think so. Although we might see yields on the long end of the UST curve fall farther, I believe that the general trend for long-term UST rates in moderately higher. However, I believe that in 2017, the rise of short-term yields should at least match the rise of long-term yields from now to the end of the year. Thus, I do not see the yield curve steepening. My base case is for the benchmark 2-year to 10-year curve to flatten, modestly, from its current slope of 109 basis points. This could squeeze junk-rated companies and reduce credit availability in the home mortgage and vehicle finance industries.
Unless we see positive surprises from fiscal policies and these surprises translate into better hard data, I expect corporate credit spreads to widen and for corporate defaults to increase, albeit modestly. Look for MBS/ABS average lives to extend out and for delinquencies to increase, but not to problematic proportions. In the MBS space, I tend to favor highly-rated bonds, with average lives inside ten years and narrow pre-payment windows. The last thing I would want here is an extendo-matic bond which experiences a sharp increase to its average life for relatively small increases in interest rates.
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.