For fixed income it is the best of times and the worst of times. The same could be said about the energy (oil and gas) market.
It all depends on to whom one listens.
Tale of Two Outlooks
There is a distinct dichotomy among market strategists regarding the fixed income market. The consensus view among fixed income strategists is that the Fed will continue to renormalize monetary policy via gradual Fed Funds Rate hikes and a steady pace of balance sheet reduction. In this scenario, the UST yield curve continues to flatten and could go flat sometime in late 2018 or early 2019 with all UST yields under 3.00%.
Among global/macro investment strategists and economists, the consensus opinion is that the bond market is underestimating both the Fed’s propensity to tighten policy and is underweighting the potential for higher inflation. This group sees a steeper yield curve and higher rates across the curve.
Readers already know that I am in the first camp, with most other fixed income strategists. Why? Because the bond market does not merely reflect future expectations, it can drive them. Remember the so-called bond vigilantes who would sell U.S. Treasuries, driving higher market interest rates? The same vigilantes can flatten the curve, thereby holding down inflation by constraining credit availability. As long as there is strong structural/demographic demand for longerdated bonds, the vigilantes can drive the curve flatter. Inflation that appears contained, due mainly to technology, global competition and demographics, aids the curve flattening strategy.
The Fed itself is flattening the curve. Fed Funds Rate hikes push short-term yields higher. Thanks to the composition of the Fed’s balance sheet, quantitative tightening tends to drive up the 5- yeart UST yield. We have seen this in recent months. Contrary to what the global macro folks and economists say, the bond market is taking the Fed at its word and is driving curve to reflect that outcome. If the bond market was not taking the Fed seriously, short-term and 5-year yields would not have risen as much and, due to a more dovish Fed outlook, longer-term UST yields would have moved higher, thereby steepening the yield curve. This is Interest Rate Markets 101. I feel embarrassed for strategists and economists who do not understand this.
We see a similar situation in the energy markets. Economists and macro strategists are out today calling for $60 to $70 WTI. This is in spite of unexpected inventory builds. Oil bulls point to geopolitical risks, effectiveness of OPEC production cuts and their belief that too much faith has been place on the long term sustainability of U.S. shale production. Although I don’t believe that WTI will move below $40 anytime soon, I believe we see $45 WTI before we see $65 WTI. Shale production is profitable sub-$40 and OPEC members with shaky economies and political situations need revenue and are likely to cheat. Meanwhile, technology augurs for slower growth in oil consumption than what was anticipated just a few years ago. Oil in a $40 to $60 range could persist for an extended period, with occasional forays above and below that range.
I find it humorous, if not somewhat troubling, that economists and investment strategists are rooting for higher inflation, interest rates and energy prices. I remember the 1970s and early 1980s. I remember double-digit inflation, fuel shortages and the damage done to U.S. households. For decades, central banks have strived to create conditions for moderate inflation and steady sustainable economic growth. Now that we might be in such a scenario, those who benefit from rising inflation, energy prices and interest rates are cheerleading for these results. Sorry folks, I just don’t see such conditions materializing. Neither does the bond market.
Yesterday, T. Rowe Price chief investment officer Mark Vaselkiv stated:
“The peak yield on the 10-year Treasury should roughly approximate where the final level of fed funds settles out, so that to us implies a flat yield curve if we assume the Fed will do two or three hikes in 2018.”
For about three years, I have opined that I do not expect the Fed Funds Rate to top 3.00%, possibly not top 2.50% during the current interest rate cycle and that when the UST curve goes dead flat, all rates should be below 3.00%. That is fast becoming a consensus opinion among bond geeks. However, T. Rowe Price is the only firm other than WS&M LLC Bond Squad to voice this opinion, to my knowledge. The pundits crowing about a steeper yield curve and surging bond yields are becoming quieter every day. In my opinion, if we see the 2-year to 10-year UST curve flatten beyond 50 basis points, we could see corporate and consumer credit conditions become constricted. This could create headwinds for GDP growth and inflation pressures. It would probably push corporate credit spreads to widen.
In my opinion, if the yield curve threatens to become flat or nearly so, the Fed is likely to slow down or halt policy renormalization. The question remains: Does the Fed slow or halt tightening 3 before economic conditions, caused by a flatter curve, take over and cause the curve to invert anyway? This remains to be seen.
Readers may have noticed I have not discussed tax reform very much on these pages. This is because I do not believe the policy that is eventually passed will add more than a few tenths to GDP. It is more likely to push inflation moderately higher which would likely be met with tighter Fed policy as the central bank seeks to meet its price stability mandate. In my opinion, the yield curve is indicating that we are in the latter stages of an interest rate cycle, as well as the latter stages of a corporate credit cycle. We can see that in the recent weakness in the high yield bond market. Bulls have tried to paint the junk selloff story as a telecom phenomenon.
Although telecom has borne the brunt of the junk debt selloff, the weakness is becoming more broadly bases and we are seeing capital rotate out of junk into investment grade rather than to other areas of the junk debt market. In my opinion, the junk debt markets are experiencing deepening cracks. My advice, where in the best interest of investors, is to move up in credit quality. I would focus high yield debt exposure to the BB area and then only after doing the necessary credit homework. In my opinion, I would not go beyond five years, preferably not beyond three years, with junk debt exposure.
About Thomas Byrne
Thomas Byrne has achieved a 26-year career in financial services, 23 of which have been spent in the fixed income market sector. In his role as Director of Fixed Income for Wealth Strategies & Management LLC., Byrne is responsible for providing strategic analysis and portfolio management to private clients and institutions, in addition to offering strategic advisory services to other financial services organizations. Byrne's areas of expertise include trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt, and convertible bonds. Additionally, Byrne provides analysis, strategy, and commentary within the fixed income market. Prior to joining WS&M, Byrne worked as Director in the Taxable Fixed Income Department of Citigroup, Inc., in addition to predecessor companies in New York, NY.
E-mail: [email protected]