It’s been a little more than three years since the Fed began the long process of normalizing monetary policy.
Interest-rate increases have been, as promised, both gradual and data dependent; the U.S. Federal Reserve's (Fed’s) process of rolling off maturing debt to shrink the size of its balance sheet—$4.5 trillion worth of U.S. Treasury and agency mortgage-backed securities (MBS) at its peak—has been well communicated and minimally disruptive to the bond markets.1 It’s hard to know when you’ve reached the end of the road until you get there, but all indications are that the Fed is pretty close to having reached a neutral monetary policy.
The odds of meaningfully higher rates are slim
Back in December 2015, when the Fed first began tightening short-term rates, we pointed out that the yield on the 10-year Treasury has historically been a fairly reliable indicator of where short rates would peak at the end of a tightening cycle. Back then, the 10 year was yielding about 2.25%. Today, the target range on the federal funds rate stands at 2.25% to 2.50%.1 History isn’t an infallible guide, but it offers one of several reasons to believe we’re near the end of the Fed’s normalization process.
Another reason is that the yield curve is exceptionally flat. At the beginning of February, the gap between 3-month and 10-year U.S. Treasuries was 30 basis points (bps); the gap between the 2- and 10-year T-bill was 18bps.1 With core inflation continuing to come in right around the Fed’s 2.0% target—it averaged 1.8% over the past 12-months’ worth of readings—there’s currently no incentive for the Fed to aggressively hike rates meaningfully higher, invert the yield curve, and likely engineer a recession.1 As of this writing, the odds of a Fed rate hike in June are almost identical to those of a rate cut; both, for the record, are low—the markets are pricing in a roughly 94% chance of no change in rates.2
As for the Fed’s balance sheet, recent comments suggest that the Fed is likely to hold more assets than originally imagined: The current consensus is that the Fed may pause its reduction plan once assets reach around $3.5 trillion, which is likely to happen at some point in the second half of the year. Until that happens, however, the excess supply in the market may apply a little downward pressure on the prices of longer-dated debt—and, therefore, upward pressure on yields. We wouldn’t be surprised to see the yield curve steepen somewhat from where it is today.
Tepid wage gains suggest the labor market may still contain some slack
There are a number of reasons inflation has been so benign. Energy has been relatively cheap over the past 3 years, and the United States has the capacity to generate enough supply domestically to become a net exporter in 2020—for the first time in 70 years.3 In addition, the historically low participation rate in the workforce has kept wage gains—a meaningful potential contributor to inflation—from growing much faster than they have been. With a strong labor market, workers who had dropped off to the sidelines have been reentering the work force as jobs are created; the effect is that wages have been creeping slowly higher, rather than rising by the leaps and bounds we'd expect in an environment with less than 4% unemployment.4
Corporate bonds have fared well, even late in the credit cycle
From 2003 to 2007—the last period of the Fed's tightening—investment-grade (IG) corporate bonds traded with spreads roughly between 80bps and 10bps. We’ve been seeing the same pattern of performance since the end of 2016 at somewhat higher levels: Spreads on IG corporates have been between about 100bps and 160bps. High-yield bonds have demonstrated the same behavior, too, albeit with more volatility.1
The key takeaway here is that interest-rate normalization is hardly a death knell for the corporate bond market; spreads historically have only widened out significantly when the economy is on the doorstep of a recession—and we see no evidence to suggest that’s where we are today.
- Against that backdrop, we’re continuing to find attractive valuations in the financials and energy sectors as well as technology, where we’re finding a number of companies that are generating good cash flows relative to debt outstanding.
- We’re finding opportunities in large, high-quality issues in the asset-backed securities (ABS) market; we generally like securities tied to credit card debt and auto loans linked to prime borrowers.
- We’re also taking a more cautious stance in certain areas, including subprime auto loans, student debt ABS, long-dated (i.e., 30 year) corporates, and U.S. Treasuries broadly. We also have an underweight exposure to agency MBS, given the potential oversupply as the Fed continues to unwind its balance sheet.
The bottom line is that with the Fed unlikely to take any further dramatic action this year—especially before June—owning higher-quality securities in the spread sectors of the market isn’t a bad game plan for generating income in today’s market. And having the flexibility to change quickly as the market evolves, as we believe we do, is an asset in any macroeconomic environment.
1 Federal Reserve Bank of St. Louis, as of February 2019. 2 CME Group, as of February 2019. 3 “Annual Energy Outlook 2019,” U.S. Energy Information Administration, as of January 2019. 4 U.S. Bureau of Labor Statistics, as of February 2019.
The views expressed are those of the author(s) and are subject to change. No forecasts are guaranteed. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index.
Investing involves risks, including the potential loss of principal. Past performance does not guarantee future results.