Market Memo: Yield moves likely to be a slog, not a sprint

10-26-2017

It’s important to remember that U.S. yields do not exist in a vacuum. They are linked to foreign markets, global growth rates and policies through a free-floating dollar. Indeed, the historically low yields of this post-crisis cycle are as much if not more an off-shoot of the historically low yields globally as they are of events at home.

I bring up this subject for the simple reason that we clearly have moved into a period of rate normalization, more aggressively at the Fed but also at central banks elsewhere. This morning, for example, the European Central Bank said it plans to further taper its monthly purchases of bonds in the open market by half, from 60 billion euro to 30 billion euro. These policy moves by the world’s central bankers are beginning to put upward pressure on yields, but let’s be clear—it’s not a race up, it’s a slog. Unlike the Fed, which has started to shrink its balance sheet, the ECB is still buying bonds. In other words, rate normalization has a long ways to go, with the German yield curve still net negative out to six years and the Japanese government bond curve negative out to seven years.

So where are we now? The 10-year Treasury yield hit 2.45% this week, well above its Sept. 8 low of 2.01%. This move up in such a short time is a reflection of the allayment of geopolitical fears associated with North Korea, economic statistics such as the global PMI that suggest the most synchronized global growth since 2012-2013, a substantive chance of U.S. tax reform being passed early next year and, as noted, the expectation of continued global rate policy normalization. At current levels, the 10-year is trading close to critical technical support at 2.48% and 2.64%. Breaks above could put 3.02% in play, approximating the high after the so-called “taper-tantrum” in the summer of 2013.

Favoring corporate bonds & short duration
The fixed-income team at Federated continues to do everything it can to protect against rising rates. We remain short duration relative to our benchmarks, and overweight investment-grade and high-yield corporate bonds as a way to mitigate rate increases with greater coupon income. Both sectors are far from max overweight and are looking to modify exposure over time. As Senior Portfolio Manager Mark Durbiano said in this morning’s voicemail to clients, while high-yield spreads relative to comparable Treasuries recently hit a cycle low of 387 basis points, there’s still some upside to this trade given a supportive economic environment, good credit quality and the historical cycle trough in spread levels in the low 300s. We also view floating-rate instruments as a complement rather than a substitute to high-yield exposure in fixed-income allocations—they can help tactically reduce higher-risk exposures.

Federated remains neutral on the yield curve, despite its recent steepening on the backup in rates. Absent an inflationary shock, our strategists still think the curve will flatten over time. It’s significant that the Fed sees its terminal funds rate at 2.75% for this cycle. With the end of a cycle typically experiencing a flat to inverted curve that has the fed funds and 10-year yields roughly equaling each other, this would indicate longer-term yields at current levels may be cheap rather than dear. However, given the accuracy of Fed forecasts since the crisis began, the current slow drift higher in yield and the prospect of tax reform, I can’t say I’m willing to make that argument yet. If we were to see an aggressive sell-off in rates like the taper tantrum or a selling climax like we saw post-election, then I’m a buyer. As for the dollar, which bounced recently off its early September lows, our fixed-income currency pod has been tactically positive since late July.

Stay tuned: the currency and other fixed-income “Alpha Pod’’ committees overseeing sector, yield curve and duration positioning will be meeting over the next few weeks. I’ll keep you posted if there any significant changes. For now, Happy Halloween!