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A long view of rates

| October 5, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

On the first Wednesday in October, the market revised its view of US rates. The 10-year Treasury started at 3.06% that day has since run to 3.22%. But of the 16 bp move, 13 bp came from higher real rates and 3 bp from higher implied inflation. The move in real rates looks surprising and unlikely to hold. And 10-year and longer rates look more likely to drop from here than rise.

The bulk of the 10-year move came Wednesday in the hours after the ISM non-manufacturing index printed 61.6, the highest level in 20 years. The strong ISM followed encouraging remarks the day before from Fed Chairman Powell. Powell said (here) that the economy looks “very good,” although some headlines (here and here) implied that he described it as “extraordinary.” He did use “extraordinary,” but not for the economy. That was his description of the very unusual current and projected combination of low unemployment and low inflation. That subtlety apparently was lost.

Exhibit 1: A record reading on the ISM Non-Manufacturing Index

Source: Bloomberg

It seems like a hard case to make that US real rates and sustainable growth over the long run have changed that much in the last week. Likely growth through 2020 has clearly changed over short horizons this year as the impact of tax reform and deficit spending have filtered into the economy. But the long end of the yield curve has to take a longer view. And that view depends much more on productivity, which has been devilishly hard to improve.

US labor productivity for the five years ending in 2017 has averaged 0.76%, well below the 3.58% pace through 2003 (Exhibit 2A). Productivity data this year have shown signs of improving, especially in the second quarter, but it’s early and the data are volatile. Without productivity growth, only growth in the labor force drives the economy. And that, too, has been weak since the 2008 financial crisis (Exhibit 2B).

Exhibit 2: Low productivity and labor force participation have hampered growth

Source: BLS, APS

As my colleague Stephen Stanley has pointed out, tax reform has encouraged more real business investment than last year and may continue to encourage investment. But finding investments that ultimately drive broad productivity gains has been elusive. Productivity across all developed economies has trended down since before the 2008 financial crisis despite a wide range of policy responses, a point highlighted most recently in the International Monetary Fund’s latest World Economic Outlook (here). Capital investment undoubtedly helps, but productivity has lost a lot of ground.

The market will likely have to wait until mid-2019 to see if US real growth has begun a sustained acceleration or if it will begin to trend back toward the 1.8% that the Fed assumes. Until then, 10-year rates closer to 3.0% seem like fair value.

* * *

The view in rates

Fed Chairman Powell’s latest remarks suggesting a steady series of hikes and a strong ISM non-manufacturing index have pushed market pricing another measure closer to the Fed’s dots. Fed funds futures at the end of 2019 now stand less than 25 bp below the Fed’s 2019 median dot. That suggests little room for repricing 2-year yields much higher for now. The action in the yield curve now shifts to longer rates, where 10-year yields at 3.22% look a little high. This looks like a good point to buy duration.

 The view in spreads

The latest rise in longer rates has pushed spreads in corporate debt and MBS wider. The average investment grade corporate cash position has widened 2 bp and par MBS 6 bp in nominal spread and 5 bp in OAS. It’s not clear that the widening makes fundamental sense with much of the jump in yields coming from real rates instead of inflation. Higher real rates, and implied stronger economic growth, should help credit fundamentals. Instead, the wider spreads could reflect capital taking advantage of higher riskless rates to reallocate out of credit and MBS.

The view in credit

A strong economy should keep some of the embedded risks in corporate debt (leverage) and leveraged loans (interest rates) at bay, and the household balance sheet already looks relatively strong. Nevertheless, risk on corporate balance sheets continues to build. ‘BBB’ credits constitute 50% of investment grade debt outstanding, and that looks set to rise. Much of the growth comes from M&A transactions, and Comcast offered the latest example with a $27 billion issuance to finance their purchase of Sky. Higher leverage creates risk if the economy slows. Since household balance sheets looks strong, a gradual reallocation from corporate into consumer debt looks like a prudent move.

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