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The Constitutional Avenue crowd waits

admin | February 1, 2019

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.

The Fed finally said out loud this week what the market had guessed since at least early January, that the Constitution Avenue crowd would wait and see where growth and inflation took monetary policy next. Fed funds would stand still until then, and the slow roll of the Fed portfolio into the sunset could stop if growth softened. The Year of Carry had officially begun.

Even before the Fed counseled patience on Wednesday, the rates market had priced for as much. Curves had largely flattened. And after the Fed, forward markets painted the next decade with yield curves that looked close to today’s (Exhibit 1). That looks right. Reasonable investors could argue that the Fed might hike once more before the year ends, or ease. If that’s the range, then volatility should remain low and price become the smaller part of returns in fixed income.

Exhibit 1: Forward markets predict a narrow range for rates

Note: all data as of 2/1/19 market open. Source: Bloomberg

Spread markets could take some comfort that the Fed might not tighten to the point of turning slower growth into recession. The Fed’s restated willingness to use its balance sheet also helped. The Fed is clearly treading cautiously. The investment grade corporate market needs that. The more than $3 trillion in ‘BBB’ debt, including pockets with leverage well above traditional ‘BBB’ levels, needs that. Slowing growth will likely put pressure on topline revenue without any pressure from the Fed. But even thinner revenue over a longer time can help pay down debt. And time allows for more orderly sale of noncore assets. That should help marque ‘BBB’ credits like AT&T and others, as Meredith Contente describes here. Wider spreads in corporate debt late last year arguably signaled the market’s impatience with growing, persistent leverage, and presumably corporate management noticed. Investors seem a little more confident that a combination of the Fed and management can manage the ‘BBB’ risk. Spreads have tightened, although slowing growth this year could still limit the magnitude (Exhibit 2).

Exhibit 2: Corporate spreads seem priced for a patient Fed

Note: all data as of 2/1/19 market open. Source: Bloomberg

The MBS market should take comfort from the mention of the Fed balance sheet. It had already recouped two-thirds of the nominal widening to the Treasury curve that started after September (Exhibit 3). MBS investors should take the Fed’s latest balance sheet discussion as further evidence that MBS should trade with a policy premium. In soft economies where the possibility of Fed loosening rises, the policy premium should rise. On strong economies, it should weaken. Since the economy looks likely to decelerate this year, the premium in MBS should keep building.

Exhibit 3: Agency MBS has recouped a large part of its earlier widening

Note: all data as of 2/1/19 market open. Source: Bloomberg

Finally, investors that view markets as cycles should take note of the Fed. It may see potential upside or downside risk to its targets, but it apparently does not see cycles. That’s a valuable perspective. Seeing markets in cycles—economic cycles, business cycles, Fed cycles—encourages investors to assume some inevitable pattern plays out. Spreads widen and then invariably tighten. Markets boom and invariably bust. But cycles almost always seem inevitable only in hindsight. It’s better to expect markets to evolve rather than fit into any determined pattern. That’s a more realistic view of most market phenomenon. That seems the Fed’s view for now.

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The view in rates

The Fed’s recent meeting and counsel of patience, as expected, steepened the yield curve slightly as rates on 2-year notes slipped on the news and expectation that the Fed would not hike in the next few years. If anything, the fed funds futures price a marginally higher likelihood of a cut. Rates on 2-year notes now stand near 2.50%, just at the top end of the fed funds range.

The curve looks tactically likely to steepen more led by higher 10-year rates. Fair value on 10-year notes still looks closer to 3.0%. The Congressional Budget Office projects labor force growth of 50 bp a year for the foreseeable future, and the San Fran Fed (here) projects productivity growth of 1.28%. The combination, with some premium for inflation, pegs fair value around 3.0%. Rates should drift up in that direction and steepen the curve.

The view in spreads

A stable Fed should keep encouraging carry trades and that should help performance of both corporate debt and MBS.  Portfolios buying corporate debt should focus on names that show organic growth or use free cash flow or asset sales to pay down debt. Agency MBS should also tighten but underperform corporates for at least the next few months.

The view in credit fundamentals

Corporate credit fundamentals remain vulnerable, but only if slower economic growth creates problems. The Fed has signaled that it stands ready to buffer any material softening.  Management may need to trim equity buybacks and reduce debt. Households, however, look strong. Unemployment should fall through 2019 even as growth slows. Strong net worth and manageable debt service should help households, too.