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Spread markets should do well

| March 22, 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.

Despite the reshaping of the yield curve since the beginning of March, the market has put its money not on recession but on an economy that weakens in 2020 and rebounds a year or two later. That’s the story in a curve inverted from one month out to five years but positively sloped beyond. It’s also the story in spread markets, which have tightened since late last year but still stand wide of earlier marks. With risk premium built in for softer growth, spread markets look likely to do well.

The message in the rates markets

Today’s implied forward rates show a yield curve in early 2020 that essentially runs flat from one month out to five years, completely undoing the inversion in today’s spot curve (Exhibit 1). That obviously implies one Fed rate cut roughly a year from now, but no more. That would be entirely consistent with economic projections from the Congressional Budget Office and the Fed that continue to show economic growth softening into 2020 to just under 2.0% before rebounding slightly in later years. That is the same pattern, incidentally, that both the CBO and Fed have projected since last spring. It seems entirely reasonable that short rates should fall to accommodate slower growth before rebounding.

Exhibit 1: Forward rates imply a drop and a rebound

Source: Bloomberg as of March 21, 2019; Amherst Pierpont Securities

What is also striking is the message across the yield curves implied 10- and 30-years forward. They are both essentially flat at around 3.30%. That is an easy level to justify assuming real rates of 1.30% and inflation of 2.00%. Real rates often run about 50 bp below real GDP growth, which the Fed now projects somewhere between 1.8% and 2.0%. The Fed projections almost certainly reflect widely discussed expectations for 0.50% annual growth in the labor force and 1.30% annual growth in productivity. Market expectations for growth and inflation in the long run should pull rates up off the levels implied for 2020.

If the market has mispriced something, the best candidate looks like the prospects for US growth implied in 10-year yields. Yields on 10-year TIPS have dipped toward 0.50% as implied 10-year inflation has rebounded back towards the Fed’s 2.0% target. That almost certainly reflects justifiable concerns about global growth but seems misplaced in the US. Yields on 10-year notes may continue to reflect low growth expectations as growth slows this year, but yields should rebound once growth stabilizes.

Exhibit 2: The market has continued to revise growth expectations lower

Source: Bloomberg as of March 21, 2019; Amherst Pierpont Securities

The message in spread markets

If the inversion of the 5-year and shorter part of the Treasury curve reflected recession rather than slowing growth, then spreads should have moved wider than they have so far in March. They have widened slightly in the last few trading sessions but still stand much tighter than they did at the end of last year when Fed projections of steady hikes did raise recession risk (Exhibit 3). If late 2018 spread levels indicate recession pricing, the market is not there yet.

The spread markets have arguably built in some risk premium for a slower economy, however.  In high yield, leveraged loans, investment grade credit and MBS, spreads still stand wide of levels in mid-2018 when real GDP peaked at 4.2%. The wider spreads almost certainly reflect the observed slowing the GDP growth and likely at least some expectations for more. That risk premium should give spread markets some cushion.

Exhibit 3: Spread markets have built in some risk premium for slower growth

Source: Bloomberg, Amherst Pierpont Securities

The other factor favoring spread markets is the heavy projected US fiscal deficits and accompanying net issuance of Treasury debt. As Treasury supply grows relative to spread markets, spreads historically have tightened (Exhibit 4). This is a significant tide running in favor of tighter spreads across high yield, leveraged loans, investment grade debt and MBS.

Exhibit 4: US deficits and heavy Treasury supply coincide with tighter spreads

Source: Bloomberg, Amherst Pierpont Securities

Slightly wider spreads in risk assets in the aftermath of the March FOMC look like a buying opportunity for fixed income investors. The economy looks more likely to slow than to tip into recession, and spread markets have built in appropriate risk premiums. The Fed is also signaling an abundance of caution in doing anything that might impinge growth. Spread markets should do well.

* * *

The view in rates

The 2.44% rate on 10-year Treasury notes still looks rich to fair value but undoubtedly reflects slowing global growth and a very dovish Fed. The 2.32% rate on 2-year notes has also has built in at least one if not two Fed rate cuts in the next two years, another signal of growth concerns. And 10-year TIPS continue to reflect falling growth expectations. The growth concerns seem hard to justify. Look for the yield curve at 10-years and in move higher in yield from here.

With the yield curve inverted out to five years and upwardly sloped beyond, investors will have to pick their yield curve spots carefully, especially when it comes to hedging. The yield curve at five years and shorter now has negative roll-down, the curve beyond five years has positive roll-down.

The view in spreads

The shape of the yield curve should put pressure on spread product with 5-year or shorter maturities with spreads widening to offset a negative roll-down. Shorter MBS, without bulleted principal that rolls down a yield curve, should look relatively better.

In general, low volatility and heavy net Treasury supply should help spread products to tighten. The corporate market still has issues with leverage in investment grade debt and loose underwriting in leveraged loans; a slowing economy should put pressure on those sectors. Agency MBS should broadly outperform corporate debt.

The view in credit fundamentals

Household balance sheets continue to look strong and corporate balance sheets vulnerable—although more corporations have started to divert cash flow toward paying down debt, have started to sell non-core assets and have curtailed stock buybacks. The ratio of household debt service to disposable income is at a record low, corporate leverage at a relative high. The Fed has signaled that it stands ready to buffer any material softening in growth.

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