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The quiet tide behind tighter spreads

| April 5, 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.

Something besides the Fed and the usual fundamentals quietly seems to be helping tighten spreads to the Treasury curve across key parts of fixed income: US deficit spending. Deficits and the surge of Treasury debt needed to fund them often leave yield spreads to swaps, corporate debt and MBS tighter; surpluses often leave Treasuries scarce and spreads wider. With the Congressional Budget Office projecting outstanding Treasury debt will rise as percent of GDP by 1.3% a year for the next decade, the tide is rolling toward tighter spreads.

Rising Treasury supply tends to tighten spreads

US public debt as a share of GDP has long affected the yield spread between Treasury debt and other parts of fixed income (Exhibit 1). As debt share rose from 55% of GDP before the 1991 recession toward 65% afterwards, for instance, spreads on 10-year swaps tightened from 80 bp to 40 bp. As falling deficits and eventual budget surpluses drove share back toward 55% in 2000, 10-year swap spreads widened to more than 120 bp. Deficits and rising debt share after the 2001 recession had no visible impact on spreads. But heavy deficit spending and the jump in debt share from 65% in 2008 to 104% today has coincided with a collapse in 10-year swap spreads toward zero.

Exhibit 1: Treasury debt as a share of GDP has shaped spread markets

Source: Federal Reserve, Bloomberg, Amherst Pierpont Securities.

A structural model of 10-year swap spreads using only public Treasury debt as a share of GDP highlights the broad link between debt share and spread markets (Exhibit 2). Debt share alone misses the peaks and valleys in swap spreads, so other factors are clearly at work. The slope of the yield curve has mattered, with steeper curves associated with tighter spreads and flatter curves with wider spreads. Financing rates on Treasury debt have mattered, too, with special financing and the improving carry in Treasury debt forcing yields on competing investments wider. Volatility, liquidity premiums and indicators for MBS delta-hedging also figure in various spread models. But debt share is a core structural element of the difference between Treasury yields and yields in other parts of fixed income.

Exhibit 2: A swap spread model with only Treasury supply captures broad trends

Note: R-squared of 0.72 based on 118 quarterly observations from 1Q1989 to 2Q2017. Source: Amherst Piepont Securities.

Since mid-2018, after the magnitude of likely US deficits started becoming clearer, swap spreads have generally tightened and MBS has performed better against the Treasury than the swap curve (Exhibit 3).

Exhibit 3: With US deficits clearer since early 2018, MBS has held spread better against Treasury than the swaps curve

Source: Amherst Pierpont Securities.

The Congressional Budget Office in January projected that federal debt held by the public would grow from 78% of GDP at the end of 2019 to 93% by the end of 2029—1.3% a year for the next decade. If history holds, swap spreads and spreads in other sectors would grind tighter by 1.8 bp a year or nearly 20 bp in total. The tide toward tighter spreads is rolling.

* * *

The view in rates

Rates look rich, especially in the belly of the Treasury curve. The 5-year real rate of 0.48%, which arguably implies growth around 1.0%, looks too low. Breakeven inflation of 182 bp also looks a little light. Growth rather than inflation looks most likely to surprise the market. The market may need to see several quarters of steady rather than declining growth to buy the consensus among economists that growth will plateau around 2.0%, but that looks very likely to happen. Fair value on 5- and 10-year notes is somewhere above 2.75%. Look for rates to rise faster on 5- than on 10-year notes.

The 2.34% rate on 2-year notes has built in slightly more than one Fed rate cut in the next two years. That seems to anticipate a Fed willing to defend growth. That seems realistic. The Fed could easily cut if growth shows any sign of slowing below 2.0%.

The view in spreads

Relatively low volatility and heavy net Treasury supply should help spread products 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. But corporate management is starting to deleverage. Still, credit concerns linger. Agency MBS should broadly outperform corporate debt.

The view in credit fundamentals

Companies have started to divert cash flow toward paying down debt, have started to sell non-core assets and have curtailed stock buybacks. Management has heard the concerns of debt investors. Households continue to look strong with low unemployment, rising home prices, and generally good performance in investment portfolios.

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