A steeper curve, tighter spreads

| July 12, 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.

Fed Chair Powell signaled the market again this week that US interest rates will skim along at relatively low levels through the end of this year and likely well beyond. Inflation in the US, EU and Japan continues to run below target and, more importantly, so do expectations. In the long run, realized and expected inflation are all any central bank can reliably control. The market should expect the Fed to encourage easy financial conditions until inflation rebounds to target and sticks. As that happens, the yield curve should steepen and spreads tighten.

Inflation below the FOMC’s 2% target and the drag on US and global growth from trade tensions topped of the Fed chair’s testimony to Congress this week. More than a decade after the 2008 financial crisis, central banks continue to struggle with low inflation despite truly heroic efforts. The assumption that growth and a tight labor market can drive up inflation—the Phillips Curve—has repeatedly disappointed for reasons that the Fed continues to diagnose. The poor track record on inflation has arguably weakened market confidence in the Fed’s ability to hit its target, and that has to be any central banker’s nightmare. Falling inflation expectations give buyers increasing reasons to put off purchases, and further slow growth and falling inflation become self-fulfilling.

With realized and expected inflation below target, the Fed runs limited risk by easing policy. The market arguably sees that. The markets interpreted Powell’s remarks as confirmation that the FOMC will lower rates at it meeting on July 31. Fed funds futures and Treasury bonds rallied after his comments, sharpening the inversion in the front-end of the yield curve and steepening the curve further from 2- out to 30-years. The new pricing reflected market expectations for 50 bp to 75 bp of rate cuts by the end of the year, with some probability of a more aggressive path into early 2020.

Whether the Fed follows the exact path sketched out by the market, the FOMC clearly seems biased to ease financial conditions. The Fed can obviously do that by cutting fed funds. It can also do that by allowing low market rates to persist and spreads to tighten, letting the market do the Fed’s work instead.

Positioning along the yield curve

Investors for now will still need to deal with significant negative carry in all but the longest Treasury securities and in a significant portion of highly rated, short- to mid-duration spread product where yields also have gravitated below the cost of financing. The front-end inversion is likely to persist until the market is convinced the Fed has concluded the easing cycle, meaning rolling up the curve in the short-end could continue to hurt returns. Intermediate spread product should remain under pressure as a result, especially in markets with heavy participation from banks and other investors sensitive to asset spread over cost of funds. The inversion, the negative carry and the pressure on intermediate spreads should diminish, however, as the Fed eases financial conditions.

Investors with intermediate duration bogeys may benefit for now from barbell trades – blending a short- and longer-maturity security to achieve the same duration. Barbells on today’s curve have potential to add yield and convexity, and, subject to reshaping of the curve, total return. Investors need to have enough liquidity in the position, however, to rebalance as the curve likely steepens.

Another option for total return investors is to capture the current wider spreads in intermediate products by going overweight the intermediate securities and going underweight Treasury or agency debt. The wider spread gives the position a carry advantage and potential price upside if spreads tighten in concert with a steeper curve.

Positioning in credit

For credit markets, the Fed’s apparent inclination to keep financial conditions easy is a boon. The fundamental risks are clear—the heavy concentration of investment grade corporate debt in ‘BBB,’ the loosening underwriting and less reliable collateral in leveraged lending—but the outcome in credit also depends on the Fed’s response.  Easier conditions help all borrowers for now, and and the Fed as recently as January showed willingness to back away from a tightening bias in the wake of tighter conditions in corporate credit. With $9.9 trillion in nonfinancial US corporate debt outstanding, the equivalent of half of US GDP, the condition of corporate balance sheets is arguably as important a lever on inflation as fed funds. Wider credit spreads could raise Fed incentives to cut funds for now, and tighter spreads could push incentives in the opposite direction.

For credit, the Fed may be a far bigger risk to performance than the fundamentals. It is easy to imagine for now the Fed continuing to cut funds if the corporate balance sheet shows signs of stress. The Fed also has QE and forward guidance in its armory for managing financial conditions. At some point, however, the Fed will reach its limit. Presumably that comes only after corporations through growth, good balance sheet management or both have cut reliance on lots of inexpensive liquidity. In that case, credit should tolerate tighter conditions. But credit markets are far from prepared today.

* * *

The view in rates

Fed chair Powell gave the market plenty of reasons why the US 10-year yield should continue ranging between 2.0% and 2.2%. He has likely set the range until September. Even though implied volatility dropped as expected after the G20, the underlying trade dispute remains only slightly less predictable than before. The US and China are talking, which helps, but fundamental differences in approach to trade seem as significant as ever. Look for volatility to rebound into September. Fundamental fair value for 10-year rates remains around 2.50%, but uncertainty around tariffs and their impact and the timing and magnitude of Fed action should keep rates from getting there.

 The view in spreads

Market expectations for Fed rate cuts should continue to help spreads, especially in credit. Credit markets increasingly reflect confidence that the Fed will act to counter any economic weakness that would normally trigger weaker credit fundamentals and wider spreads. Market volatility should counteract some of the optimism. But the credit markets feel comfortable that the Fed will and can buffer risk from slowing growth.

The view in credit

Easy financial conditions including low rates and tighter spreads should help corporate balance sheets deal with the high levels of debt accumulated since the 2008 crisis. Various measures of leverage paint a mixed picture, but many are improving. 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.

john.killian@santander.us 1 (646) 776-7714

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