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Trading on economic policy

| November 8, 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.

Fixed income markets always trade on economic policy, but policy uncertainty this year has exceeded most. With uncertainty around the Fed’s immediate path largely settled for now, the unknowns around trade remain with the unknowns of the 2020 election cycle waiting around the corner. Market volatility nevertheless looks likely to drop from here.

The market has seen plenty of policy uncertainty this year. Fed policy has made at least two pivots with one in January that took the Fed off its path to higher rates and another in July that kicked off its mid-course correction. Economic policy around trade has pivoted, too, from a pending US-China trade deal in May to an on-and-off tariff fight with Mexico in June to tit-for-tat US-China tariffs through the summer to the current state of the world.

All of it helped drive implied volatility by August to its highest level since 2015, and as policy uncertainty has faded so has volatility (Exhibit 1). The Fed has set a high bar to any changes in its policy stance, whether easier or tighter. The cost of trade tension seems to have cooled the enthusiasm for more on both sides of the US-China fight, although that is as much impression as fact.

Exhibit 1: Market volatility in 2019 has closely tracked policy uncertainty

Note: EPU reflects the Baker, Bloom and Davis composite index of economic policy uncertainty, MOVE the implied volatility of the fixed income options market. Source: Bloomberg, Amherst Pierpont Securities

If trade policy remains bounded, then the implications of the election cycle should start to play a bigger role. Nothing ultimately matters until November, and the market should gradually price in the prospects of varying degrees of political control by the contending parties. Even after November, the prospects for material change in fiscal policy will have to get filtered through the practical challenges of getting anything into law. There’s a long time and a lot between here and there.

Volatility does look likely to run lower next year than this year, and that should edge US rates higher and help most US spread sectors. US economic growth looks likely to settle around 2%, and lower volatility implies a lower tail of risk to a higher or lower pace. Rates should adjust higher as recession seems less likely, and spreads should tighten.

* * *

The view in rates

The dust around the Fed has settled. The mid-course correction is done. The bar for any move higher or lower looks high. With elections also likely to stay the Fed’s hand in the second half of 2020, the Fed could easily stay on hold through next year. That should pin down rates in the front end of the curve. A plateau in economic growth should also relieve concerns about recession and allow yields in the long end of the curve to rise. The curve should steepen. Volatility should drop.

The view in spreads

Stable growth around 2% would be goldilocks for credit, and that is a likely outcome. Investment grade and high yield credit broadly should continue to tighten. The weakest part of the leveraged loan and CLO markets could widen, but that’s an idiosyncrasy of heavy issuance of weak loans into a market dominated by CLOs, which are ill-equipped to absorb the supply. There is fourth quarter liquidity risk as banks start to draw down balance sheets. Less liquid names in investment grade and high yield should widen to more liquid names, and more complex products should widen to simpler. MBS has lagged credit as heavy volumes of refinanced loans flowed through the market. But refinancing peaked in October and spreads should start tightening.

The view in credit

Even steady 2% growth will catch the most leveraged credits, and spreads in leverage loans reflect some of that concern. Leverage in investment grade corporate credit also has trended up this year, but an accommodative Fed has provided a buffer. As for the US consumer, low unemployment, high income and high aggregate household wealth leave consumer balance sheets in good shape. The readiness of the Fed, the ECB and other central banks to backstop growth makes broad recession unlikely. The weakest credits should feel a slowing economy, but without recession, the averages should remain good.

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