A duration and risk market for now

Steven Abrahams | August 9, 2024

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. This material does not constitute research.

The most likely path for the Fed, rates and performance in risk assets is still roughly where it stood more than a week ago before the sudden repricing and then quick reversal of all these things. The Fed looks set to start an easing cycle in September, rates across most of the curve look likely to drift well below 4% through the cycle and risk assets look likely to deliver excess return. It remains a duration and risk market for now.

An easing cycle starting in September

The 4.3% print on July unemployment, reported August 2, did show the economy is slowing, but not enough to materially change the path signaled by the Fed just two days before. Since that print brought the change in unemployment for the year to 0.5%, some analysts put a spotlight on the Sahm rule that predicts recession after that kind of move. But an important part of the rise in unemployment has come not from falling labor demand—as the Sahm rule assumes—but from rising labor supply, in part from rising immigration. Employment among prime-age workers is still strong.

Fed Chair Powell said on July 31 that the Federal Open Market Committee needed greater confidence that inflation is moving toward target. And things are moving in the FOMC’s direction. The 3-month annualized rate on core PCE has come down to 2.3%. The New York Fed’s multivariate core trend PCE is at 2.1%. If July inflation comes in benign, the Fed should have what it needs. Our chief US economist, Stephen Stanley, expects a 25 bp cut in September, November and December and then another 150 bp of cuts through 2025.

The curve follows the Fed

The forward curve has already priced a substantial drop in yields along the front of the Treasury curve, but it is likely underestimating the change. Forwards expect a nearly 180 bp drop in 1-month Treasury yields and a 165 bp drop in 3-month Treasury yields, but 10-year yields actually rise 8 bp to finish at 4.02% (Exhibit 1). If the neutral fed funds rate is in the neighborhood of 3.0%, which seems reasonable based on current Fed projections, then short yields should drop further than forwards expect. As for the longer end of the curve, a rise in 10-year yields as the front end drops would run counter to most of the last 35 years of market history. Since 1990, a 100 bp drop in 3-month bill yields has come with an average 42 bp drop in 10-year yields. That is consistent with positive returns to duration in eight of the nine easing cycles since 1982. This time could be different because of extraordinary Treasury supply and the steady withdrawal of foreign central banks. The drop in 10-year yields in the cycle ahead consequently might be smaller than history suggests. But a rise in yields seems implausible absent a growth or inflation shock of some sort. And in that case, Fed easing presumably would come to an end.

Exhibit 1: Forward rates already anticipate a sharp drop in front yields

Source: Bloomberg, Santander US Capital Markets

Risk assets deliver excess returns

As long as the Fed is managing a slowing economy driven by organic economic developments, including Fed policy, risk assets should deliver excess return. That includes MBS along with investment grade and high yield corporate and structured credit, although MBS is likely to be the least volatile of the risk set. That was the pattern as the Fed eased through 2001 before 9/11 and as the Fed eased from July 2019 until pandemic in March 2020.

An important part of the support for risk should come from the significant stock of cash now in money market instruments. Money funds now hold balances of more than $6 trillion or the equivalent of more than 20% of GDP. In part, as yield curves go from inverted to flat to steeper, cash attracted to yield in the front end of the curve tends to move to longer maturities, into risk assets or both.

Support also should come from the continuing resilience of most household and corporate balance sheets. Although households in the lowest 20% of income look likely to show rising distress as unemployment rises, wealthier households have near record equity in their homes and investment accounts—the former they can borrow against, the latter they can sell. Investment grade corporate balance sheets continue to show low leverage, good stocks of cash and elevated profit margins. Speculative grade balance sheets, such as companies that borrow in the leveraged loan market, have shown rising defaults and distressed exchanges ever since the Fed began hiking in 2022. But those defaults and exchanges have plateaued recently. Declining rates should offer some relief, even if gross revenues soften with the economy.

Positioning

The most likely path for the market argues for adding duration beyond usual targets and for keeping a healthy risk allocation. One reasonable precaution, based on experience and the possibility that the economy might slow more than expected, is to move some allocation from credit into agency MBS. Excess returns on MBS have been far less volatile than excess returns to credit and less fundamentally exposed to economic risk. Add duration and allocation from credit to MBS as we move into this next Fed easing cycle.

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The view in rates

Still bullish on rates, both short and long. As of Friday, fed funds futures priced in 100 bp of easing this year—a drop of 20 bp from a week ago. The market has 1.5 cuts of 25 bp priced for September, another 1.25 cuts in November and another 1.25 cuts in December. If July inflation comes in well below 0.2% month-over-month on August 14, that could improve the chances of a 50 bp cut in September.

Other key market levels:

• Fed RRP balances closed Friday at $312 billion. RRP balances bounced between $400 billion and $500 billion from the start of March until six weeks ago.
• Setting on 3-month term SOFR closed Friday at 511 bp, down 11 bp in the last week, the sharpest drop since the collapse of Silicon Valley Bank in March 2023.
• Further out the curve, the 2-year note closed Friday at 4.05%, up 17 bp in the last week. The 10-year note closed at 3.94%, up 15 bp in the last week.
• The Treasury yield curve closed Friday afternoon with 2s10s at -11, flatter by 2 bp in the last week. The 5s30s closed Friday at 42 bp, flatter by 7 bp over the same period
• Breakeven 10-year inflation traded Friday at 211 bp, up 5 bp in the last week. The 10-year real rate finished the week at 183 bp, up 10 bp on the week.

The view in spreads

Implied volatility has spiked higher after the realized rate volatility of the last week. Credit still has momentum with a strong bid from insurers and mutual funds, the former now seeing some of the strongest premium and annuity inflows in two decades and the later getting strong inflows in 2024. The broad trend to higher Treasury supply also helps in the background to squeeze the spread between risky and riskless assets. Nevertheless, high rate and equity volatility have pushed credit and nominal MBS spreads wider.

The Bloomberg US investment grade corporate bond index OAS closed Friday at 102 bp, wider by 4 bp in the last week. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 145 bp, wider by 11 bp on the week. Par 30-year MBS TOAS closed Friday at 36 bp, wider by 7 bp on the week. Both nominal and option-adjusted spreads on MBS look rich but likely to remain steady on low supply and low demand.

The view in credit

The prospect of lower interest rates should slowly relieve pressure on the most leveraged corporate balance sheets and office properties. Most investment grade corporate and most consumer sheets have fixed-rate funding so falling rates have limited immediate effect. Rising unemployment should put pressure on consumers, but high levels of home equity and investment appreciation should buffer the stress. Other parts of the market funded with floating debt continue to look vulnerable. Leveraged and middle market balance sheets are vulnerable. At this point, mainly ‘B-‘ loans show clear signs of cash burn. US banks nevertheless have a benign view of credit in syndicated loans. Commercial office real estate looks weak along with its mortgage debt. Credit backing public securities is showing more stress than comparable credit on bank balance sheets. As for the consumer, subprime auto borrowers and younger households borrowing on credit cards, among others, are starting to show some cracks with delinquencies rising quickly. The resumption of payments on government student loans should add to consumer credit pressure.