The Big Idea

The case for an even steeper curve, even tighter spreads

| November 15, 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 market leaned into a Republican win before the November 5 US elections, but now the confirmed control of the White House and Congress has raised the likelihood of tax policy that would keep steepening the yield curve and tightening spreads in credit and MBS. On the spread front, the market could easily set and sustain new records. And the likely effects are not priced in.

Extending provisions of the Tax Cuts and Jobs Act of 2017

The market anticipated that a Republican win would mean new life for the Tax Cuts and Jobs Act of 2017, which cut taxes for individuals and corporations. For individuals, among other things, the TCJA raised the standard deduction, reduced marginal tax rates, raised the limit on estates that could pass tax-free and capped deductions for state and local taxes. For corporations, among other things, the tax rate fell permanently from 35% to 21%. Twenty provisions of the TCJA are set to expire next year.

Extending all provisions of the TCJA under the incoming administration looks likely to give Treasury supply a big boost. That supply should slowly steepen the yield curve and tighten swap spreads, and it is not priced in.

A 17% or larger increase in outstanding Treasury debt

The clearest estimate of the impact from extending the TCJA comes from the Congressional Budget Office. In May 2023, CBO projected that extending the TCJA would add $3.45 trillion to a cumulative 2024-2033 deficit then projected at $20.2 trillion, a 17% boost in Treasury supply.

A 2024 Brookings Institution study also shows a similar impact from making TCJA permanent. Brooking projected out to 2054, a long horizon over which a lot of things can happen. And Brookings also assumes some other minor changes to taxes and spending. But it estimated outstanding Treasury debt would rise by nearly 23%.

Most of the impact in each estimate reflects lower projected federal revenue, echoing results from the first TCJA, at least before the onset of Covid. Compared to projections made by the CBO before the TCJA became law, total federal revenue in the following years of 2018 and 2019 fell by 7.4%—income tax revenue by 6.9% and corporate tax revenue by 37%. Payroll tax revenue, unaffected by TCJA, came in right on target, suggesting it was TCJA rather than other factors that reduced income and corporate tax revenues.

The CBO and Brookings forecasts do not account for the impact of new business investment encouraged by lower tax rates, the original supply-side rationale for the TCJA. That would potentially raise productivity, GDP and tax revenue, offsetting lower tax rates and reducing deficits. But the record from the original TCJA is mixed. GDP did grow faster after TCJA, but that could have reflected increased spending after the tax cuts—a demand-side lift—as well as changes in oil prices and shifts in monetary, fiscal and trade policy. Real business fixed investment did grow faster after TCJA but peaked at the end of 2017 and stayed elevated only through the first quarter of 2018. And most of the investment growth came in oil and mining, with other business sectors less responsive. The rate of new business formation relative to prior years also fell in 2018 and 2019. Brookings argues that “the supply-side reaction to TCJA was at best muted and is likely to have been vanishingly small.”

The CBO and Brookings forecasts also do not account for potential cuts in federal spending, but that’s big lift. The Brookings study suggests that the administration starting in 2025 would have to cut federal spending by 1.35% of GDP, or $388 billion. To put that in context, that’s equivalent to nearly 22% of fiscal year 2024 discretionary federal spending—the part of the federal budget set through the annual appropriations process—or 6.6% of total non-interest federal spending, which includes Medicare, Medicaid, Social Security and other non-discretionary spending.

Absent a supply-side impact that offsets lower tax rates or major cuts to discretionary or non-discretionary federal spending, extending the expiring provisions of the TCJA should accelerate US federal deficits and boost Treasury supply. And this is not accounting for other tax cuts floated during the campaign, such as low or no taxes on tips and overtime.

Not yet priced in

It is tempting to assume the market has priced in the extra supply after the 16 bp jump in 10-year rates the day after the election. But if the market expected heavy supply from a Trump win, then rates on 10-year Treasury notes should have gone up relative to 10-year SOFR swaps. The spread between swap and Treasury rates is a longstanding bellwether for Treasury supply. Instead, 10-year swap rates roughly tracked 10-year Treasury rates. Rather than supply, the strongest explanation for the shift in 10-year rates was higher inflation since breakeven inflation jumped 10 bp the day after the election.

Spreads in credit also moved tighter after the election, with the OAS on the Bloomberg investment grade index moving from 83 bp the day before to 77 bp the day after. That could reflect either higher Treasury supply or the boost to corporate earnings likely if TCJA become permanent. But the sharp rise in equity markets after the election suggests most of the move in credit spreads reflects expected higher net earnings.

The impact of more supply should get priced as the new administration and Congress introduces legislation, marks it up and ultimately votes on it and signs it into law. That should happen in the first half of 2025.

A steepening yield curve

With the Fed largely controlling the level of shorter yields and likely to keep easing at least into mid-2025 and beyond, most of the impact of Treasury supply should hit yields in longer maturities. The 2s10s Treasury curve lately has hit 13 bp with the implied 6-month forward slope at 24 bp and the 1-year forward slope at 28 bp. The market expects steepening, but spot and forward slopes in the first half of next year should exceed those implied today.

Tightening swap and risk spreads

As the market prices for more Treasury supply, swap spreads should keep tightening and spreads on corporate and structured credit and MBS should ride along. Spreads to the Treasury curve in swaps, credit and MBS have long reflected the rise and fall in Treasury supply. This time should be no different. For total return portfolios, risk assets should outperform the Treasury curve, all else equal.

Some investors may look at current spreads to the Treasury curve and conclude that spreads are too tight and need to revert to wider levels. But keep in mind that the current Treasury curve embeds growing concern about supply. Compared to the Treasury curve, investment grade corporate debt, for instance, is at the tightest level in five years. But compared to the SOFR swap curve, arguably a better benchmark for riskless debt without the supply dynamics of the Treasury market, investment grade debt is only at the 60th percentile of its spread distribution over the last five years, meaning 60% of the time spreads have been tighter to the SOFR curve than the level today. That puts corporate debt a touch wider than fair value.

Risks to the opportunities

Of course, the curve and spreads could end up in a different place for a number of reasons:

  • The new administration and Congress could choose to extend or make permanent only selected provisions of TCJA, lowering the supply impact. This seems unlikely.
  • The new administration and Congress could find significant federal spending cuts, also lowering the supply impact. This also seems unlikely.
  • The Fed path could change or come into doubt if other actions by the new administration such as tariffs or deportations raise prices, although the inflation impact in both cases would likely be temporary. The Fed would presumably look through the temporary rise in prices, but if the Fed chose to respond and tighten, the curve could flatten.
  • A potential shift in Fed path would also likely push up implied rate volatility, widening spreads.

Approaching this as a curve or spread trade looks like better risk-reward than positioning for an absolute level of rates. Initially higher rates along with tariffs and deportations would have a good chance to slow the economy over a longer horizon, eventually leading to lower yields. Getting the timing right could be difficult.  But for the potential for the curve to keep steepening and spreads tightening, the risks look relatively small. This should shape debt markets over the next six months and beyond.

* * *

The view in rates

The rise in rates since mid-September has made things more interesting. The Republican control of the White House and Congress sets the table for extending the Tax Cuts and Jobs Act of 2017 and significantly raising Treasury supply. A narrowing spread between swap and Treasury rates has reflected some of that expected supply, but not all. The Treasury curve should keep steepening faster than implied by forward rates, with most of the steepening likely in the first half of next year.

Other key market levels:

  • Fed RRP balances have bounced back above $200 billion in the last two weeks. With the RRP rate at 4.55%, it now beats yields on Treasury bills, presumably drawing some cash away from the bill market. Some of the increase in RRP balance also may reflect inflows to money market funds, which grew $162 billion in the last two weeks to a record $6.67 trillion.
  • Setting on 3-month term SOFR closed Friday at 449 bp, down 6 bp over two weeks.
  • Further out the curve, the 2-year note traded Friday at 4.32%, up 11 bp in the last two weeks. The 10-year note traded at 4.46%, up 8 bp in the last two weeks.
  • The Treasury yield curve traded Friday with 2s10s at 14 bp, flatter by 3 bp in the last two weeks. The 5s30s traded Friday at 32 bp, flatter by 3 bp over the same period
  • Breakeven 10-year inflation traded Friday at 234 bp, unchanged in the last two weeks. The 10-year real rate finished the week at 212 bp, up 7 bp over the last two weeks.

The view in spreads

With implied rate volatility off sharply after the elections and the November FOMC, and with Treasury supply putting upward pressure on riskless yields, spreads in corporate debt and MBS should generally keep tightening. The offset to tighter spreads is some uncertainty about the Fed path, with fed funds futures pricing a 62% chance of a 25 bp cut in December and only two cuts priced for 2025. The uncertainty is a marginal negative for spreads in risk assets. The Bloomberg US investment grade corporate bond index OAS nevertheless traded this week Friday at 77 bp, tighter by 4 bp in the last two weeks. Nominal par 30-year MBS spreads to the blend of 5- and 10-year Treasury yields traded Friday at 131 bp, down 18 bp in two weeks. Par 30-year MBS TOAS closed Friday at 44 bp, tighter by 8 bp over the last two weeks.

The view in credit

Fundamentals for consumer and corporate credit still look relatively good. The prospect of lower interest rates should slowly relieve pressure on the most leveraged corporate balance sheets and office properties, although a slow Fed pace could delay relief. Most investment grade corporate and most consumer balance sheets have fixed-rate funding so falling rates have limited immediate effect. Nevertheless, S&P reports rising bankruptcies among the companies it rates, which includes both public companies and private companies with public debt. Unemployment has held steady, and high levels of home equity and investment appreciation should buffer any stress on consumers. Leveraged and middle market balance sheets are vulnerable, although leveraged loan defaults and distressed exchanges have plateaued in recent months. Commercial office real estate looks weak along with its mortgage debt.

Steven Abrahams
steven.abrahams@santander.us
1 (646) 776-7864

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