The Fed, The Curve and Total Returns

The FOMC last week was almost unanimous that the funds rate will increase in December.  In addition, the median estimate of the rate at year-end 2019 was 3 1/8%.  If these estimates prove correct, the rate outlook for next year is essentially a repeat of 2018–a 75 to 100 basis point increase in short-term rates and, probably, more flattening of the Treasury curve.

The median estimate of the long-run and, presumably, the neutral funds rate is 3%.  So, someone asked Chairman Powell why the 2019-2020 projections have the rate above 3%.  Would that mean a restrictive policy setting?  His answer was interesting.  He said that perhaps the neutral rate is actually higher than they had been assuming.  Thus, he believes that the economy could withstand a funds rate above 3%.

What does a 100 bps increase in the funds rate imply for the bond markets over the next 12 months?  The easy answer is that it would produce negative returns in the long-duration sectors.  Thus far in 2018, a 75 bps increase in the funds rate and a significant flattening in the curve has resulted in negative returns on Treasuries with 5-years and longer maturities. For the 10- and 30-year issues, YTD returns are -3.7% and -6.5%.  Even the TIPS market has negative YTD returns.  The same is true for the longest IG corporates and munis.  Only the high yield corporate and muni sectors have recorded positive returns.

This record suggests that further curve flattening would not be sufficient to “protect” long duration sectors from negative returns.  For example, if the yield on the 30-year Treasury bond were to rise only an additional 20 bps over the next 12 months, the total return would be negative.  The same is true for the longest munis.

But, the story is better for the shorter maturities.  The steady rise in the funds rate has pushed the 1-5-year Treasury yields to levels that could produce positive returns.  The yield on the 5-year note could rise almost 90 bps before total returns would be negative.  The 5-7 year corporate note yields could rise more than 100 bps before returns would be negative.  Munis rated A and BBB out to 7-year maturities now have a good chance of producing positive returns over the next 12 months.

As always, credit risk, not interest rate risk, is the major concern in high yield.  Spreads are somewhat narrower than I would prefer and covenants are getting weaker by the day.  But spreads could stay narrow as long as the economic outlook is favorable.  Nevertheless, in view of the weakening of covenant protection, a more conservative approach to credit quality within the high yield sector is now appropriate.

Finally, the argument that a flat or inverted curve would guarantee a recession is too simplistic.  We need to ask what level of the fed funds rate might cause a recession.  Nobody knows but, as Chairman Powell suggested, it is probably not 3%.


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