October 5, 2018
Federal Reserve (Fed) policymakers have forged ahead with tighter monetary policy, buoyed by higher core and headline inflation, a low unemployment rate, and solid economic growth data. The Fed raised the fed funds rate for the third time this year in September and is promising four more hikes during the next 15 months. Additionally, the Fed continues to allow U.S. Treasuries and agency mortgage-backed securities to roll off its balance sheet at the rate of $50 billion per month. Headline inflation was 2.7% in August and core inflation (ex-food and energy) reached 2.4% in July before falling to 2.2% in August (the Fed’s target is 2.0%). The U.S. economy expanded a healthy 2.9% year-over-year in the second quarter, the unemployment rate has fallen to 3.9%, consumer spending is healthy, and business investment remains strong. All of this has given inflation hawks at the Fed ample argument to continue the push for higher rates.
U.S. Consumer Price Index
U.S. Unemployment Rate
Not all data support the hawkish argument, however. Housing price appreciation has slowed as higher mortgage rates impact affordability, and, significantly, the 2-year inflation breakeven rate fell to 1.60% in August. Short-term inflation breakeven rates are highly volatile but offer good insight into what investors are expecting for economic activity in the short term. The 2-year breakeven inflation rate has bounced back somewhat during the last six weeks, to 1.81% at the end of September, offering the inflation hawks more cover in the push for higher rates. The fact that this figure is still below 2.0%, however, offers a warning sign that investors have some doubts regarding the longevity of the current economic expansion.
U.S. 2-Year Inflation Breakeven Rate
The Treasury yield curve has flattened considerably this year. Fed rate hikes have pushed the short end of the curve higher, with the 2-year yield rising from 1.88% at the beginning of the year to 2.82% at the end of September. The longer end of the curve has also risen though not as much, with the 10-year yielding 3.06% at the end of September, up from 2.41% at the start of the year. The yield curve is now quite flat, which presents an additional warning regarding economic growth in the next 12 months. The yield curve seems to be predicting that the economy is set to slow as short-term interest rates grind higher, the positive impact of lower corporate rates on business spending wears off, and trade conflict and increased tariffs hurt corporate profits and dent consumer spending.
U.S. Treasury Yield Curve
Despite these significant warning signs the inflation hawks are firmly in control at the Federal Reserve. We believe that Fed chair Jerome Powell will remain with the majority in the hawkish camp and that the Fed will continue on with rate hikes until forced to stop by a weakened economy, inverted yield curve, or possibly both. Powell, not an academic economist, is unlikely to adjust the trajectory of policy until forced by the market.
We expect the Treasury yield curve to flatten further in the months ahead as the Fed pushes on with interest rate hikes, with a high likelihood of inversion during the next six months. Consequently, we are maintaining duration somewhat longer than portfolio benchmarks in our fixed income strategies. Corporate spreads remain tight and we favor agency MBS, whose yields have risen while convexity has fallen. In the last few years it was common for many of our MBS positions to be trading at a premium to par, thereby exhibiting heightened prepayment risk. Today our MBS holdings typically trade at close to or slightly below par, meaning prepayment risk is significantly lessened.
Bloomberg Barclays U.S. Investment Grade Corporate Option Adjusted Spread
Bloomberg Barclays U.S. MBS Index Convexity
We believe it is likely that Federal Reserve policymakers will err by raising the fed funds rate further than the economy will be able to comfortably absorb during the next 6 to 12 months. If this occurs higher duration bond portfolios should outperform as the economy weakens and long-term yields fall. With this in mind, if long-term bond yields rise in the coming weeks we will be looking to extend duration in our fixed income strategies.
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