February 7, 2018
The U.S. Treasury market is off to its worst start of the year since 2009 as renewed fears of inflation have pushed yields higher. The 10-year Treasury yield has increased by 67 basis points since September 7th, ending January at 2.71% (Figure 1).
Figure 1 – U.S. Treasury Yield Curve
The combination of a favorable business environment driven by tax reform and financial deregulation, coupled with a declining dollar, is causing an increase in money velocity and higher commodity prices. This, in turn, has resulted in increased inflation expectations. The two year inflation breakeven rate has increased by almost 50 basis points since early December to 1.84% at the end of January. The five and ten year breakeven inflation rates have also risen to 2.04% and 2.14%, respectively (Figure 2).
Figure 2 – Inflation Break Even Rates
At its latest meeting (Janet Yellen’s last with the Fed) Federal Reserve policymakers opted to hold the fed funds rate steady while promising three rate hikes in 2018. They also reiterated their previously announced gradual pace of balance sheet reduction. Consistent with the recent rise of inflation pressures, the market is currently forecasting roughly three fed funds rate increases in 2018 (Figure 3), up from two a month ago. The possibility exists that incoming Fed chair Jerome Powell (believed by many to be more hawkish than Janet Yellen) tightens monetary policy faster than what investors are currently expecting. In the very days of Powell’s tenure, however, he has promoted continuity of policy, seeking to allay such concerns.
Figure 3 – Fed Funds Rate Implied Probabilities
Over the last four months we have been relatively defensive in our fixed income portfolios, but have begun to incrementally increase durations with the rise in rates. We view the sharp rise in rates since September as an opportunity to increase durations and thereby “lock-in” the higher yields now available. We are therefore extending duration in our intermediate and variable duration portfolios by acquiring longer duration securities.
This commentary is for informational purposes only. This commentary is in no way a solicitation or offer to sell securities or investment advisory services, except where applicable, in states where D.B. Fitzpatrick & Co. is registered or where an exemption or exclusion from such registration exists.
Information throughout this commentary, whether stock quotes, charts, articles, or any other statement or statements regarding market or other financial information, is obtained from sources which we and our suppliers believe reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. Neither we nor our information providers shall be liable for any errors or inaccuracies, regardless of cause, or the lack of timeliness of, or for any delay or interruption in the transmission thereof to the user. There are no warranties, expressed or implied, as to accuracy, completeness, or results obtained from any information contained in this publication.
Nothing in this publication should be interpreted to state or imply that past results are an indication of future performance.