by Asset Allocation Committee

Given the length of the current expansion, there is growing concern about the economy’s ability to avoid recession.  So far, none of our indicators suggests the economy is near a downturn.  Of all the indicators we monitor, the yield curve is the most reliable; however, there are potentially dozens of iterations of “the yield curve.”  The two-year/10-year T-note spread is used in the leading economic indicators.

The indicator is quite reliable with no real false positives.  This is monthly data through October; currently, the spread is around 65 bps, meaning it is approaching inversion but still above zero, meaning the economy is probably still on pace to avoid recession over the next year.

Other calculations of the yield curve offer other insights.  The spread between the implied three-month LIBOR rate from the Eurodollar futures market, two-year deferred, relative to fed funds offers insights into monetary policy.  The Eurodollar futures market is where unhedged interest rate swaps are offset, so a rising implied rate on the deferred contracts suggests increased hedging activity and fears of rising rates.  When those implied rates stop rising, it can offer a signal to policymakers that they have moved rates enough.

The lower two lines on the chart show the implied three-month LIBOR rate and the fed funds target.  The upper line is the spread between the two rates.  The important insight from this analysis is that the FOMC stops raising rates when the spread inverts.  Chair Greenspan was able to prevent two recessions, one in 1994 and another in 1998, by rapidly cutting rates when the implied rate fell below the fed funds target.  Although the FOMC did move rapidly in 2000, the rate cuts were not aggressive enough to prevent a recession.  At the same time, the 2001 recession was rather mild.  In the 2004-06 tightening cycle, the FOMC did stop raising rates once the spread inverted; however, the central bank kept rates elevated despite the inversion.  As financial conditions deteriorated, the Federal Reserve moved to cut rates aggressively but this action was not enough to prevent the Global Financial Crisis.

So, what does this chart tell us now?  As long as the spread isn’t inverted, the FOMC will probably continue to raise rates.  Note the reaction of implied LIBOR rates in 2016 after the December 2015 rate hike.  As the implied LIBOR rate fell, the FOMC, which had been signaling higher rates for 2016, held rates steady until December and only raised rates as the implied LIBOR rate rose as well.  Overall, this pattern suggests that the current spread will support a December rate hike.  However, next year’s rate moves should follow the implied LIBOR rate.  If that rate fails to rise with policy tightening, we would expect the FOMC to slow the pace of increases next year.

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by Asset Allocation Committee

[Ed note: We will not publish an Asset Allocation Weekly Comment the week of November 24. The next comment will be published December 1.]

Over the past three weeks, we have seen a rise in the yields on high-yield bonds.  The Merrill Lynch High Yield bond effective index is up 40 bps since late October.[1]  There are a number of reasons for the sudden weakness.  They are:

1. The tax bills in Congress may limit the deductibility of interest for corporations. Since many high-yield issuers are dependent on debt to fund their operations, a tax change could have an adverse effect on these companies and their high-yield issuance.  At the same time, we remain pessimistic that major tax reform is likely and so the final version of any tax changes will likely be limited.
2. Telecom and health care sectors have suffered some weaker earnings growth. The failed merger talks between Sprint (S, $6.21) and T-Mobile (TMUS, $56.52) also dampened sentiment in the telecom sector.  Since these sectors are important issuers of high-yield debt, their problems have raised concerns.
3. Spreads have narrowed significantly.

This chart shows the Merrill Lynch High Yield Master effective yield and the five-year T-note yield.  The lower lines on the chart show the average spread and the standard deviation lines.  The narrowing spread, by itself, doesn’t necessarily signal an imminent problem.  As the above chart shows, spreads can remain at the lower deviation for an extended period of time.  However, a spread at the lower deviation also suggests a market that is richly valued.

4. The relationship of high yield to monetary policy suggests that major reversals in the high-yield spread tend to occur well into a tightening cycle.

This chart shows the high-yield spread and the fed funds target.  Major spikes in the spread are more likely after policy has already been tightened.  In addition, the spread often continues to widen after policy easing has commenced.  This pattern indicates that the spread is very sensitive to financial stress; in fact, most financial stress indices include both high-yield bonds and high-yield spreads in their construction.

Although there has been much press in the financial media on the recent backup in yields, the most recent change is barely visible on the spread.  There isn’t any obvious increase in financial stress, and monetary policy, while tightening, is not at a level that indicates it is near the end of the cycle nor is it at a level that should be causing stress.  In our Asset Allocation portfolios, we have been reducing our exposure to high-yield bonds in the income-oriented programs due to high-yield spreads falling to the lower deviation.  However, we don’t expect that the recent rise in yields signifies the onset of a financial crisis.  Obviously, we will continue to monitor the situation but, for now, we are comfortable with our current allocations to this asset class.

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[1] https://fred.stlouisfed.org/series/BAMLH0A0HYM2EY

by Asset Allocation Committee

Last week, we discussed our views of the debt markets.  However, one item we didn’t examine was the dynamics of the yield curve.  The U.S. Treasury market has both a domestic and an international component.  While all sovereign debt markets have a domestic component, the international component is especially a factor for the U.S. because the dollar is the reserve currency.  In our Treasury model, we use inflation expectations and fed funds for domestic elements.  For foreign elements, we use the yen/dollar exchange rate, German bund yields and oil prices.  Our model suggests that the dynamics of the yield curve are affected primarily by the domestic component.

Shifts in the yield curve are driven mostly by a combination of monetary policy and inflation expectations.  As a general rule, short-duration instruments are more sensitive to monetary policy and less to inflation expectations.  Long-duration instruments have the opposite characteristics.   When we model the two-year Treasury and the 10-year Treasury, these characteristics are confirmed.

These are the coefficients of our Treasury model.  The impact of the inflation variable has more than twice the impact on the 10-year Treasury compared to the two-year Treasury.  At the same time, the impact of fed funds is more than twice as important to the two-year Treasury compared to the 10-year Treasury.

Our inflation variable is really about measuring inflation expectations.  We use the 15-year moving average of the yearly change in CPI and developed this variable based on Milton Friedman’s research.  He postulated that inflation expectations are formed over a long period of time.  This is our proxy for inflation expectations; although this moving average works reasonably well over time, we do realize that inflation expectations can have sudden shifts.

This chart shows the 15-year average of inflation compared to the implied five-year forward inflation rate from TIPS.  Although the moving average isn’t a perfect proxy for inflation expectations, it has worked as a measure of central tendency since 2009.  And, since the instruments haven’t been around for very long, it’s difficult to know how the average compares over a longer time frame.  But, for our purposes, it is a workable proxy.

When inflation expectations become volatile, policymakers describe these conditions as times when inflation expectations become “unanchored.”  These periods can make the conduct of monetary policy difficult.  If inflation expectations rise, policymakers are likely to raise rates aggressively to contain those fears.  At the same time, a decline in expectations can be just as problematic.  If the FOMC is raising the target for fed funds while inflation expectations are falling, the yield curve will flatten.  The FOMC would generally prefer a steeper yield curve.  The Federal Reserve doesn’t do a good job of explaining why it wants “higher inflation,” which would seem to be a goal worth avoiding.  What it really means is that it wants steady to modestly higher inflation expectations when it is raising the policy rate; otherwise, the yield curve will flatten and increase the likelihood of a recession.

Currently, the two-year versus 10-year Treasury yield spread is above zero but the curve is clearly flattening.  If the FOMC continues to tighten into stable (or perhaps falling) inflation expectations, the yield curve could invert and perhaps signal the end of this long business expansion.

The recent flattening of the yield curve suggests that inflation expectations are probably declining.  If the Federal Reserve raises rates as much as planned and inflation expectations remain anchored at around 2%, we estimate the yield curve will fall under 50 bps.  However, if inflation expectations decline, policymakers could overshoot rate hikes and increase the risk of recession.  Our base case is that central bankers will remain cautious but it is a factor we will be watching closely next year, especially as the new composition of the Fed’s Board of Governors becomes apparent.

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by Asset Allocation Committee

The 10-year Treasury yield has recently been trending upward.

Since early September, yields have risen from 2.06% to 2.46%.  What’s behind this rise and do we expect it to continue?

We use our 10-year T-note model for guidance.  It estimates the fair value level of the 10-year T-note yield based on the long-term average of inflation, fed funds, German long-dated sovereign yields, the yen/dollar exchange rate and oil prices.

Based on these factors, the current fair value is 2.24%, a bit lower than the current yield.  At the end of 2016, fair value was 1.96%, so the fair value rate has been moving higher.  The primary reason has been a modest rise in German yields, rising fed funds and higher oil prices.

What do we see going forward?  The two independent variables that have the most potential for pushing the fair value higher in the near term are fed funds and German yields.  If the fed funds target rises to 2.25% by the end of next year and nothing else changes, the fair value yield would rise to 2.78%.  If German bunds were to rise in yield to 0.75% at the same time, the fair value yield would rise to 2.80%.  Thus, the primary worry is monetary policy.  As we discussed last week, given the FOMC’s voting roster next year, the FOMC will be unusually hawkish in 2018, so the odds of higher yields are rising.

What about tax policy?  Would larger deficits boost yields?  The impact of deficits on interest rates is mixed.  Perhaps the best way to think about this is with the savings identity.[1]  The identity is: (private saving) + (public saving) + (foreign saving) = 0.  In theory, if tax cuts result in a deficit of public saving, it must either be offset by rising private saving (saving>investment) or rising foreign saving (otherwise known as a current account deficit).  If the public deficit is resolved by private saving, interest rates usually rise.  But, if it is offset by foreign saving, domestic interest rates become a function of foreign interest rates.  In other words, if foreign interest rates are low, domestic interest rates may not necessarily rise.  In practice, large deficits usually occur during recessions and private saving is rising anyway as consumption falls.  Thus, there will be talk about tax cuts boosting interest rates but the evidence isn’t clear to support such statements.

The long-term risk for fixed income is inflation expectations.  We use the 15-year average of CPI as a proxy for inflation expectations.   Although we still expect inflation expectations to remain low, if populism leads to reregulation and/or deglobalization of the economy, inflation and expectations of future inflation would likely increase.  If policymakers conclude that inequality must be reduced by restricting the introduction of new technology and restraining trade, greater inefficiencies will likely bring higher inflation.  If such policies develop, we will become more defensive on fixed income.

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[1] For a deeper discussion, see WGRs from May 2017, Reflections on Trade: Parts I-IV.