While Jim is away on vacation, other members of the TBA Investment Committee will write the market comment. Today’s comment is from Dan Rodan.
Trade tensions take center stage again as China hints at increased retaliations, and the White House signals 5% tariffs against Mexico if Mexico does not increase its efforts to slow the continued flow of Central American asylum seekers crossing the southern border. The Mexico tariffs could grow to 25% by the fall. These growing trade tensions between the U.S. and China, and now the U.S. and Mexico, rattled the markets, and the equity markets look to continue their gradual sell off which has been going on for most of May. Trade tensions combined with slowing growth and tepid inflation are all causing investors to look towards the bond market for safety, driving yields down across the board. Let’s look at the fixed income markets so far this year.
On December 18, 2018 the Federal Reserve raised the fed funds rate to a target of 2.25% to 2.50%. The 2-year Treasury was yielding 2.64% and the 10-year Treasury was yielding 2.82%, well below its cycle high of 3.24% in November. At that point the U.S. and China were in the midst of discussions on trade, the U.K. didn’t have an agreeable Brexit plan, inflation was subdued and growth concerns for the world were starting to pop up. This also came at a time when the equity markets were in a free fall up until Christmas. Despite an equity market rally back to old highs this year, many of these major events haven’t changed: the U.S. and China are in a trade war, the U.K. still doesn’t have a Brexit plan, and inflation and worldwide growth are both muted. A major change did occur in the 10-year Treasury yield as it is 100+ basis points off its high of six months ago and is trading at levels last seen in the fall of 2017 at 2.16% this morning. The cause of this drop in yields since last November can be attributed to the bond market not seeing an easy solution to these issues and now the U.S. Mexico situation. The expectations at the beginning of the year were for a U.S. and China trade deal by this point and for a soft U.K. Brexit. With those things solved, worldwide growth would have been seen as stronger going forward, and rates presumably would have remained higher.
The U.S. 10-year bond is not alone in trading at lower yields over the last six months. The German 10-year bund is trading at –0.20%, an all-time low, and the Japanese 10-year bond yield is -0.10%. Shorter-term bonds in both countries are trading at even lower negative yields. In fact, it is estimated that there is more than $12 trillion worth of bonds trading with negative interest rates. The fact that sovereign debt around the world is trading with negative rates makes the 2%+ 10-year U.S. Treasury look attractive. The more buyers the U.S. bond market sees, the more it forces yields lower. Another major factor in driving yields lower is the amount of funds that have flowed into bond funds this year. Bank of America Merrill Lynch estimates nearly $160 billion has flowed into fixed income assets so far while $135 billion has flowed out of equity markets, helping to push rates lower around the world.
Back in December, after the Fed raised rates for the fourth time in 2018, the Fed said that it expected two more rate hikes in 2019. Since then the Fed has changed its tone to more of a “wait and see” approach. It has said that it intends to hold interest rates where they are and that it does not see a reason to raise or lower them at this time. The bond market is telling a different story though. The market is beginning to price in at least one if not two rate cuts before the end of the year. Fed fund futures are now saying that there is a greater than 60% chance that there is a rate cut of at least 25 basis points by September and a 90% chance by December. Many are saying the last rate hike in December was a mistake. However, the Fed would likely have to see a sharp deterioration of U.S. economic data or a complete abandonment of U.S. and China trade talks to revise its patient, wait and see approach.
The Fed’s hand may be forced to an extent due to the inversion of the yield curve, when shorter maturity bonds yield more than longer maturity bonds. Currently the three-month T-bill is trading at 2.34%, the two-year is trading at 1.99% and the ten-year is trading at 2.17%. The last seven recessions have come after yield curve inversions. It is important to note that every inversion is not always followed by a recession. The yield curve has inverted without a recession as in 1998 with the Russian debt crisis leading to the hedge fund Long-Term Capital Management collapse. In 1998 the Fed cut rates by 75 basis points, and recession was avoided.
Corporate bond spreads, the amount that corporate bonds pay above an equivalent Treasury bond, have held up despite the move lower in Treasury yields. Since the financial crisis there has been a surge in U.S. corporate debt, partially due to the fact that interest rates have been so low. Debt issued by nonfinancial U.S. companies has risen by 48% to more than $9.8 trillion. More than half of the U.S. corporate debt is now in the lowest investment grade category by both Moody’s and Standard and Poor’s. Prior to the financial crisis that number was about 35%. Most of that can be attributed to the financial sector, which the credit rating agencies re-rated lower after the crisis despite these financials being better capitalized. Corporate yields are still at historically low levels compared to the last 50 years.
Municipal bonds have also participated in the cash inflows and lower yields that the rest of the fixed income market has experienced. Out of the $160 billion that has flowed into fixed income assets, $37 billion of that has been into municipal bonds. That is the most in almost thirty years. $8 billion of that has flowed into high-yield municipal bonds, the most through May, since 1992. The recent tax changes have helped the inflow as municipal bonds are one of the few remaining tax shelters. However, the high-risk municipal market has seen an uptick in issuance led by charter schools, retirement communities and infrastructure projects that are not backed by the taxing power of cities or states or the revenue sources of essential services like water and sewer utilities. These are riskier investments that currently pay more but carry a higher default chance. As investors continue to move into the sector and chase yield, yields will drop just like Treasuries and at some point, this will become unsustainable.
While the equity market continues to sell off over the past few weeks, it is important to pay attention to the fixed income markets as well. Fixed income is an important part of investors’ portfolios and often considered less risky than the equity markets. Knowing and understanding what you own in your fixed income portfolio is just as important as the equity side. Just like on the equity side, a diversified portfolio of quality bonds will help ride out any move in interest rates. Interest rates could continue to fall as global trade tensions rise and growth and inflation remain subdued. The Fed may have to act at some point too. The bottom of interest rates in this cycle might not be in yet.
Dan Rodan, 610-260-2217