INSIGHTS

On October 04, 2016

Where is the Sweet Spot on the Curve?

With the somewhat contradictory dynamics of a looming threat of Fed tightening (which has been the headline story since before the rate hike in December 2015), limited data indicating any consistent increase in inflationary pressures, unusual global central bank policies (negative rates overseas and most recently the Bank of Japan targeting 0% for 10-year paper), what is an investor to do?

Let’s review some data to understand where we have been and where we find ourselves today. The Fed had maintained an accommodative policy range of 0.00% to 0.25% since December 2008 in the midst of the global financial crisis. In our opinion, we first began to hear rumblings of a potential tightening bias in late 2014, as the quantitative easing policy (QE3) was set to end. These projections for the Fed’s willingness to raise its target rate were suggesting timing at various points in 2015. Though this timing scenario had been suggested for some time prior 2014, our interpretation is that neither the market nor economists were giving such forecasts any credence until late 2014. In short, the market and investors have been on their heels since late 2014 on concerns that a Fed rate hike was approaching.

The below chart highlights points along the AAA MMD (Thomson Municipal Market Data) curve at three different points in time:

• The beginning of 2015 (the start of the calendar year in which projected rate hikes were expected to occur)


• The day before the initial rate hike in December 2015


• Current – as of September 30, 2016

Source: AAM, data courtesy of Thomson Reuters

BPS = basis points

A few observations from this data

• Present AAA municipal rates are lower today across the curve than both prior dates, with the exception of the very front end since the early speculation that Fed Rate hikes were imminent and the day before the first rate hike in December 2015. Just to make sure this point is understood: Non-short-term rates are lower today than during the entire period for which investors were concerned that the Fed was raising its target short-term rate.


• The curve is flatter, particularly and most noteworthy between the 2-year and 10-year spots on the curve. The spread between 2-year and 10-year rates compresses from 150 basis points to 118 basis points to 69 basis points as we move through this analysis.

By definition, the Federal Funds Rate is a short-term rate (overnight) which primarily impacts the front-end of the market. Therefore, we expect near-term impact upon interest rates from changes in policy to be most felt on shorter-dated maturities. Economists generally concur that it takes approximately 18 months for the effects of monetary policy to be felt throughout the system. This suggests that the effect upon longer-dated maturities from changes in economic policy to be muted until the effects of the change can impact consumers, in other words non-short-term borrowers of capital.

Our analysis suggests that significant increases to longer-term rates are not imminent and investors who prematurely reduce duration by focusing purchases on the front-end of the curve are purchasing securities whose value is most expected to decline in the near-term due to the tighter economic policy of the Fed. We believe a more balanced investment approach to maintain participation in the market and avoid reduced-return scenarios would suggest looking at securities with calls (the issuer can redeem bonds earlier than the maturity date) between the 4-7 year range with mid-range (12-20 year) final maturity structure.

CRN: 2016-1003-5566R

AAM was not involved with the preparation of the articles linked to in this email and the opinions expressed in these articles are not necessarily those of AAM.