INSIGHTS

On May 21, 2018

AAM Viewpoints – The Rates Rubik’s Cube

The 10-year Treasury broke through the psychological barrier of 3.00% and controlled chaos began in the prognosticating the potential of this mythical rate…well mythical in the sense that was last there in 2011. Considering we have a high propensity to forget intermediate-or-longer history and seem to replace it with recent events, one can empathize with this attempt. We can also understand that when viewing the unsexy but complex world of rates, it often looks like a Rubik’s Cube that has 43 quintillion possible combinations.

To determine the importance of this move and where it heads from here, let’s look at some break downs of its 50-year history:

• The 50-year average of the 10-year U.S. Treasury is 6.43% with Consumer Price Index (CPI) year over year averaging 4.1%. In the table below, we break this down into three distinct periods: (Source: Bloomberg, Bureau of Labor Statistics)

Source: AAM | Past performance is not indicative of future results.

QE=Quantitative Easing

• During that timeframe we encountered seven recession that lasted just under one year on average and is right at the average duration since the end of World War II.

• From a parochial view, we see the U.S. yield curve representing the following:
  
  
  
  • Maturing less than two years are mostly impacted by the Federal Reserve,
  
  
  • 5-10 year impacted by economic and political actions and the
  
  
  • 30-year influenced by long-term inflation movements.
    
    
    
    
  
  
  
  

With the recent Fed Fund Rate being an average of 300 bps (basis points) over the three most recent recessions, we begin to get a target of where the terminal Fed Funds Rate might be based off a starting point of 0%. Hint: it’s 3.00% if history repeats itself. However, we know from Mark Twain that “History doesn’t repeat itself, but it does rhyme.” That means from here we have another 125 bps of hikes if this were to be the top of this cycle and that would correspond to six more 25 bps hikes which equates to 18 months from here based on recent history. We would argue that the potential error may be higher based on recent fiscal stimulus and the urgency of the Fed to get to a more normalized position with their base rate and their balance sheet.

The conundrum of the recent move is showing up in some very unique ways that represent some potential large ramifications. We know that the issuance of Treasuries is increasing as the budget deficit increases. Recently the federal government reported huge increases in revenue from taxes, up over 8% from the year earlier. However, spending is estimated to be up 11%. This requires greater issuance of debt or borrowing to bridge that gap. Therefore, we are expecting 650 billion in net new issuance by the Treasury this year.

Recently, the Treasury has been issuing a larger percentage of Treasury bills (T-bills) and rolling them over at each auction. However, with the recent spike in the short-term rates, the 1-year Treasury has gone from 1.07% a year ago to 2.28% today, the marginal value of issuing short-term T-bills relative to longer term has waned substantially. That brings up the stronger likelihood of issuing further dated bonds relative to what they have done in the past. In the recent year, they have favored short term to long term by a 52% to 48% difference.

If they begin issuing even slightly more longer dated paper, the yield curve begins to shift outward if even slightly so. A slightly steeper curve would catch many institutional traders in a contrarian trap and possibly exacerbate the spread, not to mention the creeping rate of inflation in the system which we have discussed at length. As the spread has flattened, it does not mean a recession is imminent. We have discussed that even an inversion of the curve still provides 12 months or more before a recession occurs. So, while the Federal Reserve is raising rates, this might be counteracted a bit by the increased issuance of Treasuries and elevated state of inflation.

For those looking at where to be in late stage cycle investing, consider the historic bubble that exists in the spread between the U.S. Treasury and global interest rates. The current spread between the 10-year U.S. Treasury and a blended weight of the euro and Japan 10-year government bonds is nearly two standard deviations away from its average.

This wide variance has only occurred in history since the euro’s introduction as it did in May 1999 to June 2000.

• During this timeframe, the generic Eurozone 10-year yield jumped 111 basis points while the U.S. 10-year Treasury went up only 41 bps.

• The Euro Stoxx 50 Index increased by a total return of 38.7% while the S&P 500 was up 7.17%.

• The euro declined by nearly 12% while the trade-weighted dollar was up over 6%.

The focus on international investing during this point in the cycle still points to a better risk/reward than other areas. The European equity market, however, is not the only area where we still see select value.

As the hike to higher rates continue, a quick checklist of what has occurred in the three most visible investment grade indexes domestically in the Barclays Bloomberg Family of fixed income indexes. (Through 05/15/2018)

Source: AAM | Past performance is not indicative of future results.

While the large repatriation of money from the corporate tax cut has seen a decrease in corporate debt for certain higher-grade companies, the real story moving forward for fixed income investors is the basic supply-demand function of net new issuance this year. Over the long run, the increased issuance in corporate and Treasuries begins to have a bigger impact on rates moving higher. On the contrary, the lack of net new issuance in the Municipal sector (annualized at 0.7% over last eight years) relative to its long-term average (averaged 6% annualized since 1980) starts to tell a more intriguing opportunity in the late stages of this cycle. You want to consider increasing credit quality and shorten duration by either maturity or coupon (or both). Selective Municipal bonds generally provide this over other areas. While no one looks for negative returns, we believe the basic function of a well-balanced portfolio necessitates diversification, always.

CRN: 2018-0507-6653R