INSIGHTS

On July 01, 2019

AAM Viewpoints – What’s a Debt Investor to Do?

Investors are facing many challenges this year, but not because things are trading down. In fact, perhaps the most unusual aspect of mid-2019 is that almost everything is trading up at the same time: The S&P 500 Index is within 1% of its all-time high, gold has jumped to a six-year high, crude oil is up 10% in June, the yield on the 10-year U.S. Treasury bond has fallen below 2% for the first time since 2016, and 30-year mortgage loan rates have fallen below 4% for the first time in three years. It would seem that it is all good news in the capital markets on first look.

There are other aspects of the economy that have some investors concerned that the next market move might be down. The drop in long-term interest rates has been rapid and that historically has proceeded a slowdown in economic growth. This time, however, there is now an unprecedented $13 trillion in sovereign debt with negative yields around the globe; a situation that makes comparisons with similar past circumstances problematic. Despite low mortgage rates, home sales are slowing. Unemployment in the United States is at decades-low levels, yet consumer confidence is softening. Many investors remain concerned with ongoing negotiations of new trade agreements between the United States, Canada and Mexico as well as China, which has resulted in trade slowing and could lead to an outright tariff war.

More specific to debt investors are expectations that the U.S. Federal Reserve (Fed) will cut overnight interest rates very soon. The last time the Fed cut rates was December 2008. Current expectations are virtually 100% that the Fed will cut rates at their next meeting at the end of July, at least 0.25% with some calling for a 0.50% reduction and most expecting a second 0.25% cut later in the year. This expectation is best expressed by the now-inverted U.S. Treasury yield curve (a situation where shorter-term debt yields more than longer-term debt) a circumstance which has preceded recessions several times in the past. If the Fed makes the expected rate cuts and the yield curve returns to its normal positive slope, it is likely that longer maturity interest rates will stay where they are at or may even fall slightly further. If, however, the Fed postpones or reverses their indications of cutting rates, there is likely going to be increased volatility in the debt markets, depending on what reason the Fed gives for not cutting rates.

What’s a debt investor to do? If the Fed cuts rates – as expected – there should be limited volatility as the yield curve re-assumes the preferred positive slope (i.e.; short maturities yielding less than longer maturities). Nevertheless, the longer end of the curve now has record interest rate risk and it is difficult to conclude you are being paid enough to take that risk. The yield on the shorter end of the curve is likely to fall when the Fed cuts. Intermediate maturities appear to be the most attractive at this time as the yield is near what longer maturities pay, yet the interest rates risk is noticeably less. At the same time, the easing taking place by central banks, both here and abroad, leads one to conclude that taking on additional credit risk for additional yield at this time may not be prudent, at least until the trade issues appear resolved, and staying in Investment Grade credit quality is the better choice for now, in our opinion.

CRN: 2019-0603-7462R  

The opinions and views of this commentary are that of Dial Capital Management and are not necessarily that of AAM.