Headwinds for US Yields

11 Sep 2017

  • US yields have moved lower, the curve continues to flatten, and the recent range has been breached
  • We remain cautious, despite the consensus view of higher interest rates and wider spreads following the Fed’s balance sheet normalization, due to slow growth and weaker inflation
  • Non-economic factors continue to influence markets and put downward pressure on yields

Our thoughts and prayers are with our neighbors in Texas, Louisiana, Florida, Mexico, Puerto Rico and all islands in the Caribbean for their health, safety and well-being.

Interest rates have breached the lower end of the range this week, breaking through the key support level of 2.10% on 10-year notes. There is not considerable technical support below this level so next week’s economic data releases, especially inflation data, are extremely important for the near term level of yields and resetting of a range. The spread between the 2-year and 10-year US Treasury stands at 79 basis points, 20 basis points below its level at the time of the 2016 US presidential election. This is not however, indicative of confidence in the government’s ability to spur growth or any structural reflation of the economy. Further elevating risk are potential policy changes coming out of this month’s Federal Open Market Committee (FOMC) meeting, ongoing geo-political risk, and the still not fully realized impact of the devastating weather in the southern US.

The FOMC is expected to implement their balance sheet normalization process. The consensus view is that the impact from this should lead to higher interest rates, a steeper curve, and a general loosening in spreads over time. Given the Fed’s desire to remove liquidity via balance sheet reduction while simultaneously containing any material pickup in realized volatility, as occurred in the 2013 taper tantrum, investors should be cautious of falling in line with the consensus. The process will, in all likelihood, take much longer than planned due to weaker growth and slower inflation, leading to prolonged lower interest rates. This also means reduced volatility across spread products, and less opportunity.

Geo-political risk also continues to exhibit downward pressure on yields. Economic growth and inflation could be much higher, but the threat of nuclear confrontation with North Korea would still mean lower yields. This weekend’s reporting of Hurricane Irma took center stage, but North Korea-focused headlines should return relatively quickly. The North Korea situation is very concerning, and any US reaction to aggression must be cautious and well thought-out, considering the proximity of our allies in the region.

Hurricane Irma hit Florida this weekend and has helped to maintain pressure on yields. Initial estimates of the cost of this storm’s damage have moved lower following the weekend, but the damage inflicted should not be discounted. This hurricane and the devastating Hurricane Harvey that struck Louisiana and Texas have caused extensive damage. We ultimately believe this will boost economic data in terms of a small bump to inflation data and a pickup in government and private spending on the recovery.

It certainly feels as if risk markets are at an inflection point. The excess yield available to the marginal dollar of investment has been greatly diminished. The spread between risky and riskless assets is as low as it has ever been. Credit spreads are close to or tighter than they were going into the crisis. Equity prices have rallied and remain close to their all-time highs, yet interest rates have moved much lower and the yield curve has not been this flat since the crisis. The liquidity induced rally in asset prices feels as if it is at capacity, yet yields continue to move lower. We are biased to reducing risk in to the fourth quarter, as risk feels very asymmetric at this level of yields, and highly susceptible to non-economic factors.

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