Bonds Commentary

Bonds: Remaining Range-Bound

July 2018

As noted previously, the FOMC dot plot released in the wake of the Committee’s June 12-13 meeting highlighted an expectation among FOMC participants that a Fed funds rate target range midpoint of 2.375 percent at year-end would be “appropriate monetary policy.” Interestingly, the median expectation among dot plot participants was that the Fed funds rate by year-end 2019 will need to be above the FOMC’s own longer run median estimate for the neutral Fed funds rate. The FOMC dot plot effectively pulled forward one rate hike previously included in the Committee’s 2020 projection, raising the expectation for 2018 by one hike and leaving expectations for 2019 alone. By pulling forward one rate hike, the Committee was perceived to be more “hawkish”, dragging yields on long-dated Treasury bonds lower. The yield on 10-year U.S. Treasury bonds dropped from 2.98 percent on June 13 to 2.85 percent at month-end, and the yield on 30-year Treasury paper fell from 3.10 percent to 2.98 percent.

The yield curve has continued to flatten out, with the 2/10 spread compressing down to just 33 basis points at the end of June. Investor concerns over a yield curve inversion may come into play sooner than we had previously anticipated. Trade war fears and what is perceived to be a more hawkish FOMC are acting as powerful gravitational forces for the long end of the curve, and together should keep long-term interest rates under wraps, barring a thawing of icy trade relations near-term. The European Central Bank (ECB) appears poised to remain accommodative well into 2019. Market participants initially expected policy normalization via rate hikes to commence in the back half of 2018. An incrementally more dovish ECB, an incrementally more hawkish FOMC, continued repatriation of foreign profits by U.S. multinationals, political angst abroad, and stubbornly low wage growth, make U.S. Treasuries attractive, for domestic and foreign investors alike.

The 10-year yield has been trading in a wide range between 2.7 and 3.1 percent since the start of February, finding a “comfort zone” between 2.8 and 2.95 percent. It’s likely in our view that 3 percent will act as significant near-term resistance on the upside, while 2.75 percent should provide meaningful support. With short-term yields rising and long-term yields falling, the best opportunity for investors appears to be on the short end and in the belly of the yield curve. Credit, while still expensive, is less so than had been the case earlier in the year. The yield-to-worst on the Bloomberg Barclays U.S. Corporate High Yield Index sat at 6.49 percent at month-end, a year-to-date high, and the highest level since the end of November 2016. High-yield defaults remain subdued, and the rally in energy prices lends support to approximately 15 percent of the Index, but we’re late in the game, and we’re likely closer to the exits in high yield than we are to playing extra innings. While Treasuries may be garnering capital at present, we would use the recent rally in Treasuries to re-position on the shorter end of the yield curve, while diversifying via structured products and dollar-denominated emerging market debt.

Source: Bloomberg


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