This past week the weaker economic data seemed to put more at ease that the next rate increase isn’t coming when the Fed meets on Wednesday, yet rate talk continues to dominate market conversations and markets will be waiting for what is said on Wednesday as to if a December increase is likely. As rates do ultimately rise at some point, we would expect to see a larger move in the shorter rates, but don’t expect to see a huge spike in the medium to longer term rates (5 and 10-year Treasury rates)—in short, we’d expect a flatting of the yield curve. Ever since the Fed began their tapering in 2013, we have started to see the yield curve beginning to flatten.1
The Federal Funds Rate and rates and US Treasury debt are independent of each other. Federal Reserve action changes the Federal Funds Rate, which is an interbank lending rate. This in turn can impact market expectations for rates and market psychology, and market forces (investor demand) in turn “set” the rates on US Treasury debt. For instance, if investor demand lessens for Treasuries and they all of a sudden require to get paid more to hold Treasuries, this causes Treasury yields (rates) to increase. In our own high yield market, “spreads” are priced off of comparable maturity Treasury rates, so it is these 5- and 10-year rates that are in focus for us.
With the most recent Fed chatter, we have seen the 10-yr move about 30 bps up from its 2016 lows of 1.37 bps in early July to 1.7 bps today, with an almost 30bps move in the 5-year Treasuries over this period as well.2 Yes, this renewed rate talk does bring an immediate market reaction in US Treasury rates; however, we don’t expect to see a sustained and significant spike in the longer-end 5-, 10-and 30-year rates, even if/when the Fed takes further action in raising the Federal Funds Rate over the next year. We would expect the shorter-end of the curve to be impacted by Fed action, but we’d expect the longer-end of the curve to continue to be constrained by a number of factors, including the following:
- Global Growth: We are in the midst of a weak global demand outlook and a weak global economic environment. China has been slowing, quantitative easing is still underway by the ECB hoping to get things going in Europe, and the Bank of Japan has been even more aggressive in their intervention. Demand worldwide is tepid, impacting corporate profits and demand her at home. Retail sales, industrial production, and GDP growth have been anything but robust here in the US. In short, we certainly don’t have a strong economy that the Fed needs to temper and that the strong “data” the Fed looks to may be hard to come by in order to make much of a rising rate argument. These longer dated Treasuries certainly take their cues from the data as well.
- Global Rates: We expect that historically low, and in some cases negative, rates on sovereign debt throughout much of the developed world compared to our rates and economy will cause a continued demand for much higher yielding US Treasuries. For instance, investors are in essence paying to have their money held for 10-years in Japan, Switzerland, and Germany. Much of the rest of Europe has rates sub 0.5%, while the UK, even if the face of all of the Brexit uncertainty has rates under 1%.
- Global Demographics: The population is aging and with that investors will become more and more focused on capital preservation and income generation causing them to rotate from equities into fixed income. Additionally, as pensions focus more on liability driving investing (matching assets/income with upcoming liabilities/payouts), stability and calculated income will be key. We are already in the beginning stages of this and expect it to continue (see our pieces “Zero Sum Game” and “Of Elephant and Rates”), causing a demand for fixed income assets in the years and decades to come.
While we may see some continued near-term volatility in the 5- and 10-year rates on this resurgence of Fed-speak, we ultimately don’t expect the see a sustained upward swing in these yields. We expect that the yield curve will flatten and in this low yield environment investors will continue to search for yield, and we believe that with the yields offered by high yield bonds, this remain an asset class investors should consider as they look for this yield.