June 10, 2020
Grading on a Steepening Curve

  • Intermediate and long US yields have risen significantly in recent weeks, primarily in response to monetary policy and better-than-expected jobs numbers, but remain well below pre-COVID highs.
  • The rise in yields has steepened portions of the curve from a historically flat trajectory to levels unseen in several years.
  • At this point, we believe the recent move in the yield curve is largely in its latter stages over at least the near-term heading into the fall, with the expectation for further steepening into 2021 as the economy improves.
  • We continue to favor credit exposure over duration and US Treasuries.

What Happened

Leading up to periods of perceived economic stress or when Federal Reserve (Fed) policy is less accommodative relative to growth expectations, the yield curve can become very flat—or even inverted (i.e., short-term bonds yield more than longer-dated bonds)—as we saw in the middle of 2019. By March, the inversion had corrected itself, but the yield curve remained extraordinarily flat. Since February 21, the 2- to 10-year US Treasury curve (i.e., the yield differential between 2- and 10-year US Treasury maturities) has widened more than 50 basis points (0.50%). Two years ago, the Federal Reserve Bank of San Francisco stated that the US Treasury curve between the 3-month and 10-year maturities was actually a better yardstick of economic health. The researchers’ paper raised the relevance of the 3-month/10-year curve, and economists applied more emphasis upon its signals. Since February 26, the 3-month/10-year curve has steepened approximately 80 basis points (0.80%) from a 17 basis point inversion. The US Treasury curve as a whole (out to 30-year maturities) steepened by 112 basis points (1.12%) over that same span.

Near-Term Outlook

Short-Term Yields Tethered to Zero

Given the already strong shift upward in the 10-year and longer portion of the curve, we expect the powerful steepening via rising long-dated US yields to abate. The Fed remains committed to holding its short-term policy rates near zero for the foreseeable future. Today, the Fed’s updated quarterly projections suggested policymakers will not entertain any increase to the Fed funds target range until at least 2022.  In other words, the central bank’s rate stance will directly anchor the front end of the US Treasury curve for quite some time. Additionally, the Fed may utilize yield curve control to cap US Treasuries at targeted rates via open market operations. We also believe the Fed will limit its influence to the first few years of the curve. If executed, this policy action would only add to the suppressive forces on short rates in the near term.

Monetary Policy Suppressing Long-Term Rates

An array of forces is currently in play that will make it difficult for intermediate and long US yields to find higher ground. For one, part of the Fed’s emergency response to the virus outbreak was the reinstatement of unlimited quantitative easing. In today’s FOMC statement, the Fed committed to maintaining its current pace of US Treasury purchases (roughly $80 billion per month) for months to come. Secondly, the pandemic’s historical disruption to consumer demand has unfurled a significant deflationary force in the short term. Since January, year-over-year growth in headline CPI has fallen from 2.5% to 0.1%, its lowest reading since Q4 2015.

As the economy reopens and demand for goods and services rebounds, inflation should follow suit. But it will take time to achieve pre-pandemic levels of activity, and secondary outbreaks could create periods of risk-off trading.  Uncertainty surrounding the global economic recovery will continue to fuel domestic and foreign demand for safe haven US assets. Additionally, US Treasuries still offer positive yields in an era when $11 trillion in foreign debt is paying a sub-zero rate. US yields’ relative value will persist in the months ahead, which contributes to our stable near-term expectations.

Longer-Term Outlook

As we look into the next year and beyond, our base case scenario for high-grade fixed income incorporates further steepening in the US yield curve. Even over a longer horizon, we believe the Fed’s policy rate setting will remain accommodative, tethering short US yields. Our expectations for short US yields beyond this year remain very low.

The yield curve dynamics from five years and beyond are more complex. To start, the Fed is already slowing its pace of weekly US Treasury purchases. As the Fed phases out its unprecedented quantitative easing program, a major source of US debt demand will sunset. That should have a net upward effect on US yields (i.e., lower prices). The effects of the Fed’s massive monetary policy response and Congress’ shock-and-awe fiscal aid packages have yet to fully seep into the US economy. Policymakers’ decisive responses were essential and praiseworthy—but they will come with a long-term cost, including heightened inflation concerns. As economic activity normalizes, prices should recalibrate higher and pull US yields higher in concert.

The other cost of the US government’s enormous spending plans is more literal.  To pay for the Coronavirus Aid, Relief, and Economic Security (CARES) Act, the US Department of the Treasury will have to issue trillions of dollars’ worth of US Treasury debt. That spike in supply—in the face of waning Fed demand, no less—is expected to create its own lift in US yields.

Another potential side effect of the pandemic: a repatriation of the supply chain. The virus outbreak revealed the vulnerabilities associated with a heavy reliance on foreign manufacturing for essential products. Political momentum is building to bring more manufacturing onshore to mitigate future disruptions in the supply chain.  If US-based companies follow through, that effort would likely result in higher labor and material expenses.  Those costs would ultimately be thrust upon US consumers in the form of higher prices, pressuring inflationary forces higher.

Within 18 months following the end of the previous three recessions in 1991, 2001, and 2009, the steepness of the 3-month/10-year curve peaked between 360-380 basis points (3.50-3.80%). Today, the spread between the 3-month US Treasury bill and 10-year US Treasury note sits at just 66 basis points (0.66%).  While no cycle is the same, curve behavior during those downturns suggest our yield curve may look drastically different as we put the COVID-19 crisis in our rearview mirror.

Conclusion

The curve has shifted to dramatically lower absolute yields over the last several months and deflationary forces should keep them contained. The bond market will grapple with the push of improving economic data from severely depressed levels and more supply against the pull of high unemployment, safe haven demand and inflation well below the Fed’s target.

To position for this combined outlook, we recommend maintaining a slightly shorter duration bias to protect portfolios from the rising rate environment while remaining well positioned for extension as longer yields become more attractive. We favor emphasizing credit exposure over US Treasuries as investors search for yield in this low rate environment. Based on the risk-reward profile, the 5- to 10-year portion of the curve currently offers the greatest value given the Fed’s influence on short yields and the interest rate risk that exists beyond 10 years. The current rate environment does not create a compelling case to extend duration immediately, but we believe that the opportunity will emerge as the economy fully recovers and the effects of the US’s massive aid packages seep into system.

Disclosures

This material was provided by SunTrust Private Wealth Management for use by BB&T Wealth.

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