Drew O'Neil discusses fixed income market conditions and offers insight for bond investors.
As we head into the final stretch of the year, let’s take a look at the current state of the market and the ground we have covered year-to-date.
The very short end of the Treasury curve has remained anchored with very low yield levels, as the 1-year is within a basis point of where it was at the start of the year. The rest of the curve has sold off, taking yields higher and prices lower. Intermediate maturities have seen the largest increases in yields, with the 5 and 7 year maturities higher by about 80 basis points and the 10-year up by just under 70 basis points year to date. The 2-year yield has more than tripled (~0.12% to ~0.42%) while the long-bond is higher by ~40 basis points. Keep in mind the relative nature of these moves, as Treasury yields across the curve experienced all-time lows in 2020. Yields are higher and might continue to move in that direction, yet have a long way to go before they will be considered high.
Investment-grade corporate yields have moved in a similar fashion to Treasuries, with yields higher across the curve and intermediate maturities seeing the largest increases. Looking at the BBB curve, the 5 to 10 year range is higher by 65-70 basis points. The slope of the “sweet spot” of the curve remains roughly the same as it was at the start of the year, with the 10-year BBB maturity offering 118 basis points of additional yield over the 4-year (compared to 116 basis points on 12/31/20). Spreads have remained consistent as well, with the 10-year BBB corporate to Treasury spread currently less than a basis point changed year-to-date. High-yield corporates have told a different story, with spreads tightening by ~60 basis points and currently sitting near historical lows. Highlighting the strong demand across the taxable bond space recently, ICI data shows 30 consecutive weeks of net inflows into taxable bond funds.
While municipal bond yields have risen, they have been much more stubborn than their taxable counterparts this year, as demand for high-quality, tax efficient investments has been a major headwind to higher yields. According to ICI data, municipal funds have had 31 consecutive weeks of net inflows and have only had one week of net outflows so far in 2020. Despite the headwinds, yields have managed to climb across the curve with intermediate and long maturity yields on the AAA curve higher by 15-25 basis points. Municipal relative value to Treasuries, as measured by the 10-year muni-Treasury ratio, remains low, although it has been steadily rising since June (it is currently ~73%). Overall, the credit quality of the municipal sector remains very strong and has proved resilient throughout the pandemic.
The Fed is currently purchasing $120 billion in Treasuries and mortgage backed bonds every month. Current expectations are for the FOMC to announce the start of tapering at their next meeting on November 3rd, with a likely $15 billion per month reduction in purchases. If things progress on this timeline, the taper would be complete by next summer (although this is merely speculation, as nothing has been officially announced). Keep in mind that when the Fed is finished tapering, it does not mean that they are stepping away from the market and/or their balance sheet will be reduced. Assuming that the process looks similar to the last time, they will continue to reinvest all principal and interest payments produced by their ~$9 trillion portfolio.
Bloomberg calculations based on Fed Funds futures are predicting a 77.5% chance that the FOMC raises the Fed Funds rate by next July and are pricing in two rate hikes by the end of 2022. These estimates mark a significant change in sentiment in just the past few weeks. At the start of the month, these same models were forecasting a 22% change of a rate hike by July and just under a 100% chance of a single rate hike by the end of 2022. These market-based forecasts seem to differ from the language we hear from Fed officials as well as market forecasters and economists, where the sentiment is that we are further away from an initial rate hike than market based indicators are predicting. The FOMC has emphasized that the decision to taper and the decision to raise the Fed Funds rate are not linked, and a decision to taper should not be viewed as a signal for the timing of a rate hike. In addition, in August 2020, the FOMC announced a change to their inflation target from 2% to an average of 2% over time, which gives them significant flexibility and the opportunity to let inflation run hotter for longer while still staying within their mandate.
After remaining under 2% since January 2019, Core PCE (Personal Consumption Expenditures), the FOMC’s preferred gauge of inflation, has been running in the mid-3% range since April. Considering the FOMC’s target of an average inflation rate of 2%, the average of Core PCE over the past two years is 1.91%. While some market forecasters are predicting that the recent trend will continue, the FOMC’s official forecasts for 2022 and 2023 are in the low 2% range.
The most recent Change in Nonfarm Payrolls number fell short of estimates (194,000 versus 500,000 estimated), yet the unemployment rate improved, falling further than expected (4.8% versus 5.1% expected). At the end of the day, the market interpreted these numbers as “good enough” to not derail the FOMC’s planned taper announcement next month. To provide some context for how bad things looked as the pandemic took hold last year, the unemployment rate peaked at 14.8% in April 2020 and the Change in Nonfarm Payrolls bottomed at negative 20.6 million that same month.
To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.
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