Rates: Fed Policy Will Dictate Demand

A barbell position remains appropriate as the yield curve flattens further.

August 16, 2017


This Rates sector report is excerpted from the Third Quarter 2017 Fixed-Income Outlook.

As the market was expecting, the FOMC raised rates by 25 basis points at its June meeting, bringing the target range for the federal funds rate to 1.00–1.25 percent. In addition to releasing an updated Summary Economic Projections (SEP), the FOMC announced a detailed balance sheet normalization plan, setting the stage for this process to begin over the next few months. The FOMC acknowledged that inflation has declined recently, and that market inflation expectations remain low; however, they believe that this decline is temporary. Over the course of the quarter, the long end of the yield curve moved lower, led by inflation breakevens, possibly indicating that the market believes that low inflation could prove to be persistent.

Inflation Remains Stubbornly Low

Yields at the long end of the curve moved lower over the course of the quarter, possibly indicating that the market believes factors leading to declining inflation pressures are more than transitory.

Inflation Remains Stubbornly Low

Source: Bloomberg, Guggenheim Investments. Data as of 6.30.2017.

The yield curve continued to flatten during the second quarter. The Fed tightening caused yields at the front end of the curve to rise and the two-year Treasury yield to increase from 1.26 percent to 1.38 percent. Meanwhile, declining inflation pressures caused longer-term yields to fall, with the 10-year Treasury yield decreasing from 2.39 percent to 2.31 percent. The Bloomberg Barclays U.S. Treasury index returned 1.3 percent for the quarter, bringing the total return for the year to 1.9 percent. The Bloomberg Barclays U.S. Agency index returned 1.0 percent for the quarter and 2.1 percent for the year. Globally, the Bloomberg Barclays Global Treasury index returned 2.35 percent for the quarter and 4.5 percent for the year as foreign sovereign markets outperformed.

Looking forward, we expect the FOMC to announce the start of its balance sheet reduction plan at its September meeting, and to increase the federal funds rate an additional 25 basis points at its December meeting. Should inflation remain below the Fed’s inflation target of 2 percent, additional increases in the fed funds rate may put the Fed ahead of the curve on inflation, which may result in a monetary policy stance that is more restrictive than the Fed expects, causing long-term yields to fall. We continue to believe that the yield curve will flatten further, and that a barbell position remains appropriate. Within the government sector, longer-dated Agency securities offer attractive spreads over Treasury securities and should benefit in a risk-off event. Note: “Rates” products refer to Treasury securities and Agency debt securities.

Low Inflation Raises Risk Monetary Policy Will Become Too Restrictive

Should inflation remain below the Fed’s inflation target of 2 percent, additional increases in the fed funds rate may put the Fed ahead of the curve on inflation, which may result in a monetary policy that is more restrictive than the Fed expects.

Low Inflation Raises Risk Monetary Policy Will Become Too Restrictive

Source: Bloomberg, Guggenheim Investments. Data as of 6.30.2017.

—Connie Fischer, Senior Managing Director; Kris Dorr, Managing Director; Tad Nygren, CFA, Managing Director

 
Important Notices and Disclosures

This article is distributed for informational purposes only and should not be considered as investing advice or a recommendation of any particular security, strategy or investment product. It contains opinions of the authors but not necessarily those of Guggenheim Partners or its subsidiaries. The authors’ opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. Past performance is no guarantee of future results.

Investing involves risk. In general, the value of fixed-income securities fall when interest rates rise. High-yield securities present more liquidity and credit risk than investment grade bonds and may be subject to greater volatility. Asset-backed securities, including mortgage-backed securities, may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity risk. Investments in floating rate senior secured syndicated bank loans and other floating rate securities involve special types of risks, including credit risk, interest rate risk, liquidity risk and prepayment risk. Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Real Estate, LLC, GS GAMMA Advisors, LLC, Guggenheim Partners Europe Limited, and Guggenheim Partners India Management. ©2017, Guggenheim Partners, LLC. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC.


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