Rates: Markets Are Underestimating the Fed's Resolve

We continue to believe that the yield curve will flatten further and that a barbell position is appropriate.

November 14, 2017


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

Front-end Treasurys have been selling off since the Federal Open Market Committee (FOMC) announced in September that it would begin rolling off its balance sheet in October. This selloff has continued even through the FOMC’s latest meeting in November, at which it left rates unchanged but communicated that economic activity warrants gradual adjustments in monetary policy. The market’s shift in rate expectations has caused a bear-flattening of the curve. Our Macroeconomic and Investment Research team’s work around recession timing shows that if the three-month/10-year Treasury yield curve flattens at a rate consistent with past cycles, a recession is only two years away.

Historical Yield Curve Averages Suggest a Recession Is Two Years Away

The market’s shift in rate expectations has caused a bear-flattening of the curve. Our Macroeconomic and Investment Research team’s work around recession timing shows that if the three-month/10-year Treasury yield curve flattens at a rate consistent with past cycles, a recession is only two years away.

Historical Yield Curve Averages Suggest a Recession Is Two Years Away

Source: Bloomberg, Guggenheim Investments. Data as of 9.29.2017. Yield curve shown is the difference between 10-year Treasury yield and three-month Treasury yield. The average includes cycles ending in 1970, 1980, 1990, 2001, and 2007.

During the third quarter, the two-year Treasury yield increased from 1.38 percent to 1.49 percent, and the 10-year Treasury yield increased from 2.31 percent to 2.33 percent. The Bloomberg Barclays U.S. Treasury index returned 0.4 percent for the quarter, bringing the total return for the year to 2.3 percent. The Bloomberg Barclays U.S. Agency index returned 0.8 percent for the quarter and 2.9 percent for the year. The Barclay’s Global Treasury index returned 1.6 percent for the quarter and 6.1 percent for the year.

Despite the rate selloff, we find that the market is not yet fully discounting the Fed’s advertised rate hikes for 2018 as suggested by the latest Summary of Economic Projections. As the Fed delivers these rate increases, the market will have to reprice everything under five years at higher yields. Such a repricing is likely to be interpreted as a move toward restrictive monetary policy, which would support our expectation that long-term rates will not need to increase at the same pace as shorter rates, causing a further flattening of the yield curve. Looking forward, we expect the FOMC to increase the fed funds rate by 25 basis points at its December meeting, and stay on a tightening path in 2018. With the market currently pricing in less than two additional hikes by the end of 2018, the front end of the yield curve should come under pressure. As such, we believe that a continued flattening of the yield curve warrants a barbell position. We are focusing on longer-dated Agency securities, which offer attractive spreads over Treasurys of comparable maturities.

Market Projects a Very Shallow Path of Rate Hikes

We expect the FOMC to increase the fed funds rate by 25 basis points at its December meeting, and stay on a tightening path in 2018. With the market currently pricing in less than two additional hikes by the end of 2018, the front end of the yield curve should come under pressure. As such, we believe that a continued flattening of the yield curve warrants a barbell position.

Market Projects a Very Shallow Path of Rate Hikes

Source: Bloomberg, Federal Reserve, Guggenheim Investments. Data as of 11.10.2017. Market projections of fed funds rate is based on OIS forward curves. Federal Open Market Committee (FOMC) projections is based on the Federal Reserve’s September FOMC Summary of Economic Projections. The FOMC defines “longer run” as five to six years into the future.

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

 
Important Notices and Disclosures

Note: “Rates” products refer to Treasury securities and Agency debt securities.

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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