Rates: Limited Room for Rates to Rise
The yield curve should flatten further as economic strength continues to justify Fed tightening.
The Federal Open Market Committee delivered another rate hike in September, raising the federal funds rate by 25 basis points to a target range of 2.00–2.25 percent. The probability of a September rate hike was priced in at over 90 percent based on overnight index swaps (OIS) by early August. Despite this near certainty, Treasury yields increased as additional hikes were priced in further out on the curve, with two-year yields higher by 29 basis points, and five-, 10-, and 30-year yields higher by 20 basis points over the quarter. The two-year/10-year Treasury yield curve continued its flattening trend quarter over quarter, as did the two-year/10-year swap curve, though both steepened a little in early October. We believe the flattening trade remains intact as the impetus for the Fed to keep hiking remains strong for reasons outlined by our Macroeconomic and Investment Research Group.
Treasury and Swap Curve Still in a Multi-Year Flattening Trend
The two-year/10-year Treasury yield curve continued its flattening trend quarter over quarter, as did the two-year/10-year swap curve, though both steepened a little in early October. We believe the flattening trade remains intact as the Fed will keep hiking in response to strong economic data.
Source: Bloomberg, Guggenheim Investments. Data as of 10.24.2018.
Higher yields resulted in the U.S. Treasury market delivering a negative total return of -0.6 percent, and a year-to-date total return of -1.67 percent. The U.S. Treasury 20+ Year index returned -3.0 percent, bringing the year-to-date total return to -5.9 percent. The U.S. Agency index returned 0.3 percent, resulting in a year-to-date total return of -0.6 percent. The move higher in yields was not just a U.S. phenomenon: The global Treasury index returned -1.7 percent during the quarter, bringing the year-to-date total to -2.6 percent.
The move higher in yields has provided attractive buying opportunities in high-quality, long-duration fixed-income assets. For example, we are constructive on low-coupon, long-maturity callable Agency bonds, which have seen durations extend and are trading at deep discounts because of the call option being out of the money. These look especially attractive given that we do not see much more rate upside from current levels. Our Macroeconomic and Investment Research Group forecasts that 10-year Treasury yields will peak around 3.75 percent, and that the yield curve will flatten further in 2019.
10-Year Treasury Yields Are on Track to Peak Around 3.75 Percent
10-Year Treasury Yields vs “Terminal Fed Funds” as Proxied by the January 2020 Fed Funds Futures Contract
Our Macroeconomic and Investment Research Group forecasts that 10-year Treasury yields will peak around 3.75 percent, and that the yield curve will flatten further in 2019.
Source: Bloomberg, Guggenheim Investments. Based on daily data from 8.1.2017–10.11.2018.
With 30-year Treasury yields trading around 3.34 percent, we see relatively less room for yields at the long end of the curve to rise. Thus, deep-discount low-coupon callable Agency bonds provide an attractive yield with relatively limited downside based on our outlook for higher rates and a flatter curve.
—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. ©2018, 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.
VIDEOS AND PODCASTS
Scott Minerd, Guggenheim Partners Global CIO and Chairman of Guggenheim Investments, joins Bloomberg TV on Fed Day.
Brian Smedley, Chief Economist and Head of the Macroeconomic and Investment Research Group, discusses the Fed’s third straight 75 basis point hike and its meaning for the economy and investors.
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Guggenheim Investments represents the following affiliated investment management businesses of Guggenheim Partners, LLC: Guggenheim Partners Investment Management, LLC, Security Investors, LLC, Guggenheim Funds Distributors, LLC, Guggenheim Funds Investment Advisors, LLC, Guggenheim Partners Advisors, LLC, Guggenheim Corporate Funding, LLC, Guggenheim Partners Europe Limited, Guggenheim Partners Japan Limited, GS GAMMA Advisors, LLC, and Guggenheim Partners India Management.