Rates Reflect Market Optimism
The recent rise in Treasury yields reflect a very optimistic “if” scenario based on the incoming administration’s anticipated policies.
The Treasury market focused on two events during the fourth quarter: The U.S. elections on Nov. 8, and the FOMC meeting on Dec. 14. With the election of President Trump, and the Republicans maintaining their majorities in the House and the Senate, the expectation for stronger domestic growth through reduced regulation and fiscal stimulus, potentially financed with increased Treasury issuance, helped to drive nominal interest rates higher and the curve steeper. In contrast to the election results, the Fed’s increase of its target for the federal funds rate from a range of 0.25–0.50 percent to 0.50–0.75 percent had little immediate impact on rates. The market was more focused on the Summary of Economic Projections, which conveyed a more hawkish outlook through the projection of three rate increases in 2017, up from two in September.
The Yield Curve Flattens as the Fed Tightens
If history is a guide, the yield curve will flatten as the Fed moves through a cycle of rate hikes, shown here as the spread between the five-year and 30-year Treasury yields.
Source: Guggenheim Investments, Bloomberg. Data as of 1.6.2017.
During the fourth quarter, the two-year Treasury yield increased from 0.76 percent to 1.19 percent, and the 10-year Treasury yield increased from 1.60 percent to 2.45 percent, producing negative total returns for the period. The Bloomberg Barclays U.S. Treasury index returned -3.84 percent for the quarter, finishing 2016 with a total return of 1.04 percent. The Bloomberg Barclays U.S. Agency index returned -2.10 percent for the quarter and finished 2016 with a total return of 2.27 percent.
Looking forward, we expect the Fed to raise rates three times in 2017. This should cause the curve to flatten, in which case we believe that a barbell position is prudent. Treasury market volatility is likely to remain elevated until there is more clarity around fiscal stimulus. Agency debt supply is projected to shrink in 2017, given that interest rates have increased significantly, and there will be fewer callable bond redemptions. This should be a positive technical for Agency spreads, and we will continue to look for attractive investment opportunities in longer-maturity Agency bullets, STRIPS, and callable bonds.
Market Repricing of the Fed Path Will Cause Yield Curve to Flatten
The Forward Overnight Index Swap (OIS) curve is pricing in two Fed rate hikes in 2017, versus a median projection of three in the Fed’s Summary of Economic Projections. We expect three rate hikes this year, which should result in a flatter yield curve. In this environment, a barbell strategy may be appropriate.
Source: Guggenheim Investments, Federal Reserve Board, Bloomberg. From the December 2016 Summary of Economic Projections. OIS data as of 1.17.2017. Note: OIS forward rates reflect market expectations for the effective federal funds rate in the future. Central tendency is the range of FOMC participant projections excluding the three highest and three lowest. The FOMC defines “longer run” as five to six years into the future.
—Connie Fischer, Senior Managing Director; Tad Nygren, CFA, Director; Kris Dorr, 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.
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.