Rates: Higher Yields, Flatter Curve
Increased volatility could lead to wider credit spreads and a migration to higher-quality fixed-income assets.
The first quarter set the stage for an optimistic 2018 for capital markets: gross domestic product growth finished 2017 on a solid footing and 2018 estimates were similar; employment growth remained strong; inflation was under control; equity markets set new highs; and the new Tax Cuts and Jobs Act of 2017 had just been signed into law. This combination of data and events helped to drive a continued bear flattening of the Treasury yield curve, with yields 20–40 basis points higher across the curve. Increased Treasury supply, which was mostly concentrated at the front end, also contributed to the increase in yields at the front of the curve. On March 21, 2018, in an ongoing effort to continue tightening monetary policy under newly appointed Fed Chair Jerome Powell, the Federal Reserve delivered a 25 basis point increase in the federal funds rate. We have witnessed increased volatility in risk assets and, as the Fed continues its tightening cycle, this volatility is unlikely to subside anytime soon. This increased volatility could lead to wider credit spreads and a migration to higher-quality fixed-income assets. Federal Open Market Committee (FOMC) economic projections remained at three hikes for 2018, although the individual data actually showed a migration toward four expected hikes for 2018. The FOMC projections for 2019 and longer term were revised slightly higher as well. We believe the Fed will raise rates three more times in 2018 for a total of four.
Equity Market Volatility Spiked as the Market Priced a Steeper Path of Rate Hikes
We have witnessed increased volatility in risk assets and, as the Fed continues its tightening cycle, this volatility is unlikely to subside anytime soon. This increased volatility could lead to wider credit spreads and a migration to higher-quality fixed-income assets.
Source: Bloomberg, Guggenheim. Data as of 4.24.18. VIX is the ticker for the Chicago Board Options Exchange SPX Volatility index, which reflects a market estimate of future volatility. LHS = left hand side, RHS = right hand side.
The move higher in yields during the quarter produced negative total returns for the Treasury market. The overall U.S. Treasury index returned -1.2 percent for the quarter. The U.S. Treasury 20+ year index, a proxy for long-end Treasury market performance, returned -3.4 percent for the quarter. The Agency index returned -0.7 percent. The global Treasury index was the positive outlier, delivering total returns of 2.9 percent for the quarter.
Looking ahead we expect the FOMC to increase the fed funds rate by another 25 basis points at its June meeting. We believe that the market will eventually move to expecting a total of four rate hikes in 2018, which would cause the Treasury yield curve to flatten further. A move wider in spreads, along with higher interest rates in general, could present more relative value opportunities in Agency debentures.
Average Number of Hikes per Year Projected by FOMC Participants
FOMC economic projections remained at three hikes for 2018, although the individual data actually showed a migration toward four expected hikes for 2018. The FOMC projections for 2019 and longer term were revised slightly higher as well. We believe the Fed will raise rates three more times in 2018 for a total of four.
Source: U.S. Federal Reserve, Guggenheim Investments. Data as of 3.21.2018.
—Connie Fischer, Senior Managing Director; Kris Dorr, Managing Director; Tad Nygren, CFA, Managing Director
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