Rates: The Beginning of the End
With one more rate hike expected by our macro research group, we believe this is the beginning of the end of the upward move in rates.
The fourth quarter of 2018 experienced a substantial increase in capital market volatility. The poor performance of risk assets drove a flight to quality. Treasury yields declined 20–45 basis points across the curve, with the belly outperforming as forward-dated FOMC rate hikes were priced out of the market. Nominal yields declined more than real yields, as the broad move lower in commodity prices drove a decrease in breakeven inflation rates.
Treasury Yields Declined as Market Priced Out Fed Rate Hikes
Rate Implied by Jan. 2020 Federal Funds Futures Contract
Treasury yields declined 20–45 basis points across the curve, with the belly outperforming as forward-dated FOMC rate hikes were priced out of the market.
Source: Guggenheim Investments, Bloomberg. Data as of 12.31.2018.
Inflation Breakevens Narrowed as Nominal Yields Declined More than Real Yields
Nominal yields declined more than real yields, as the broad move lower in commodity prices drove a decrease in breakeven inflation rates.
Source: Guggenheim Investments, Bloomberg. Data as of 12.31.2018.
The significant move lower in U.S. Treasury yields generated strong returns for the asset class, delivering a total return of 2.6 percent for the quarter and resulting in a total return of 0.9 percent for the year. Meanwhile, the Agency index produced a total return of 1.9 percent for the quarter, and a total return of 1.3 percent in 2018. Longer maturity Agency auction bonds were not immune to the selloff, as they cleared 20–30 basis points wider in spread than comparable Treasury bonds.
Fed Chair Powell stated that the December hike put short-term rates at the lower end of the FOMC’s estimate range for the neutral rate. Recent experience shows a high sensitivity of modest rate changes on economic activity, supporting this statement. Previous work from our Macroeconomic and Investment Research Group found that given the level of nonfinancial corporate debt to gross domestic product, U.S. corporates could only support rates somewhere in the range of 2.50–3.25 percent before the increase in borrowing costs makes it difficult to continue to service heavy debt burdens. Thus, our Macroeconomic and Investment Research Group’s forecast of one more rate hike in the second half of 2019 suggests this could be the beginning of the end of the upward move in rates for the cycle. One more rate hike implies that 30-year Treasury yields, currently 3.00 percent, will peak below 3.25 percent. It also leaves some room for the Treasury yield curve to flatten, but most of the flattening we expected to see in this cycle is behind us. The 2s/10s and the 10s/30s Treasury yield curves have flattened by 113 and 38 basis points, respectively, against 225 basis points of monetary policy tightening since December 2015. Once the hiking cycle is over, we think more attractive buying opportunities will materialize around the belly of the curve.
Note: “Rates” products refer to Treasury securities and Agency debt securities. Treasury and Agency returns are represented by the Bloomberg Barclays Treasuries index and the Bloomberg Barclays U.S. MBS index, respectively.
—Connie Fischer, Senior Managing Director; Kris Dorr, Managing Director; Tad Nygren, CFA, Managing Director
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