While much of the current economic news has been positive, there are signs that rising interest rates are starting to take a bite out of the economy. Recently, the Atlanta Federal Reserve revised its forecast for 1Q Gross Domestic Product (GDP) growth down from more than 5% to a mere 1.9%. Despite this, The Federal Reserve (“Fed”) seems intent on continuing their path of least resistance by raising rates, despite the fact they acknowledge that inflation, as measured by CPI, isn’t a risk at this time. While most market watchers agree that interest rates have remained too low for too long, investors should be aware of the long-term market trends we are now testing.
Examining the chart below for the U.S. Treasury 2-year and 10-year bond yields illustrates the market is testing a long-term resistance level dating back to the early 1990s. It’s interesting to note that when the spread between the 2-year and 10-year rates compresses to near zero, it has historically been a reliable precursor to an economic recession (highlighted by the gray bars). Said differently, while the Fed may control short-term interest rates, long-term rates are based on the market’s expectations for future growth. Essentially, the yield curve shifts from its normal upward sloping direction, where long-term rates are higher, to a downward sloping curve, where short-term rates are higher. During this type of market environment, investors generally tend to place a higher priority on preservation of capital and, as such, rush to buy long-term Treasury bonds. Given the current market environment, we believe investors should pause and consider the following three potential scenarios:
- Bond yields begin to fall rapidly: Looking at the charts below, we can see that the long-term resistance levels have historically signaled the top in an economic expansion. If yields fail to breach this threshold then it is most likely due to investors’ lack of confidence in the economy. This loss in confidence can result in a “flight to quality” trade resulting in US Treasury rates declining rapidly with corresponding price appreciation of these Treasury securities. Outside of purely historical analysis, the news from the Administration regarding trade tariffs and their implications for global growth going forward could contribute significantly to this “falling yields” scenario playing out in the near-term if cooler heads don’t prevail. On an economic basis this scenario seems somewhat unlikely given the recent GDP growth numbers and strength in the labor markets. While the yield curve is nearly flat between 2s and 10s, there are other technical factors such as foreign flows that are also weighing on the market.
- Bond yields exceed the resistance level: While there is probably a natural limit to how far rates can rise before foreign investors begin buying Treasury Bonds, rapidly rising interest rates may also likely put pressure on businesses as borrowing costs increase. While we haven’t observed this impact in the high yield (HY) market yet (see HY OAS Spread chart below), these companies would likely be the first and most negatively affected by increasing capital costs. The likelihood of this scenario playing out depends primarily on the Fed and the new Chairman’s desire to maintain their stated plan for increasing interest rates. The market is forecasting three potential rate hikes the remainder of 2018. We’ve already seen the short-term market’s London Interbank Offered Rate (LIBOR) react to this expectation with monetary tightening already taking hold. While we are not in the business of accurately calling the break in a long-term trend, it would seem likely if the economy continues to post 2%+ GDP growth and business activity remains robust, shorter duration assets and those structured to benefit from rising interest rates will do better than long duration assets.
- Yields test the highs and then fall back: Frankly, we would put this sequence of events as a lower probable outcome. The scenario would suggest the economy is not running too hot or cold. Unfortunately, the job market is telling us hiring activity is heating up, which would typically drive wage growth, and ultimately inflation, higher. The key here will be the pace of future Fed rate hikes and if they can manage to keep a lid on inflation.
While the recent spate of equity market volatility has gotten a lot of attention, it would be wise for investors not to forget what is happening in the “less flashy” bond market and corresponding interest rate environment. While we don’t believe that the market is poised for a break-out in rising rates, investors should remain mindful of rate trends, and as always, cautious of seemingly certain outcomes. Talk to your consultant or advisor about the differences between core and intermediate fixed income allocations along with high quality corporate debt relative to high yield. If you are considering more risk, you may wish to consider investments like bank loans (floating-rate securities) as a way to try to benefit from rising interest rates while providing potentially better recovery profiles and lower default rates than alternative traditional high yield bonds.
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