Duration continued its 2019 outperformance in the second quarter. Longer dated treasury, corporate, and municipal bonds outperformed shorter durations in anticipation of future rate cuts from the Fed and lackluster inflation. 30-year Treasury yields ended the quarter at 2.53%, bringing the total 2019 shift down in yield to 48 basis points.
The table below summarizes the returns of some major BofA/Merrill Lynch fixed income indices.
The Yield Curve
During the past 10 years we have advocated using a barbell strategy to take advantage of a potential flattening of the yield curve. After the Fed took the Fed Funds rate down to the zero bound, the yield curve became very steep. We created portfolios with some exposure to the very short end of the curve, and maturities in the 7-15 year part of the curve. The chart below shows how the yield curve tends to flatten as the Fed raises rates and steepens as the Fed lowers rates. The chart is for the period from 1990 to the present. The blue line shows the Fed Funds rate and the gray line shows the steepness of the yield curve from 3 months to 10 years for UST.
During past cycles the Fed began lowering rates when the yield curve became inverted. We are now at a point where the yield curve is about as flat as it is going to get. Since the Fed is planning to reduce short term interest rates, we are expecting the next major move to be a steepening of the yield curve. We are currently structuring portfolios to align with our expectations of a yield curve steepening, and allowing durations to trend lower. We are hesitant to add duration through maturity extension at these yield levels and have been reinvesting maturities in the shorter parts of the curve.
We are also becoming increasingly concerned about the potential for inflation to pick up due to several factors: trillion dollar deficits by the federal government, increases in average hourly earnings and wage pressures from a shortage of workers, and a reversal of the globalization trend (due to the increase in popularism). These factors could all put pressure on rates in the longer part of the curve
Foreign Sovereign Rates
It is important to look at U.S. rates from a global perspective. Bond rates in the U.S. are relatively attractive compared to other developed nations. They are higher than all other countries shown in the chart below. We believe it will be difficult for our rates to rise significantly when they are already higher than those in other parts of the world. Also, the European Central Bank (ECB) has been lowering rates to stimulate European economies. In fact, rates for most countries shown below have yields which are negative. Italy is the exception to this, but their rates are still lower than those in the U.S.
Monetary Policy: The Fed Funds Rate
The primary focus in the media today pertaining to monetary policy is centered on the level of the Fed Funds rate. We know that since the financial crisis ten years ago the Fed has raised the rate on overnight borrowings for banks to 2.5% from zero. There is currently intense discussion as to what that rate should be. Fed members, who six months ago thought rates should be increased several notches this year, are now questioning their previous thoughts. Many, including our President, think the Fed has tightened too much and the rate should be lowered. The bond market is near unanimous in that opinion.
Market expectations are for the Funds rate to be reduced soon by at least 25 bp’s and many believe a reduction of 50 bp’s would be appropriate. The bond market has rallied strongly since last November based largely on the belief monetary conditions are too tight and we are in danger of slipping into a recession unless the Fed cuts rates soon. This belief is primarily based on an inverted yield curve which has been a reliable indicator/predictor of an increasing probability of a recession happening in the next year or two. Most people consider an inversion of the yield curve to be when the 90 day T-bill yields more than the 10 year treasury bond. Since the 3 month T-bill has had a higher yield than the 10 year UST for several months this indicator is flashing “red” for the economy.
Monetary Policy: Quantitative Tightening
After the financial crisis the Fed took the Funds Rate to zero, but decided the economy needed more stimulation than the zero bound Funds Rate could give so they engaged in a series of measures called “Quantitative Easing.” During these periods the Fed bought UST securities and mortgages in an effort to stimulate the economy by increasing their Balance Sheet from about $800 billion to over $4.5 trillion. This provided an incredible increase in the monetary base. Many investors were concerned this would cause rampant inflation. However, inflation remained under the Fed’s target of 2.0%. About 18 months ago the Fed began the process of normalization and began reducing it’s balance sheet by letting the bonds they had bought mature without reinvesting the funds in other treasury securities. The chart below shows that since March 2018 the balance sheet has been reduced about $600 billion to $3.815 trillion.
This represents a reduction of about 13.5% in the monetary base. We believe this drastic reduction in money has had a significant impact on the economy. This belief is based on the principle of economics called the “quantity of money theory.” This principle can be represented as MV=PY. Where M is the money supply, V is the velocity of money, P is the change in prices or inflation, and Y is GDP. The theory thus states the Money Supply times the Velocity of Money=Inflation times GDP. Since the Fed reduced the money supply by 13.5% and the velocity of money has remained constant, we should expect the right side of the equation to be lower as well. This has been the case. Inflation has been coming in at less than 2.0% and GDP has been showing signs of slowing down.
At the same time the dollar has been strong and has risen about 11% as shown by the Dollar Index in the chart below. The Fed is currently scheduled to stop winding down the balance sheet in September. We believe this will reduce demand for the dollar and cause it to trend lower. A lower dollar would make our exports more attractive, help emerging markets, and lend support to commodities and gold. We believe this will help Closed End Funds (CEF’s) in these sectors. Since the dollar and bonds are not highly correlated we do not anticipate a significant impact on bond prices.
There are several cross currents taking place in the global economy. We are in an unprecedented period of coordinated global economic policy actions and political uncertainty. The U.S. government is projected to run $1 trillion deficits into the foreseeable future and the Fed is getting ready to cut rates and stop unwinding its balance sheet. This will stimulate the economy even though the economy is still growing and the unemployment rate is below 4.0%. Developed nations are prepared to do whatever it takes with monetary policy to keep their economies going.
Monetary policy tools developed during the financial crisis are now routinely being used by many nations during non-crisis times as a normal policy tool. So far, printing money has not created high levels of inflation. However, we are concerned about several economic trends which are negative for keeping inflation under control. Average hourly earnings have been slowly increasing for workers, the low unemployment rate makes hiring good workers difficult and more expensive, and support for raising the minimum wage to $15.00 per hour is rising.