Yield Curve Changes in The Muni Market
Since the election on November 8, 2016 yields in the Muni market have risen dramatically. The chart below shows the yield curve shift for a AAA rated General Obligation bond which has taken place. The solid blue line shows the yield curve for 11/29/16 and the dashed red line shows the yield curve for 11/8/2016 which is the day of the election. The yields are shown on the left side axis. The yellow bars show the yield curve shift for each maturity during that same time. For example, a bond due in 14 years is down about 70 bp’s since the election.
The 10 year UST bond yield bottomed for the year on July 8, 2016 at 1.36%. Yields in the Muni market reached their lows for the year on July 6, 2016. The chart on the right shows the changes in the yield curve since that time. Muni yields have risen about 120 bp’s in the 10-14 year part of the curve since then.
TFS Outlook for Rates: Models
For the last several years we have believed we are in a low rate environment for a long period. We have not changed our outlook. The two primary drivers of interest rates are the growth rate of the economy and inflationary expectations. It is very difficult to achieve
strong economic growth in an economy that is highly indebted. Our research shows that Debt to GDP ratios of over 90% inhibit economic growth. The chart above shows the yield of the 10 year UST compared to the rise in Debt/GDP for the period from 1966 to the second quarter of this year. There is a strong inverse relationship between these variables. We have developed a model based on a presentation by HIMCO at a Grant’s Conference in early October of this year. Our model shows a strong correlation between over indebtedness and UST yields. The chart below shows this correlation for the period from January 1980 to the end of the second quarter 2016. The orange dots are the predicted values
for the 10 year and the blue dots are the actual values. The current Debt/GDP input is 105% which is the highest value we have seen and continues to rise rapidly. Since the Financial Crisis in 2008 the current administration has taken this ratio from about 60% to 105% which is almost a doubling of the ratio. We believe this explains the anemic growth rate we have seen during the last 8 years. Our model currently calls for a 10-year yield of 0.35% using the existing ratio of 105% Debt/GDP. If the ratio would rise to 110% the model would predict a negative yield for the 10 year UST.
We have also done studies which show what the typical spreads are between the Fed Funds rate and the yield on the 10 YR UST. The table below shows the spread has averaged 1.10%. The Funds rate is currently targeted to be 0.25%-0.50%. We expect this to change to 0.50%-0.75% in December. If the Funds rate goes to 0.75% we would expect fair value for the 10 year to be 1.85%-2.75%. The 10 year currently yields 2.39% which is within this range.
|Effective Federal Funds Rate vs. Generic 10 Year UST|
|Average Spread Since 1962||1.1|
|Average 50 Year Spread||1.1|
|Average 25 Year Spread||1.7|
|Average 10 Year Spread||1.9|
|Average 5 Year Spread||2.0|
|Average 1 Year Spread||1.5|
We follow a broad range of different economic indicators and models. These include, but are not limited to, the Chicago Fed National Activity Index, the Velocity of Money, 12 different indicators on our economic dashboard, and several measures of future inflation expectations. We do not rely on any one indicator. While we respect what the models predict we would not blindly follow their predictions. Instead, we view the models as tools which give confirmation, along with other indicators, we are in a classic liquidity trap. The economy has not responded well to extreme monetary easing and fears of rapidly rising inflation have not materialized. It confirms our belief that the biggest problem our economy faces today is over indebtedness. Unfortunately, all the developed nations have the same problem. This makes future global economic growth very difficult. In a liquidity trap, Monetary and Fiscal policies are largely ineffective tools to increase economic growth. Japan has been in a period of low rates for the last 20 years. They have tried to stimulate their economy using massive amounts of both Monetary and Fiscal stimulus to no avail. During this period the ratio of Debt/GDP has skyrocketed and yields on the 10 year JGB have remained stubbornly low at yields around 0.0%.
The chart below was also part of the HIMCO presentation at Grants, and it shows the Japanese JGB 10 year has had declining yields for 26 years since their financial crisis in 1989, while we are only 8 years into the period after our financial crisis in 2008. This chart would suggest we have several more years of low rates ahead of us.
Since the election Muni
There is significant research which shows over indebtedness cannot be cured with Monetary or Fiscal policies designed to stimulate the economy. The cure for too much borrowing is not more borrowing. Borrowing just robs future economic growth by bringing economic activity into the current period. We will continue to be skeptical of rapidly rising rate scenarios until there is some evidence we are going to get our Debt/GDP ratios to more manageable levels so we can get out of the liquidity trap the economy is currently in.