The yield curve narrowed continuously throughout most of 2018. The spread between 2- and 10-year Treasuries fell to just over 9 basis points in December and sits at 14 now. Where is it headed? The answer is likely towards an inversion. The Fed is releasing its minutes, and once it does, it seems likely the spread will continue to narrow. There are two scenarios that would likely create an inversion. The first is if the Fed minutes show that the central bank may raise rates again soon (sending short term yields higher). The other, and perhaps more likely, scenario is that the Fed expresses some anxiety about a recession (pushing long-term yields lower).
FINSUM: This is interesting because the two most likely scenarios for what the Fed might say/do in the near-term both add up to the same thing—a yield curve inversion.
FINSUM is at the Inside ETFs conference in Hollywood, FL this week, and we wanted to bring you a little live coverage. Yesterday, there was a major session at the event discussing the outlook for fixed income. The consensus was that even though the Fed has paused, there is now way to tell when rates may rise again. Further, while China’s economy looks weak right now, that could turn around rapidly in the event of a trade deal with the US. Finally, all of the five panelists discussing fixed income said the ”liquidity mismatch” between ETFs and fixed income instruments is overblown and that there is not nearly as much to worry about as some think.
FINSUM: Fixed income’s outlook is murky right now. On the one hand, the Fed has paused, but on the other, rates could start rising anytime. On balance, we do think the risk-reward is slightly in favor of a shorter-duration long position.
Some advisors are always searching for the next blow up on the horizon. Well, with that in mind, Fitch has just put out a warning to investors that the next big market storm will likely start in credit funds. Fitch’s warning is predicated on the well-trod idea of a liquidity mismatch between the daily liquidity that open-end bond funds offer, and the relative illiquidity of their underlying holdings. In December, open-ended loan funds saw steep withdrawals, which led to big losses.
FINSUM: This is a fairly well-covered topic, but it is still a big risk. It has not yet happened on a major scale, but if it did, the potential for losses is massive.
Active funds have been much maligned in the press over the last couple of years. The rise of passive investing has drawn the value of active investing into question, and the media has focused lot of attention on large groups of underperforming funds. That said, active funds, at least in fixed income, are winning right now. In every period from one to ten-years, actively managed bond funds have outperformed ETFs. Such funds are less constrained in their ability to seek out safe high yields, whether that be in junk bonds or emerging markets.
FINSUM: In many ways this makes sense, as there are many more bonds than there are equities, which means that there is likely more alpha to be generated through an unconstrained approach.
There are currently a lot of fears about corporate credit’s ability to sink the economy and markets. There has been an absolute massive surge in issuance since the Financial Crisis, and a great deal of that issuance happened in credits just on the bottom fringe of investment grade. And while a good amount of that debt may founder and sink into junk, it won’t be enough to hurt the economy much. The reason? It is because US households have not increased their leverage significantly in recent years, which is likely to prove a saving grace for the economy. Growth in household debt has been lower than inflation, a sign of relative health.
FINSUM: While corporate credit can get markets in trouble, so long as the American consumer is not deleveraging, things will probably not get too bad in the wider economy.
Investors may not be thinking about it much, but that does not mean the US deficit is not continuing at massive levels. This year will see another $1 tn shortfall in the US budget, a fact that the US Treasury will have to make up for by issuing lots of debt. This will be the second straight year of $1 tn Treasury issuance. So far the market has been happy to absorb the extra debt, and as such, the Treasury is planning to maintain a similar schedule of issuance this year.
FINSUM: The market seems to be a long way from having its fill of Treasuries, but at some point yields will move higher simply as a force of extra supply.