Until the week of December 3rd 2018 the financial press and the majority of financial professionals were convinced that interest rates would continue to rise and that the Fed would continue steady tightening until the Fed Funds rate reached between 3.00-3.50%. We continue to believe the Fed will stick to their current course of tightening when they meet later this month by raising the Fed Funds rate another 25 bps. At Copper River, we have long believed that the Fed will hit the pause button on the tightening cycle sooner than many expect and we still have that view.
Of interest is how much the yield curve has flattened over the past several weeks. On December 5th the spread between two-year treasury bonds and 10-year treasury bonds is 11 basis points. It is important to remember that the Fed doesn’t set rates outside the curve, they only set the Fed Funds rate. At the long end of the yield curve, rates are determined by inflation expectations and the supply/demand equation of how much issuance is hitting the market versus investors’ appetites for long-dated bonds. Inflation has been running well below its historical pace compared to where it’s been at this point in the cycle and when levels of unemployment are this low. In particular, wage inflation is approximately 1% below its rate when we were last at or below 4% unemployment. There are plenty of reasons for this and none are particularly transitory. Put a different way, long-term inflation expectations are relatively low and are unlikely to rise much this cycle. We might see core inflation numbers rise slightly from here, but even a 2.5% core inflation rate seems like a stretch.
As for the supply/demand balance there is a lot more uncertainty. We know that Treasury supply will be increasing dramatically over the next couple of years due to lower tax revenue and increased government spending. It’s far more difficult, however, to forecast what the demand for bonds will be. Foreign demand, in particular, remains robust thus far as the nominal rates on Treasuries (and high-grade credits for that matter) are much higher than what can be purchased in other G7 countries’ home markets.
If we assume that demand remains sufficiently strong, given that inflation is expected to remain subdued, we will not see much pressure on long rates. With the Fed intent on continuing to “normalize” policy, this results in the very real possibility of a flat, if not slightly inverted, yield curve (we saw spots of inversion on 12/4 and expect it to be a continued theme), with all Treasury rates in the 3.00%-3.50% range.
While rates and prices in the global fixed income markets are volatile and unpredictable, we have seen an increased demand for buy and hold bond portfolios. The primary interest and the best solution for corporate treasury has been laddered treasury bond portfolios, with properly managed duration. These portfolio meet the objectives of safety, liquidity and yield more so than any other options in the marketplace. The partners at Copper River have decades of experience in the fixed income markets and are happy to have one on one discussions about private bond portfolios and/or the subject matter discussed above.