No sooner had I written my fourth quarter newsletter highlighting how the yield on the 10-year U.S. Treasury note had finished 2017 lower than where it began the year than I was surprised by an increase in the yield by 30 basis points by the end of January. It did not stop there. By February 21, the yield on the 10-year Treasury had climbed to 2.95%, more than 50 basis points higher than we ended the year. The 10-year Treasury yield closed at 2.74% at quarter-end. The chart on page 3 illustrates how rates across the entire Treasury yield curve have moved since the end of 2017. We have discussed the shape of the yield curve and its significance many times. The chart illustrates how the curve has flattened over the quarter and where the rise in interest rates is most noticeable. While the very short end of the yield curve has risen the most, the focus for the capital markets remains on the longer interest rates. The reason is that longer-term capital investments play a larger role in economic growth and development. So, the current difference between the 2-year and 10-year Treasury yield stands at 0.47% (47 basis points), the lowest spread since the financial crisis of 2008.
Notwithstanding the flatter yield curve, every sector of the Bloomberg Barclays Aggregate U.S. index was negative for the quarter. The Aggregate index is the broadest of the U.S. bond market indices. It had a total return of -1.46%, while the Government/Credit Intermediate index (our benchmark) was at -0.98%. Even the U.S. Corporate High Yield index had a negative return of -0.86%. Performance favored shorter, high quality bonds. As such, the bond market was not able to offset the negative performance of the volatile equity markets. There are times when both asset classes can come under stress and perform negatively. The future uncertainties have more to do with the direction of asset prices as of late than underlying economic conditions. The uncertainties that contributed to bond market performance have been monetary policy, fiscal policy and, most recently, the rhetoric surrounding trade policy.
Monetary Policy & Inflation Expectations
The Federal Open Market Committee, the policy voting members of the Federal Reserve Board, met in January and March. At each meeting, the members voted unanimously to increase the overnight bank lending rate by 0.25%. This fed funds rate is expected to be targeted within a range with lower and upper bounds (now between 1.5% and 1.75%). This latest increase is the sixth since the Fed started tightening interest rates in December of 2015. All the increases have been widely anticipated by the capital markets. The expected trajectory of the fed funds rate is slow and steady increases of 0.25% reaching a peak of 3.5% by the end of 2020, and settling longerterm between 2.8% and 3.0%. We’re about halfway through this tightening cycle based on the median forecasts of the Fed. Additionally, the assets that were purchased by the Fed after the 2008 crisis are being allowed to mature and are not being reinvested. This is another form of tighter monetary policy that reduces the supply of money within the banking system. It is unclear what the appropriate amount of excess reserves should be in the future. We know that prior to the emergency liquidity programs that were put in place to stabilize the banking system, the Fed’s balance sheet had about $900 billion of liquid assets that grew to $4.5 trillion during the asset purchase programs. However, monetary policy tightening does not fully explain why we have seen a shift up in longer interest rates.
We’ve also seen a weakening of the U.S. dollar, which normally helps by making our goods and services relatively cheaper in the global market but also makes foreign investment in our financial assets less attractive. In early January, there was worry about decreased demand for our Treasury notes as the BOJ signaled its intent to buy less of our long-dated debt. This increased the sell-off of our currency versus other reserve currencies. Then we had inflation expectations taking a firmer hold in anticipation of improving domestic growth and expectations that central bank asset purchases around the world may have peaked. There was also the notion that deficit spending as suggested by the new tax policy, along with higher private capital investment, should lead to higher real interest rates. Inflation expectations have indeed increased since last year. Breakeven rates between inflation-protected Treasury notes and nominal Treasury notes have increased by about 20 basis points in 5- and 10-year maturities.
Protectionism & Inflation
The first signs of the Trump Administration making good on campaign promises regarding “fair trade” appeared in February. The potential for disrupting current global supply/demand dynamics sent shock waves through the capital markets. I want to emphasize the unintended consequences of protectionist policies. Protectionism limits the supply of goods and services by either banning and limiting imports or imposing tariffs on them. In either case, it raises costs to consumers. One of the factors in keeping inflation low has been reducing the cost of goods and services through competition and technological advancements. For quite a while, there has been abundant supply of goods and services to satisfy demand. If there is no scarcity of goods and services for a given level of demand, prices cannot rise in an open market. If supply is suddenly cut, demand will need to adjust downward to keep prices stable. That is the dilemma facing U.S. consumers if protectionist policies significantly affect supply.
Consider the mid-70s when OPEC voluntarily reduced the supply of crude oil. The resulting shortage of refined gasoline and other petroleum products led to huge increases in the price of petroleum-based products and crude oil. That was the intent of OPEC. Since there were no substitutes, consumers had no choice but to pay higher prices or curtail demand. The unintended consequence of this action was economic stagflation (high unemployment with high inflation) that ultimately reduced demand for crude oil in the longer-term. Subsequent OPEC policy ensured that it was in the cartel’s best interest to keep the supply of oil fairly stable. This example should be noted by proponents of protectionist policies. There is a reason why the capital markets are concerned by the mere talk of potential disruptions to global trade. The trade deficit in the U.S. is offset to a great extent by creating a capital account surplus, or positive foreign investment in the U.S. It is extremely important for the U.S. economy to encourage foreign investment, especially to offset our domestic budget deficits and our national debt that needs to be refinanced as Treasury obligations mature. So, while we cannot foresee what the risks are, we can safely say that the negative potential impacts are greater than any specific benefits to those industries that the policies are intended to protect. These policies could have dramatic unintended consequences, so we remain cautious and on alert for the potential risks.