March 8, 2021 | Cameron Parkhurst
Hi Everyone,
It sure has been an interesting for us fixed income traders and portfolio managers. If you have been following our recent missives, we have been talking up this potential inflation story and it seems to have finally come to fruition to some extent.
With the vaccine rollout approaching 80+ million doses in the USA and 270+ million worldwide, and with Johnson & Johnson recently approved for a single dose shot (which doesn’t need super cooling), there is a fairly rosy picture as to the future of us entering a post-COVID 19 world. We are still in a bit of a wait and see approach here, however. Along with the positive vaccine news, there is also uncertainty being caused by numerous virus mutations and whether the vaccines will continue to be effective. This is leading some analysts to call for a 4th wave to emerge before summer.
Combining the important COV-19 news (which currently drives seemingly most everything), along with various stimulus packages (with more to come soon), there is an opinion by many market professionals that we could see robust growth and
economic acceleration with America and other parts of the world “opening up”. Some analysts, for example those from Bank of America, are forecasting 6.5% GDP growth. On one hand this seems crazy talk, but on the other hand, one must weigh in on all the free money that his been pushed into the economy, especially if there is a return to normalcy.
Our fear as bond market participants has been essentially centered on this inflation discussion. All this free money will ultimately have to be paid off. The pay off will likely be in the form of rising prices. We have seen inflation recently rear its head in energy and various other commodities. There is a thought on Wall Street that we may continue to see accelerating goods and service prices, as things normalize, and the pandemic recedes.
Looking at the below chart highlighting YTD top performers, check out how various commodities stack up to their peers:
The big questions to us are two- fold: 1) How will the Fed act during this period of rates rising and asset prices pushing up, and 2) Will we see the economy overheating to any extent? Both have implications as to rates.
Many market participants believe in this higher price theory with a healthier economic backdrop. Most, however, do not prognosticate that we will see a significantly overheating economy and agree that we will have inflation above the Fed’s 2% hurdle rate but not runaway inflation. The Fed has also indicated that their current plan is to continue asset purchases, at least for the time being, and that they hope to telegraph any change in course as to avoid “taper tantrum” effects, thus eliminating the potential for rate spikes.
With the continuation of central bank purchases of fixed income assets, and in maintaining the zero bound for Fed Funds rates, the Fed is essentially working to anchor front end rates, while longer rates can move upwards. This is causing a clear yield curve steepening effect:
If we examine the 2-year Treasury and the 30-year Treasury, we are essentially flat vs. up 60 bps respectively since the turn of the calendar year. This steepening is significant and can have implications on investment strategy for those buying long term bonds. However, when evaluating the chart below, even a 60-basis point move is only about half of the steepening that we have seen in other historical events:
Importantly, with our focus primarily being on short to intermediate term bonds, we have seen upward yield momentum, but have not seen an unraveling market. This
move feels dissimilar to the March 2020 spike and quick retracement. This current environment seems much more organized and methodical, and to us likely points more towards the outlook of an economic recovery/growth cycle, rather than panic in the streets and sloppy trading markets.
While we believe that Treasury yields are flashing a caution light, we do not think that they are foretelling a story of rampant inflation. Real yields, which highlight what one earns above or below inflation, are still running negative when evaluating the 10-Year, and have briefly pushed slightly positive on the 30-Year:
The 10-Year Treasury is towards the top of its 1-year yield highs, but with real yields still negative, it implies that most market participants are not overly concerned about runaway inflation or price growth.
Our feeling is that, at least for this move, we may have seen the top in rates on Feb 25th when the 7-year auction essentially failed and only had an approximately 40% subscription rate. This caused the 10-year Treasury to ratchet up for a few minutes to as high as 1.62% before quickly normalizing around the 1.45% range. As the calendar has rolled into March, there seems to be some upward momentum in Treasury yields, but the markets have been surprisingly orderly when evaluating both the bid side and the offer side regarding this sell off. Both taxable and tax free munis did not get overly sloppy, which is very different than the disorderly sell off that happened in March 2020, with intermediate term rates spiking to over 3% and the coming right back down to immediate lows.
On Thursday, Jerome Powell, The Federal Reserve Chair, took a bit of a shot across the bow of the bond market, but an many eyes came up short. Saying that the selloff “caught his attention”, but then in the same breath indicating that the Fed was not even close to turning its back on supporting the economy, his remarks caused many market participants to take pause. Many bond market participants were relying on more detailed information regarding how the Fed might stem the tide on longer rates rising. Many were waiting to hear the Fed discuss a program similar to Operation Twist, thus minimizing purchases of short-term Treasuries and T-bills in favor of longer-term Treasuries. This lack of clarity caused a slight bit of market sloppiness, with the 10-Year again testing its recent 1.62% top, before retreating to 1.55%. To us, this shows a second test of this mid-1.60% level and shows that it has proved to be a resistance point.
We do not typically rely on technical analysis when evaluating Treasuries, but one final point is below. We do love charts that show very long-term historical views. This chart shows Treasury bonds all the way back to the 80’s, and highlights that it is normal for Treasuries to stay in a band close to one standard deviation above/below its glidepath. The upward bound on one standard deviation is 1.70% and is coming lower. This meshes well with our thoughts that 1.62% may have been the short-term top:
Our current hypothesis is that we will see short/intermediate high-quality bonds remain muted in moves, while we have the potential for significantly more upward mobility in rates on the long end. This could have implications on mortgage refinancing, real estate, etc. Obviously if we take steps backwards with COV-19 cases reemerging and/or the vaccines not taking hold, rates would be moving back down and a flattening effect occurring.
Now, how does all of this relate to the bond market? In short, net of rates ticking up a bit across the curve and us seeing some steepening driven by upward momentum of rates on the long end, we are maintaining the course of buying primarily high quality short to intermediate term bonds in our ladders. The intermediate term spot seems to have the most value, as shorter-term bonds are being held artificially low by nature of the continued Fed action. Thus, the 3-to-15-year spot seems to hold the most value here. One very important point to take away is that, assuming that a controlled rising rate environment is in effect, rates are our friend. With our laddered approach, we have systematic, defined maturities with principal consistently coming due. Thus, a moderate, organized, rising rate environment allows an individual bond holder to consistently reinvest at better/higher yield levels. Most of the other bonds in a laddered portfolio, outside of extenuating circumstances, will be held and income earned through the coupons. Thus, over time, this scenario can improve the portfolios yield expectation.
As to our primary sub-asset classes, spreads have compressed across almost all fixed income sectors but have been offset by these moderately rising rates. We continue to see value in taxable municipals over most corporates, CDs, and Agencies here.
Interestingly, munis have remained strong in the face of recent rising Treasury rates. This has led to a dynamic, at least temporarily, where there could be a case to be made to overweight taxable bonds vs. tax free in the current environment.
The chart below shows AA taxable muni 15-Year yield expectations vs. tax adjusted yields on tax free munis. Even for someone in a moderately high tax bracket, taxable munis are ahead of the game by the largest margin in the last 3 years.
This doesn’t mean we are completely avoiding tax free munis, but for those in moderate tax brackets, you could see taxable bonds implemented where you may have considered tax free munis in the past.
Tax free bonds were at super rich levels a few weeks ago but have normalized to some extent during the rate move. Tax frees seemed to move with Treasuries, which is a bit rare (usually they have a lag and more muted moves/lower Beta). However, in this case,
we believe that the muni rubber band was perhaps stretched to the point that something had to give. At its peak, muni ratios vs. Treasuries were under 50% for shorter term bonds, whereas we typically see them above 70%, and sometimes significantly higher when we consider the market “cheap”. During this rate rise, ratios expanded, and we have been seeing some bonds back in the 70% range for tax frees.
This has helped to normalize the markets. However, we feel that taxable munis currently provide additional benefit over tax frees for low to moderate tax bracket clients.
One last point, when coming to us for proposals you may begin to see us implementing small corporate positions in bonds like CPI-linked notes. We used securities like these long ago and have recently begun to see some value again in them on the bid side, noting the uptick in inflation numbers. It is not a huge market but could be used as small positions in portfolios when we can find the bonds. This is simply an example of how we consistently evaluate relative value in most taxable, investment grade sub-asset classes and hope to allow your clients to benefit from this analysis that we conduct.
As always, we are here to help you in any way regarding your portfolios. Please do not hesitate to reach out with any questions, comments or to set up a short discussion.
Until Next Time,
Your PeachCap Fixed Income Team
The above summary of statistics/prices/quotes has been obtained from sources believed to be reliable but is not necessarily complete and cannot be guaranteed. The information and opinions herein are for general information and illustrative use only. This data is not meant to replace Adviser's portfolio management/performance reporting systems. Please consult Adviser performance reports for actual performance data. Such information and opinions are subject to change without notice, are for general information only and are not intended as an offer or solicitation with respect to the purchase or sale of any security or as personalized investment advice. Past performance is no guarantee of future results. Market risk is a consideration if sold prior to maturity. May lose value. Not insured by any federal agency. Subject to availability and price change. Securities offered through PeachCap Securities, Inc., member FINRA, SIPC, MSRB registered.
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