The yield curve for U.S. Treasuries continues to flatten, reflecting a dimming of expectations on significant economic boosts from President Trump's proposed reforms, continued thirst for yield globally, the Federal Reserve moving to tighten monetary policy, and some investor anxiety about the apparent separation of stock market prices from underlying fundamentals.
A comparison of the yield curves from May 1, 2017 (lighter blue line) and June 23, 2017 (darker blue line) shows the flattening process that began earlier this year and has continued into the summer. The flatter yield curve can be attributed to four primary causes:
I. Dimming of Expectations of Pro-Growth Reforms
After his election as president and through the first couple months of his presidency, Donald Trump advocated an agenda heavy with reforms that, if implemented as promised, would likely give a substantial short- to medium-term boost to the languishing economy. Some of his most notable campaign ideas included repealing and replacing the Affordable Care Act passed under President Barack Obama, significant tax reform, and substantially relaxing regulations on financial institutions (namely the Dodd-Frank Act). Market participants saw the potential bounty of economic growth that these reforms could bring, and have sent all four major stock market indexes skyrocketing in the time since the November 2016 election.
Roughly five months since President Trump's inauguration, these reforms have not been fully realized as investors had hoped. Some progress has been made on easing regulations on financial institutions, but a significant defeat of the initial new health care bill a couple months back, paired with the newly-released health care bill this past week still garnering skepticism from within the Republican Party shows that any significant health care reform will take some time. Tax reform, another potential Congressional flashpoint, has yet to be proposed as legislation. As the year has gone on it has become apparent to many investors that if Trump's reforms are to be fully implemented as promised (still a very big "if"), it will take notably longer than they had expected. As such, any significant economic boost is still a ways off, and thus inflation expectations have dimmed to levels not seen since just before the 2016 presidential election. Bonds then become more attractive to investors, one reason why the yield curve has once again begun flattening.
II. Continued Global Thirst for Yield
This factor is much more long-term than the first factor we discussed. The search for yield has been intense for years now, amidst this global low-interest-rate environment, and while the global economy is beginning to pick up steam, American long-term debt remains much more attractive to foreign investors than those investors' own domestic sovereign debt.
Above is a list of major countries' 10-year bond yields. There are countries like Japan, France, Germany and the U.K., all with easy access to the global financial markets but with sovereign debt yields well below the United States' 10-year yield. Consequentially, as we have seen for a few years now, foreign investors are plowing money into long-term U.S. debt to get those higher yields. In turn, this is also helping keep the long end of the yield curve flat.
III. The Federal Reserve Tightening Monetary Policy
The federal funds rate now stands at a range of 1.00% to 1.25% after three rate increases, each by a quarter of a percentage point, over the last six months by the Federal Open Market Committee. Let's first be clear in recognizing that even despite these increases, a 1.25% federal funds rate is still quite accommodative. It is not the 0.25% that this range ceiling reached at the nadir of this cycle, but a range of 1.00% to 1.25% remains quite accommodative by historic monetary policy standards. The St. Louis Federal Reserve branch's Financial Stress Index also portrays how loose monetary policy remains:
Intriguingly enough, this index has been falling even amidst the FOMC's rate hikes, but that's another discussion for another post. For now, the focus is on the Federal Reserve's tightening of monetary policy (through rate hikes and reducing its $4.5 trillion portfolio of Treasury bonds and mortgage-backed securities, set to begin later this year) sending short-term U.S. Treasury debt yields higher, as typically happens in tightening monetary policy.
It is worth noting that when the Federal Reserve begins allowing its Treasuries to mature and not re-invest to maintain the size of the $4.5 trillion portfolio, longer-term Treasury debt yields are expected to rise somewhat as supply increases in the market without a clear replacement buyer as the FOMC steps away. But again, this is another discussion for another post.
IV. Some Investor Anxiety
Let me first start off and assuage you that this discussion will not be about the CBOE's Volatility Index, or VIX. We are all well aware that the VIX continues to remain incredibly subdued, whether due to complacency or genuine investor confidence in the economy or even a side effect of massive central bank stimulus. There is likely a degree of all three present in where the VIX lies today, but that's not relevant to this section.
Rather, there is some investor anxiety over a culmination of the uncertainty in President Trump's promised reforms from above, weaker economic data as of late that raises questions of if the Federal Reserve may accidentally tighten monetary policy too much and cut off economic growth, very high stock price valuations even in the face of improved corporate earnings, geopolitical tensions (which seem to rise every other day in some aspect), and more. To me, it comes down to substantial risks to the market being at least partially offset by continued strongly accommodative monetary policy by central banks worldwide. I say partially because we have seen some rattled nerves in recent months following bouts of increased uncertainty or tension, but overall this has not been enough to persuade investors to fully dive into haven assets like U.S. Treasuries or gold. Gold is up over $100/ounce from the start of 2017 to 6/23, and the U.S. 10-year Treasury yield has dropped 30 basis points in that same timeframe. Again, these signal some investor anxiety, but not enough to make the stock markets or other riskier assets notably less attractive.
So what's the outlook? Unless Congress can force the most recent health care bill through in the near term, it looks to be more of the same: A gradually flattening yield curve as uncertainty over Trump's promised reforms, tightening monetary policy, an insatiable global thirst for yield, and hints of investor anxiety amidst heightened geopolitical tensions.
Andrew
A comparison of the yield curves from May 1, 2017 (lighter blue line) and June 23, 2017 (darker blue line) shows the flattening process that began earlier this year and has continued into the summer. The flatter yield curve can be attributed to four primary causes:
I. Dimming of Expectations of Pro-Growth Reforms
After his election as president and through the first couple months of his presidency, Donald Trump advocated an agenda heavy with reforms that, if implemented as promised, would likely give a substantial short- to medium-term boost to the languishing economy. Some of his most notable campaign ideas included repealing and replacing the Affordable Care Act passed under President Barack Obama, significant tax reform, and substantially relaxing regulations on financial institutions (namely the Dodd-Frank Act). Market participants saw the potential bounty of economic growth that these reforms could bring, and have sent all four major stock market indexes skyrocketing in the time since the November 2016 election.
 |
| Stock Index Performance since the 2016 Presidential Election (11/8/2016 to 6/23/2017). From top to bottom: Dow Jones Industrial Average, S&P 500, Nasdaq Composite, Russell 2000 Chart from stockcharts.com |
II. Continued Global Thirst for Yield
This factor is much more long-term than the first factor we discussed. The search for yield has been intense for years now, amidst this global low-interest-rate environment, and while the global economy is beginning to pick up steam, American long-term debt remains much more attractive to foreign investors than those investors' own domestic sovereign debt.
 |
| Worldgovernmentbonds.com |
III. The Federal Reserve Tightening Monetary Policy
The federal funds rate now stands at a range of 1.00% to 1.25% after three rate increases, each by a quarter of a percentage point, over the last six months by the Federal Open Market Committee. Let's first be clear in recognizing that even despite these increases, a 1.25% federal funds rate is still quite accommodative. It is not the 0.25% that this range ceiling reached at the nadir of this cycle, but a range of 1.00% to 1.25% remains quite accommodative by historic monetary policy standards. The St. Louis Federal Reserve branch's Financial Stress Index also portrays how loose monetary policy remains:
It is worth noting that when the Federal Reserve begins allowing its Treasuries to mature and not re-invest to maintain the size of the $4.5 trillion portfolio, longer-term Treasury debt yields are expected to rise somewhat as supply increases in the market without a clear replacement buyer as the FOMC steps away. But again, this is another discussion for another post.
IV. Some Investor Anxiety
Let me first start off and assuage you that this discussion will not be about the CBOE's Volatility Index, or VIX. We are all well aware that the VIX continues to remain incredibly subdued, whether due to complacency or genuine investor confidence in the economy or even a side effect of massive central bank stimulus. There is likely a degree of all three present in where the VIX lies today, but that's not relevant to this section.
Rather, there is some investor anxiety over a culmination of the uncertainty in President Trump's promised reforms from above, weaker economic data as of late that raises questions of if the Federal Reserve may accidentally tighten monetary policy too much and cut off economic growth, very high stock price valuations even in the face of improved corporate earnings, geopolitical tensions (which seem to rise every other day in some aspect), and more. To me, it comes down to substantial risks to the market being at least partially offset by continued strongly accommodative monetary policy by central banks worldwide. I say partially because we have seen some rattled nerves in recent months following bouts of increased uncertainty or tension, but overall this has not been enough to persuade investors to fully dive into haven assets like U.S. Treasuries or gold. Gold is up over $100/ounce from the start of 2017 to 6/23, and the U.S. 10-year Treasury yield has dropped 30 basis points in that same timeframe. Again, these signal some investor anxiety, but not enough to make the stock markets or other riskier assets notably less attractive.
So what's the outlook? Unless Congress can force the most recent health care bill through in the near term, it looks to be more of the same: A gradually flattening yield curve as uncertainty over Trump's promised reforms, tightening monetary policy, an insatiable global thirst for yield, and hints of investor anxiety amidst heightened geopolitical tensions.
Andrew
