SHORT FIXED INCOME MARKET COMMENTARY, DECEMBER 2019
Three Quick Investment Themes
Investors hate uncertainty. Which is too bad really, considering our world involves analyzing and interpreting uncertain things. Sometimes markets seem a little less uncertain. The near-term outlook for those markets-driven by Federal Reserve (Fed) policies feels like one of those times. A forthright commitment to increasing bank reserves in the financial system - aka: quantitative easing - and escalating Fed-speak about allowing inflation to run hot have put a nail in the coffin of any rate hikes in the coming year. Given these words and actions, the Fed has laid out an asymmetric path for monetary policy, with policy risks decidedly skewed toward patience and accommodation over tightening. With this in mind, we have a few investment themes for short-term investors.
Range trading will rule for quite a while. So, with Fed rate hikes off the table for 2020, the short end of the U.S. Treasury curve - defined as five years and in - should spend the next several months trading within a band of 1.50% to 1.70%. If recent rate moves are any indication, the primary catalyst will be news on China trade talks. If yields pop toward the higher end of the range on a positive tweet or rumor, buy out the curve. Right away. Because the opportunity won't last long. Given recent developments, striking a meaningful trade deal seems increasingly unlikely. China will simply not agree to any trade pact with teeth, and - to my surprise - the Trump Administration seems unwilling to settle for anything less. Conventional thinking argues the President would love to get a pre-election stock market boost from a trade deal - any deal. Cynically, perhaps the Administration believes it would open itself up to intense criticism if all the rhetoric and pain of the tariff war yielded a deal that is more smoke than substance. More generously, perhaps officials truly believe no deal is better than a feeble deal. Regardless, bond market sell-offs based on improving U.S. / China trade prospects seem misguided...and an opportunity to buy duration.
Spreads are tight, but investment-grade credit should continue to outperform Treasuries. Investment-grade credit spreads are rich vs. historical levels, which seems reasonable given our outlook for modest growth and an accommodative Fed. Unfortunately, rich credit spreads offer little opportunity for incremental price return from spread tightening. The good news for short-end credit is that stretched valuations are less of a concern given: a) the ability to underwrite credit risk is better over a shorter horizon, and b) the shorter duration of the assets limits the negative impact of spread widening. Absent a convincingly negative outlook for credit, our core investment strategy is to add coupon income to portfolios through exposure to credit. In periods like today's with relatively tight spreads, our strategy focuses on maintaining a bias toward spread product but increasing overall portfolio credit quality by: 1) focusing on more stable issuers, 2) allocating capital toward higher quality credit sectors, and 3) by reducing the duration of lower-rated investments.
The Fed will pull out all the stops to control repo funding rates. This is hardly insightful analysis given the stops have already been pulled out. Still, the Fed's actions do have implications for money fund managers and corporate treasurers. The Fed will continue to flood the market with enough overnight and term liquidity to keep current and year-end funding rates in line with the Fed's targets. The upshot for cash investors is the chance of another 100 to 300 basis point spike in overnight rates is low. Stable repo rates should make the break-even calculations for making term trades - say 90 to 180 days - vs. overnight depositsor funds more straightforward. Remember, term rates are essentially the average yield of overnight rates over that given time frame. If term rates are pricing inexcess volatility in repo and other overnight rates, we would view this as an opportunity to extend purchases and boost interest income.
The Fed holds its final meeting of the year on December 11th. Much to President Trump's chagrin, there shouldn't be much in the way of new policy stimulus or changes to the Fed's outlook. There is a very decent chance Chairman Powell will use the press conference to reinforce the Fed's commitment to letting inflation pass the Fed's 2% target and allowing prices to run a little hot for an extended period. How he positions this is important and may offer fodder for certain snarky fixed income writers to act like they know better.