There have been two topics concerning the yield curve in the press over the last few days, which we think merit closer attention. As regular readers will know, the US yield curve in particular is closely followed by market participants and can dictate a lot of what happens in fixed income markets globally.
Firstly, there has been renewed interest about the possibility of negative interest rates in the US, the UK and other geographies, and the impact this could would have on monetary policy, the banking sector and the wider economy going forward. Central bankers have for the most part responded that they do not like negative policy rates, but the strength with which they have ruled them out has varied and therefore been interpreted in different ways by investors.
The Fed in particular has been quite clear that it does not intend to take rates into negative territory. The Fed’s chairman, Jerome Powell, said explicitly last week that his committee’s view on negative rates “has not changed” and it is “not something we’re looking at”. Of course things can change in the future and Powell himself acknowledged the huge uncertainty ahead regarding the economic recovery. However, we think, and the Fed seems to agree, that there are more efficient tools in its armoury to manage the current situation. Hence, we do not see monetary policy rates going negative in the US, though we also don’t see them going higher for now, meaning the short end of the US yield curve should remain well anchored at around current levels.
Secondly, there is the subject of ‘yield curve control’. Yesterday the Fed published the minutes from its April meeting and one passage in particular caught our attention; “a few participants also noted that the balance sheet could be used to reinforce the Committee’s forward guidance regarding the path of the federal funds rate through Federal Reserve purchases of Treasury securities on a scale necessary to keep Treasury yields at short- to medium-term maturities capped at specified levels for a period of time.” The TwentyFour team has discussed over recent months the prospect of the Fed going down what we might call the Bank of Japan route, setting targets not only for the effective funds rate but also for longer dated Treasuries. Ultimately we thought that given all the Fed has done, it seemed very unlikely that it would let the longer end ‘run away’ if this was not justified by decisively better economic data. The above statement points in that direction, and to us reinforces the view that the middle and the longer end of the curve should also remain relatively well anchored around current levels.
So what does this mean for fixed income investors? If we assume short term rates are not going lower, and that the Fed would like to keep a healthy level of positive steepness in the US yield curve to help maintain a level of bank profitability, but at the same time yields at longer maturities should not increase significantly (to help protect consumer mortgage rates, for example), then the Fed is clearly facing a tricky balancing act to fulfil, which could result in some degree of yield curve control. Credit investors could thus conclude that the interest rate duration risk they import by buying longer dated credit is lower than the numbers might suggest. In a scenario in which we think credit spreads are offering medium term value from a historical perspective, but where the default rate in high yield is still highly uncertain (particularly for single Bs and CCCs), we would think the best way of gaining exposure to spreads is through longer dated higher quality credit, unhedged for interest rate risk. We expect overall yields to be heading lower over the longer term, which would also support longer dated credit.
In our opinion, the argument for buying higher quality credits with decent corporate spreads at the longer end of the curve would seem to outweigh the argument for higher beta credit at the short end.