As the Fed moved again on June 13th, we thought we would share our thoughts on portfolio construction as it pertains to one’s fixed income allocation. At Ballast, we think about credit first (see this piece), and then, we move on to the curve. The below chart shows the treasury curve from June 13th (green line) compared to five years ago. So, today’s long bond (30-year) is the same yield as it was 5 years ago. The 10-year as of today is just shy of 3%, whereas it was about 1.80% 5 years ago.
Treasury Curve May – June 2018
Why is all this important?
The chart above shows that 5 years ago it was the Fed’s mission to get people to lend at all costs (aka- free money). You were paid to extend (steep slope to yield curve – orange line). This resulted in the unintended consequence of people lending or investing in items that may not have been a good asset for them.
This reminds us of Argentina. One year ago, the market was ‘yield hungry’ – so hungry, that it has gobbled up $2.6 Billion of Argentinian debt at a 7.90 yield. We remarked back then with surprise. Today, that bond is at $77. So, although an investor clipped 7 points of interest, they have lost 13 points of principal. We don’t have an opinion on Argentina and are simply citing its track record. This isn’t the opportunity for your capital.
What does this mean today?
It means that you get paid almost as much for lending 5 years as you do for 10 years. In bond jargon, we talk about ‘the roll’. The roll five years ago made sense – since when you buy a bond, you buy a coupon. As that bond moves closer to maturity, [if the required yield from market is lower (steep slope) as you move shorter] there is price support provided. This is unlike today, where you get no roll, so you would not extend maturity unless there were other reasons to do so.
So, as we construct portfolios, we continue to focus on the 3-5 year part of curve (thus limiting our duration while capturing yield). If we had a strong bias of rising or falling rates, we could see ourselves adding or shortening duration, but at this time, it seems the Fed is on record for another 2 hikes this year – which will really flatten the curve.
Which means what?
Well, it means that the long end of the curve yields less than the short end of the curve. Therefore, the long end is saying forward rates need to be lower – which some tend to associate with anticipating an economic slowdown. The chart below shows the 10-year treasury versus the 2-year treasury. The top chart shows the 10-year yield (white line) and the 2-year treasury (orange line). The bottom chart shows the yield difference. Notice that the difference went below zero in early 2000s (preceded recession) as it did again in mid-2007 (another recession). The recent trend seems to be heading toward zero,. Also, with market expectations of two more fed hikes, that takes Fed Funds to 2.25-2.5 % and the 2-year will move close (if not above) the 10-year.
2 – 10 Year Spread
What does this mean for our clients?
It means there is less incentive to lend money long term. They can capture yield in the front end without risking it for 10 years.
If the curve inverts, it could indicate we are closing in on the end of one the longest economic cycles in recent times. If that is the case, we look forward to clipping our coupons and being presented with many opportunities to choose from as risk assets re-price for the end of growth.