22 Jan A New Fed Chair Inherits a Flattening Yield Curve
On November 2, 2017, President Trump announced that Jerome “Jay” Powell will replace Janet Yellen as the Federal Reserve Chair starting in February 2018. According to sources, five candidates including Powell and Yellen were considered in the running for the job. The end of Yellen’s tenure is marked by low unemployment (4.1% for December 2017) and stable, even if lower than targeted, inflation for the duration of Yellen’s term.
Jerome Powell, Yellen’s replacement, was appointed to the Fed’s Board of Governors in 2012 by President Obama. When compared to the other candidates for Chairman, economists believe that Powell’s monetary policy views compare most favorably to Yellen’s. Additionally, like Yellen and Ben Bernanke before her, Powell is considered a leader who will favor open decision-making rather than centralized power in the Chairman. Collectively, these similarities lead experts to believe there will be a smooth transition of leadership and that the Fed will remain on its established course of steadily rising interest rates and what markets hope will be a gradual reduction in the Fed’s balance sheet.
The Fed continued on this course in 2017 by announcing a 25 basis point increase in interest rates at its December 13, 2017, meeting, raising the Federal Funds rate target that heavily influences short-term rates to 1.50%. This marks the fifth 25 basis point hike since December 2015, which can be seen below on the short end of the current yield curve when compared to yield curves from one and five years ago. Economists currently expect an additional two-to-three 25 bps raises in 2018.
These yield curves show a “flattening” where yields on the short end have increased, while yields on the long end have slightly decreased. Another way to view this flattening is by analyzing the spread between short- and long-term treasuries. As shown below, the spreads between the 2-year and 10-year Treasury and between the 2-year and 30-year Treasury have both declined over the past 5 years.
This is largely due to the absence of inflation concerns in the long end, meaning that further tightening by the Fed may not be warranted. An inverted yield curve is never a good sign for the economy. The argument to stay shorter in duration is therefore not supported by risk due to further rising rates. It is supported, however, by the fact that the risk premium for taking longer duration risk is minuscule. We therefore maintain our neutral/underweight posture on investment grade debt and continue to recommend that investors seek yield through short duration and floating rate bonds that are less sensitive to interest rates and through exposure to private credit markets that feature generally more favorable risk/return profiles.
With respect to high yield, current option-adjusted spreads (“OAS”) of 340 bps are well below the 20-year historical average of 557 bps and much of the universe is trading above par. Additionally, in Europe, the desire for yield has pushed European high yield spreads to extreme lows, with a year-end OAS of 294 bps versus a historical average of 609 bps. As a result, the yield to worst for the Barclays Pan-European High Yield Index (2.99%) is lower than the dividend yield of on the MSCI Europe Index (3.28%). Due to tight spreads around the world, we revise our outlook for high yield fixed income from neutral/underweight to underweight.