Fixed Income Has Entered a Sweet Spot for Investors

We all know the sweet spot when we see it. It’s that point on a bat, racket or club that delivers the ball effortlessly exactly where it should go. It’s also the time of the day when the kids are happy, well fed and safe, and it’s that time of life when work, home, hobbies and giving back are all in balance. It’s sweet.

And while it may not spring to most people’s minds, there is a sweet spot in fixed income investing happening now. Rates and spreads are stable to tightening and there is not a lot to worry about. While today’s fixed income markets may not give the same rush as swinging a two iron and landing on the green from 220 yards, it is still satisfying.

This last quarter and year-to-date treasury rates have fallen, muni ratios have contracted and corporate spreads have tightened. Sweet results, if not spectacular. This has all occurred while the Fed is normalizing monetary policy by raising interest rates and planning to shrink its balance sheet.

We know hitting the sweet spot can be fleeting; if that perfect golf swing were perfect all the time we would all be professional athletes. But since golf swings and markets can be unpredictable, we are keeping our eye on a few things: Federal Reserve tapering, signs of inflation, and the direction and pace of the economy and corporate earnings.

This quarter the FOMC announced the Federal Reserve would start shrinking its $4.5 trillion balance sheet starting in October 2017. The technical term is tapering, and the Fed will start slowly by shedding $10 billion monthly, gradually increasing to $50 billion monthly. The Fed has not disclosed how far it wants to run down its balance sheet, but most expect a reduction to the range of $2.5 to $3.0 trillion. Of course, tapering means more bonds will be in the market, and we expect this increase in supply will depress prices and slowly increase yields. Some analysts anticipate a 20 bps increase in treasury and agency yields due to tapering over the next year. The Fed will also continue normalization of the Fed funds rate, but again this appears to be a very gradual process, with the Fed projecting to increase the rate from 1.25% today to 2.75% in 2019 and 3.0% in 2020.

Raising the fed funds rate will, of course, be dependent on the outlook for inflation. The inflation rate, as measured by PCE (Personal Consumption Expenditures), has been below the Fed’s target of 2.0% for the last five years, so it is obvious a little bit of patience is in order when talking about inflation. However, we do believe a very low and still falling unemployment rate will eventually lead to higher wage pressures and inflation, and we do not think it will take another five years.

Inflation is resting at the moment, and the economy is continuing its slow and steady expansion. We expect growth to continue, yet the data could be messy over the next few months due to the hurricanes. It is hard to see what would derail this economic recovery in the short-term outside of some unanticipated inflation, geopolitical shock or central bank policy mistake.

Corporate earnings are growing faster than the economy, with results near cyclical highs. Earnings are supported by synchronized worldwide growth, accommodating central banks and a weaker dollar, so it is hard to see earnings retreating in the short-term. A reduction in the corporate tax rate would boost already very strong corporate earnings and a repatriation of corporate cash would likely increase stock buybacks. The risk is that introducing tax breaks with the economy at full employment may just quicken inflation and pull forward fed tightening, moving us closer to the next recession.

The impact of tax reform on municipals is still unknown and will ultimately depend on the details of any final plan, yet absent a few well known weaker credits, municipal finances and credit quality are quite strong. A favorable supply and demand environment has been and should continue to support municipal bond prices.

It is good to be in the sweet spot, but not necessary for successful fixed income investing. High quality bonds are a low volatility asset class that can provide a continuous stream of income for years, through good times and bad. Not as exciting as the perfect two iron shot landing on the green 220 years away, but a lot more predictable!

Source: The Federal Reserve, Bloomberg, the Wall Street Journal, the Financial Times