December 6, 2018
Yields Decline While the Markets Churn
For those of you planning for the issuance of bonds, the last month has brought some welcome news on borrowing costs. After increasing steadily for most of the year, muni yields have declined in the last month. More on that later.
In the meantime, U.S. financial markets have continued a trend of volatility. The major U.S. stock indices all increased from about October 29 to November 17, then declined over the ensuing week. There are undoubtedly many factors that contributed to the decline in stock values, but two of the most commonly cited factors were:
- Concerns about the impact of trade disputes between the U.S. and other major world economic powers; and,
- Concerns that continued rate increases by the Fed could put a damper on economic growth.
From November 23 through December 3, stocks rallied again, reportedly on the prospect of the loosening of trade barriers, but on Tuesday, December 4, stock prices declined sharply again.
Treasury yields (and other interest rates) generally move in the same direction as stock prices during volatile periods, and that was certainly true over the last month. For example, the yield on the 10-year Treasury Note rose from 3.08% on October 26 to 3.27% on November 7, then declined to 3.01% on November 30. It has continued to decline in the week of December 3 and is currently at the lowest level since early September, closing at 2.89% on December 5.
All Eyes on the Fed
The last meeting of the Federal Reserve’s Federal Open Market Committee (FOMC) for 2018 will conclude on December 19, and market watchers are speculating about both the Committee’s decision on the fed funds rate and on the language of the policy statement, which could provide important signals about the direction of monetary policy in 2019.
There is a general consensus among economists that the FOMC will raise the fed funds rate a quarter point (0.25%) at the December meeting for the fourth time this year. The federal funds rate is the rate at which banks lend reserve balances to other banks on an overnight basis. The CME FedWatch Tool currently shows a roughly 66% probability for a 0.25% increase in December, which is down form a little over 80% just last week. Some market participants are concerned that the fed funds rate is already at or near the “neutral level” (the point that theoretically balances inflation against growth). On November 25, Matt Egan and Jordan Valinsky of CNN Business wrote that “the bulls on Wall street are hoping that Fed chief Jerome Powell signals a slower pace in 2019.” The National Association of Realtors released a report in which they blamed the recent slump in the housing market partly on rising interest rates and urged the Fed to reevaluate its policy to help ease the financial burden on home buyers. (CNN Business, November 25, 2018).
The minutes of the November FOMC meeting, which were released on November 29, provided some clues that a shift in policy could be coming. The meeting summary noted some concern about the “timing” of rate hikes. And officials indicated that statements at future FOMC meetings could be altered to remove the reference to “further gradual increases.” If such a signal comes after the December meeting, it could provide a boost to the stock market, which also stabilizing financial markets, generally.
Yield Curve Inverts
In our Commentary of August 8, we wrote extensively about the flattening yield curve and the possibility of an ‘inverted yield curve.” A yield curve shows the relationship between term to maturity and yield on bonds. In most cases, yields for bonds with a longer maturity are higher than bonds with shorter maturities (a positively sloped yield curve). In recent years, the yield curve has flattened – meaning the difference in yields between shorter and longer maturities has decreased. An inverted yield curve occurs when the yield for bonds with longer maturities drops below the yield for shorter maturities. Historically, an inverted yield curve is often followed by a recession, although it is difficult to prove any causal relationship or establish how long a recession occurs after such an inversion.
Brian Chappatta of Bloomberg reported on December 3 a portion of the treasury yield curve inverted for the first time in more than ten years. Specifically, the yield on a five-year Treasury Note dropped below the yield on a three-year Note. This may be an indication that some investors expect rates to decrease in the future. This trend will bear watching in the coming months. Others have commented that the inversion may be technically driven by investors positioning themselves as we approach the end of the calendar year.
Muni Yields Decline
As mentioned in the first sentence of this Commentary, muni yields over the past month have experienced their biggest declines this year, to date. The table below shows that yields on AAA-rated bonds (as reported by Bloomberg Valuation) declined by 0.12% to 0.17% from October 26 to November 30.
While this is not a massive change in yields, it is a welcome relief to the trend of increasing yields that has persisted for most of 2018. The table below shows trends over the last two years in the “Bond Buyer 20 Bond Index,” a weekly index published by The Bond Buyer that shows average yields on municipal bonds maturing in 20 years with an average rating of AA/Aa2. The index increased by over 1.00%, from 3.29% on December 8, 2017 to 4.37% on October 12, 2018. One of the chief causes of the increase over this period is likely the federal tax reforms enacted last December, which significantly reduced marginal income tax rates primarily for corporations, thereby reducing the value of tax-exempt income for large institutional investors, such as banks and insurance companies.
The drop in yields over the last month has been attributed to the continuing low supply of new municipal bonds and more recently to remarks by Fed Chair Jerome Powell indicating the Fed may slow the pace of rate hikes (The Bond Buyer, December 3, 2018).
Investment Trends – Ehlers Investment Partners
While the FOMC remains poised to raise the target range for the fed funds rate again in December, this directive shouldn’t elicit much of a trading response since it was very much in-line with prevailing expectations. Yet there is ongoing uncertainty over how much further the target range for the fed funds rate will increase. That will be an ongoing source of volatility for the markets.
Going back to the middle of 2018, the general consensus was for a continued path of fed funds rate increases well into 2019, which was primarily motivated by comments and interest rate expectations of various federal reserve officials, including voting members of the FOMC. Those expectations have recently diminished in fairly stark fashion. Market sentiment has been a significant driver of increased yields through about the five-year maturity spectrum of the interest rate curve, which has manifested in the aforementioned flattening of the yield curve.
Regardless of the future path of short and intermediate rates it is important not to abandon a laddered maturity approach to your investment portfolio. While maintaining this strategy, consider shortening maturities and positioning maturities more frequently. Ehlers Investment Partners, with a combined five decades of staff experience, assists all forms of local governments in the development and implementation of investment strategies. Contact an Ehlers Investment Partners advisor today for assistance in evaluating your current investments and developing a strategy for consistent and predicable revenue.
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