Given the importance of the consumer to our domestic economy we received two important releases this week on said consumer. On Tuesday the Conference Board’s Consumer Confidence Index dipped slightly to 135.1 from 135.8 in July but result easily beat the 129.0 forecast indicating confidence remains solid despite the swirl of negative headlines. Following on the heels of that report, this morning’s personal income and spending numbers for July also reflected a consumer that continues to blissfully spend. While personal incomes rose only 0.1%, missing the 0.3% expectation and the outsized 0.5% gain in June, personal spending rose 0.6% beating the 0.5% expectation and the 0.3% gain in June. The Fed’s favorite inflation metric, core PCE, came as expected at 1.6% YoY and that moribund reading gives the Fed another reason to cut rates next month. Thus, despite trade tensions, geo-political machinations, global slowdowns and stock volatility the consumer, and inflation, seems fairly unaffected by it all, at least for now.
As news of the yield curve inversion hit mainstream media outlets last week it brought into vogue yield curve conversations by folks that know very little about the subject. Friends and family may have begun to offer views on the subject, and perhaps you were asked about it from previously uninterested sources. However, the yield curve and its flattening to inversion has been something banks have been dealing with for more than a year.
Many banks use a portion of their portfolio for pledging purposes, and often these investments are short-term in nature to match with the seasonality of the bank’s public funds on deposit. With the “stickiness” of fed funds this year, banks have struggled to justify buying the 1-3 year part of the yield curve. The front-end of the curve was early to the game in expecting the Fed would cut rates and started pricing in more than 50bps of rate cuts. Meanwhile, with the Fed in its “patient pause” mode, the fed funds rate remained near 2.50% and that yield advantage presented a dilemma for many portfolio managers.
In fact, with the continued rally in Treasuries that has brought the 30yr bond below 2.00%, portfolio managers now see the Fed funds rate as the highest yielding risk-free rate available, regardless of the maturity. As we have conversations with customers about committing capital we often caution against staying in Fed funds because of the certainty that rate is moving lower.
That dilemma got us thinking about the tradeoffs for banks that need to invest in short term, pledge-able assets if the Fed continues with rate cuts for the foreseeable future. Below we provide some analysis into that question. To summarize, we took the projected path of Fed Funds, based on today’s implied forward rates, and what we arrived at is that the 1-2 year part of the curve does offer slightly more yield than staying in Fed funds if the Fed does what the market expects.
For example if you have a one-year investment horizon, you have two options, you can stay in fed funds or you can buy a one-bond maturing in one year.
2.125% From Aug – Sept
1 Year Bullet Yielding ~1.70%
1.875% From Sept – Oct
1.625% From Oct – May 2020
1.375% From May – Aug 2020
Weighted Avg. 1-Year Yield of 1.63%
You can see in this example that the bond generates more yield more than the weighted average Fed funds yield. Also, it’s important to keep in mind that this analysis is based on the current expectation that the Fed will cut three more times, with the third cut not occurring until June 2020. That seems a pretty conservative outlook such that a quicker and/or more frequent easing schedule will only tilt the math more in the bond’s favor. Ultimately, it is our opinion that the Fed will be forced to return the fed funds rate to near zero as the forces of global slowing, trade tensions and geo-political uncertainty conspire to keep growth and rates lower for longer. In that scenario, investing now versus sitting in fed funds becomes even more favorable. Below is a graphic analysis that extends the timeframe to April 2021. (Many thanks to Todd Davis for this analysis).
2yr-10yr Treasury Curve Finally Inverts
We’ve been watching the flattening of the 2yr-10yr Treasury for the last couple years and it has now finally moved into inversion with the 2yr yield at 1.52% versus 1.48% for the 10yr. The graph shows the 2yr-10yr yield spread back to 1980 and it’s pretty clear that inversions precede recessions (shown in red) in almost every case. The caveat this time is the inversion probably needs to increase and persist before the recessionary signal becomes louder. All this might be beside the point, however. Whether an inverted curves signal a coming recession it appears investors are growing increasingly pessimistic about long-run growth and grabbing yield further out the curve thereby forcing those yields ever lower.
Agency Indications — FNMA / FHLMC Callable Rates
|Maturity (yrs)||2 Year||3 Year||4 Year||5 Year||10 Year||15 Year|