- We see higher yields as an opportunity for investors to add exposure to shorter-term U.S. Treasuries.
- Global stocks fell on fears over U.S.-imposed trade tariffs, while remarks from the Fed chair cemented the idea of at least three 2018 rate hikes.
- China’s National People’s Congress is expected to rubber stamp a broad government overhaul that further centralizes power.
A rapid rise in short-term yields in U.S. government debt is restoring their appeal. This marks a major shift away from the post-crisis era of near-zero yields on such instruments. The upshot: Investors now have a viable alternative to cash with yields finally above inflation levels.
U.S. Treasury yield cushion by maturity, 2014-2018
Sources: BlackRock Investment Institute, with data from Thomson Reuters, March 2018.
Notes: The yield cushion is defined as the percentage point rise in yield that would cause a price decline large enough to wipe out one year’s worth of income. Short, intermediate and long maturity Treasuries are represented by the Bloomberg Barclays 1-3 year, Intermediate and Long U.S. Treasury Indexes.
The steady increase in shorter-maturity bond yields provides a thicker cushion against concerns around further rises in interest rates. The light green line in the chart above shows interest rates would need to jump more than one percentage point to wipe out a year of income in the two-year Treasury note. This is nearly double the cushion on offer two years ago – and far larger than the thin insulation provided by longer-term bonds today. We believe the short end offers relatively compelling income along with a healthy buffer against the prospects of further increases in yields.
The fruits of normalization
The rise in short-term U.S. rates reflects multiple market crosscurrents. The U.S. Treasury market is catching up with the Fed’s own projection of rate hikes in 2018. This reassessment is largely driven by stronger growth expectations tied to fiscal stimulus. Fed Chair Jerome Powell’s upbeat appraisal of the economy has reinforced expectations for three to four rate hikes this year.
But two important aspects are influencing rates at the short end of the curve. First, the tax overhaul and budget agreement are spurring a sharp uptick in U.S. Treasury issuance, particularly in one-month to one-year bills. We estimate net bill issuance to hit $500 billion this year, far beyond that seen in recent years. This comes as the Fed is winding down its bond holdings.
Second, U.S. companies repatriating cash following the passage of the Tax Cuts and Jobs Act are causing some ripples in the front end. Money market funds, one of the largest buyers of front-end credit, may be building liquidity in anticipation of any repatriation-related redemptions. Meanwhile, actual and anticipated selling of short-duration bonds as companies repurpose repatriated cash has led to a widening in spreads.
We believe both these factors are technical and the back-up in yields opens up opportunities. Short-dated Treasury debt now provides an attractive real return as yields now stand firmly above realized and target levels of inflation. And as the market has adjusted to an outlook of three to four Fed rate hikes, we see limited downside from price erosion as we see pricing in more than four hikes as very unlikely.
Traditionally “safe” and liquid assets can now better compete for investor capital. Broadly, we still prefer equities over credit due to strong earnings growth, modestly cheaper valuations following last month’s swoon and market’s pricing in expectations of Fed rate increases. And repatriation of corporate cash may lead to more share buybacks. Our preference leans firmly toward pro-cyclical stocks. Within fixed income, we see higher yields as an opportunity for investors to add short-end exposure that avoids duration risks further out the curve.
- Global equities suffered another setback as U.S. President Donald Trump said the United States will impose tariffs on steel and aluminum imports – a move likely to increase tensions with major trading partners, including China. Fed Chair Powell’s first testimony to Congress briefly pushed benchmark Treasury yields back near four-year highs.
- Renewed uncertainty about the path ahead for Brexit negotiations drove the British pound lower. Germany’s Social Democratic Party (SPD) membership approved a coalition with Chancellor Angela Merkel.
- A string of manufacturing data underwhelmed around the world, with figures showing some payback from previous strength. U.S. consumer confidence hit a 17-year high in February. U.S. core PCE prices rose as expected in January and incomes posted a surprisingly strong gain.
Weekly and 12-month performance of selected assets
|Equities||Week||YTD||12 Months||Div. Yield|
|U.S. Large Caps||-2.0%||0.7%||13.0%||2.0%|
|U.S. Small Caps||-1.0%||0.0%||11.3%||1.2%|
|U.S. Investment Grade||-0.2%||-2.8%||2.7%||3.7%|
|U.S. High Yield||-0.2%||-0.7%||3.4%||6.2%|
|Emerging Market $ Bonds||0.0%||-2.2%||4.5%||5.7%|
|Brent Crude Oil||-4.4%||-3.7%||16.9%||$64.37|
Source: Bloomberg. As of March. 2, 2018.
Notes: Weekly data through Friday. Equity and bond performance are measured in total index returns in U.S. dollars. U.S. large caps are represented by the S&P 500 Index; U.S. small caps are represented by the Russell 2000 Index; Non-U.S. world equity by the MSCI ACWI ex U.S.; non-U.S. developed equity by the MSCI EAFE Index; Japan, Emerging and Asia ex-Japan by their respective MSCI Indexes; U.S. Treasuries by the Bloomberg Barclays U.S. Treasury Index; U.S. TIPS by the U.S. Treasury Inflation Notes Total Return Index; U.S. investment grade by the Bloomberg Barclays U.S. Corporate Index; U.S. high yield by the Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Capped Index; U.S. municipals by the Bloomberg Barclays Municipal Bond Index; non-U.S. developed bonds by the Bloomberg Barclays Global Aggregate ex USD; and emerging market $ bonds by the JP Morgan EMBI Global Diversified Index. Brent crude oil prices are in U.S. dollars per barrel, gold prices are in U.S. dollar per troy ounce and copper prices are in U.S. dollar per metric ton. The Euro/USD level is represented by U.S. dollar per euro, USD/JPY by yen per U.S. dollar and Pound/USD by U.S. dollar per pound. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. Past performance is not indicative of future results.
Asset class views
Views from a U.S. dollar perspective over a three-month horizon