If you thought achieving income yields was difficult, life will only get harder—the Fed that giveth can taketh away. Just as investors were getting accustomed to the taste of at least modestly non-zero rates, expectations have shifted swiftly.
To the doldrums of lower rates once more we go. The market is currently pricing in a zero percent chance of a rate hike not just this year, but at any point before 2021. For perspective on how extreme that forecast is, even the New York Times gave Donald Trump an 8% chance!
Wall Street now pegs the odds of at least one cut by year end at 99.0%, with three cuts the most likely scenario. Indeed, the market now assigns a greater probability of a return to zero than of a single hike in the next 18 months.
More striking yet is not just the expectation of no further tightening, but the level of conviction in dramatic monetary easing. Wall Street now pegs the odds of at least one cut by year end at 99.0%, with three cuts the most likely scenario. Indeed, the market now assigns a greater probability of a return to zero than of a single hike in the next 18 months.
The chart below details the magnitude of these market gyrations. While expectations of a rate hike had long since evaporated (depicted in gray) by the end of March, only since June’s beginning had expectations for a July cut firmly solidified (illustrated in blue). Friday’s jobs report hardened the calculus on rate cut predictions, as not only did May numbers miss by 105,000 jobs, but March and April were revised downward by a further 150,000. In the blink of an eye, a quarter-million job deficit confronted markets, and the previously forlorn “Powell Put” may be back in action.
The New (No Yield) Normal?
Reflecting these revised odds, the ten-year treasury yield has undergone a 117 basis points drawdown since last November, touching as low as 2.06%, and it is not as though it had the basis points to spare relative to short term rates. The yield curve has transformed into a “yield valley,” where rates dip 49.5 bps from the 2-month to the 3-year, before recovering slowly down the long end of the curve. As the chart above depicts, the current yield environment is a far cry from November 30th, 2018, the last day before partial inversions started entering the curve.
For all the mythology surrounding yield curve inversions, perhaps the only certainty to emerge this inversion cycle is that everyone has a different definition of what counts as a true inversion.
For all the mythology surrounding yield curve inversions, perhaps the only certainty to emerge this inversion cycle is that everyone has a different definition of what counts as a true inversion. Do partial inversions count a la 3-year/5-year, or is the 2-year/10-year spread the final arbiter of all inversions? It turns out no one agrees.
Technicalities aside, one point that illustrates the extent of dislocation in the curve is that the 2-month bill, propped up by the Federal Funds Rate, is not surpassed in yield until roughly a 20-year maturity. In other words, Mr. Market is so confident in imminent rate cuts that investors must assume 120 times the maturity to get an equivalent yield.
A Death of Cash
If 2018 marked the year cash made its return as an asset class—indeed it outperformed both stocks and bonds over those 12 months—2019 could be the year of its demise.
If 2018 marked the year cash made its return as an asset class—indeed it outperformed both stocks and bonds over those 12 months—2019 could be the year of its demise. With the projected cuts coming, yields in all its forms may be much harder to come by, whether risk-free or otherwise. This brave new world of lower rates puts the challenge of generating meaning income yields into sharp focus once more. All these factors frequently leave investors asking how meaningful yields can actually be achieved.
The most unfortunate aspect of this rate reversal is that conservative investors and yield-dependent retirees may disproportionately bear the burdens. Estimates of 4 cuts would reduce risk-free income streams by approximately 44%, and risk spreads would likely see contractions as well. These developments leave income-oriented investors in the unenviable position of assuming greater amounts of risk for higher yield potential or accepting lifestyle reductions. The trend of price appreciation for lower yields on many income assets is already underway; look no further that the Bloomberg Barclays Aggregate Bond Index (commonly known as the Agg).
We cannot know with certainty how a variety of factors, from trade tensions to a potential economic deceleration, may impact Fed policy and in turn influence market behavior. We can however think strategically about the full range potential outcomes before us, so that our portfolios may be prepared should market realities not precisely mimic expectations. As the market performs this radical about-face on rates, yesterday’s alternatives may serve a larger role in tomorrow’s portfolios as the hunt for yield intensifies. Income may no longer be taken for granted.