- Flattening yield curve reflects lower inflation expectations
- The Fed will likely increase rates again this year and two or three times next year
- Corporate credit quality remains stable to slightly better
One measure we pay particular attention to when managing fixed income portfolios is the slope of the yield curve (measured by the difference between two-year and 10-year Treasury yields). This measure reflects the bond market’s consensus estimate of the future path of interest rates, which is based on both the Fed’s monetary policy as well as inflation expectations.
During the second quarter, we saw the slope of the yield curve decline materially, from 113 basis points (bps) to 91 bps at month’s end. Although some of this flattening was due to the Fed’s mid-June rate increase, most of it was due to a decline in 10-year yields. This is important because it implies a change in market expectations, in this case declining inflation expectations.
Lower inflation expectations have reduced market expectations regarding additional rate increases by the Fed. The market is signaling that it anticipates only one or two more hikes by the end of 2018. This contrasts with Fed projections of four additional rate hikes, supported by low unemployment with inflation of about 2%.
City National Rochdale expects the Fed will likely raise rates again later this year and perhaps two or three times next year, with long-term rates rising only modestly.
We also track corporate credit spreads, the incremental amount of yield that corporates offer over Treasuries. When credit quality deteriorates, corporate yields increase relative to Treasury rates. Corporate spreads declined modestly during the quarter, indicating stable to slightly improving credit quality. Leverage is higher, but this has been offset by lower interest costs, and we expect positive earnings growth going forward.
Even though corporate spreads are lower than in prior years, they reflect stable credit conditions and result in yields that are more attractive than Treasuries. Given a stable macroeconomic environment with rising earnings, we remain comfortable with our allocations to corporate bonds. That said, we will look for opportunities to increase overall credit quality by swapping lower-rated issuers for higher-rated ones when the yield difference is minimal.
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