Long-dated Treasury yields stabilize near 2-month high after Powell articulates Fed’s new framework


U.S. long-term Treasury yields slipped Friday as investors processed data on the health of the economy in the aftermath of the Federal Reserve’s historic shift in its monetary policy framework a day earlier.

On Thursday, Fed Chairman Jerome Powell said the central bank would aim for an average annual inflation rate of 2%, shifting longstanding policy that are likely to have lasting impacts on financial asset prices.

How did Treasurys perform?

The 10-year Treasury note yield
TMUBMUSD10Y,
0.719%

fell 1.7 basis points to 0.727%, while the 30-year bond yield
TMUBMUSD30Y,
1.501%

pulled back 0.9 basis point to 1.508%, after the long bonds on Thursday notched their highest yields since mid-June, according to Dow Jones Market Data.

The shorter 2-year note rate
TMUBMUSD02Y,
0.156%
,
meanwhile, retreated 2.3 basis points to 0.135% on Friday. Bond prices move inversely to yields.

For the week, the 2-year note shed 1 basis point, enough for its sharpest weekly fall in about a month, the 10-year yield rose 8.8 basis points, while the 30-year rate tacked on 15.5 basis points.

What drove Treasurys?

Fixed-income markets were parsing the Fed’s decision on Thursday to alter its policy framework by aiming for a yearly average inflation rate of 2%. in contrast with the past policy of pre-emptively raising rates when inflation neared 2%. The Fed’s new policy thinking also allows the labor market to strengthen, with unemployment lower for longer periods without it raising alarms by policy makers.

Need to Know:The Fed might never hike rates again. Here are growth stocks for the long run, according to one strategist

On Friday, investors digested a batch of economic reports.

Data showed U.S. personal income rose 0.4% in July, while consumer spending was up 1.9%. Economists surveyed by MarketWatch had expected income to fall another 0.4% after a 1.1% drop in June. Spending was expected to show a 1.6% rise after a 5.6% increase in June.

Spending on durable goods was up 12.2%, while spending on services was down 9.3% for a net shortfall of 4.6% in total consumer demand, said Aneta Markowska, chief financial economist at Jefferies, adding that the variation in spending patterns explains “part of the disconnect between the stock market and the economy, since the former has much less exposure to the service sector than the latter.”

Meanwhile, the final reading of the University of Michigan’s August consumer sentiment index came in at 74.1 versus a preliminary reading of 72.8 and up from 72.5 in July.

The data come as Fed officials on Friday offered a measured outlook for the U.S. economy, which is still wrestling with the COVID-19 pandemic. “I do believe that the recovery is likely to be a slow one,” said Cleveland Fed President Loretta Mester, in an interview on CNBC.

In at later interview on the business network, Philadelphia Fed President Patrick Harker said he thought job growth and consumer spending were moving sideways in August.

“It will take a while for the employment situation to heal,” he said.

Harker and Mester are voting members on the Fed’s interest-rate committee this year.

Separately, market participants were watching news that Prime Minister Shinzo Abe would resign due to illness. Abe, whose term ends in September 2021, is expected to remain in office until a new party leader is elected and formally approved by parliament.

Read:Who will replace Shinzo Abe? 5 things investors need to know about the resignation of Japan’s prime minister

The Japanese 10-year government bond
TMBMKJP-10Y,
0.059%
,
or JGB, was trading with a yield of 0.059%. Japanese shares fell sharply, leaving the Nikkei 225 Index
NIK,
-1.40%

down 1.4%.

What did market participants say?

“Powell characterized permissible overshoots as moderate (which is to say not large) and for some time (which is to say not permanent), but he emphasized that it was important for people to ‘understand that this is not a formulaic approach […] the Committee will continue to consider all of the things that it typically considers in making monetary policy, but we’ll aspire to have inflation run above 2% after periods in which it runs for an extended period below 2%’,” wrote Morgan Stanley analysts in a research report published on Friday.

“For every dollar invested in the broad US equity market, companies are earning 4.4%. Every dollar invested in a 10-year US Treasury rate yields roughly 0.5%. Seen through that lens, it’s hard to make the case that equities aren’t attractive. Low interest rates tend to be supportive for equity multiples, as they inflate the value of future cash flow and tend to push equity market multiples higher,” wrote Invesco Global Market strategists Brian Levitt and Talley Leger in a Friday research note.



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Mortgage rates keep falling — will they finally drop to 0%?


Mortgage rates have dropped to record lows on eight separate occasions in 2020 so far, as the coronavirus pandemic has roiled the global economy.

But could they eventually drop to 0%? Well, if past precedent is any indication, there’s indeed a chance.

Freddie Mac
FMCC,
+0.70%

deputy chief economist Len Kiefer posted to Twitter
TWTR,
+0.21%

a chart showing the movements in the average rate of the 30-year fixed-rate mortgage following the Great Recession. As he pointed out, interest rates on home loans dropped in four of the five years following the 2008 financial crisis, falling roughly three percentage points.

This week, mortgage rates moved up a bit. The 30-year fixed-rate mortgage averaged 2.96% for the week ending Aug. 13, rising eight basis points from the week prior, Freddie Mac reported Thursday. The 15-year fixed-rate mortgage averaged 2.46%, while the 5-year Treasury-indexed hybrid adjustable-rate mortgage stood at 2.9%. The week prior mortgage rates had fallen to a record low for the eighth time this year.

So were we to see a repeat of what happened after the Great Recession, then rates indeed would drop to 0% — or even into negative territory. Predicting whether that will happen isn’t so simple.

“Interest rates are super hard to forecast,” Kiefer told MarketWatch. “Economists, myself included, have not had a great track record of predicting where rates would go. For many years, folks were saying rates were headed higher, and they ended up continuing to head lower.”

A 0% mortgage isn’t a fantasy — in fact, it’s the reality across the pond. In Denmark, Jyske Bank
JYSK,
-1.93%

began offering a 10-year fixed-rate mortgage at negative 0.5% last year, and Finland-based Nordea Bank announced around the same time that it was offering a 20-year fixed-rate mortgage in Denmark that charges no interest.


‘For many years, folks, were saying rates were headed higher, and they ended up continuing to head lower.’


— Len Kiefer, deputy chief economist at Freddie Mac

But economists say there are many reasons to believe that mortgage rates won’t drop to 0% or lower any time soon in the U.S. For instance, Freddie Mac’s most recent forecast estimated that the 30-year mortgage would average 3.2% in 2021, not too far from where it stands now.

That’s in large part because the Federal Reserve wouldn’t likely let it happen. The Fed doesn’t directly control mortgage rates. Instead, mortgage rates roughly followed the direction of long-term bond yields, particularly the 10-year Treasury note
TMUBMUSD10Y,
0.709%
.

However, expectations regarding the Fed’s interest-rate policy are cooked into the yields for those bonds and mortgage rates. When the pandemic became a major concern, the Federal Reserve did move to cut the short-term federal funds rate to zero — and sure enough, since then both the 10-year Treasury yield and the 30-year mortgage rate have dropped to record lows.

In order for 0% mortgages to become a reality, “We’d probably have to see negative Fed funds rates,” said Danielle Hale, chief economist at Realtor.com.

“The central bank rates in Denmark had been negative for five years or so before mortgage rates got to zero,” Hale added. “The Fed has been clear that it’s not their preferred course of action.”

A lot would need to happen for the Fed to take rates negative, including perhaps a major demographic shift.

“The U.S. population is a lot younger than Europe or Japan,” Kiefer said. “Perhaps in 10 years, depending on immigration and other things, we may look more like them. If that is one of the driving factors of inflation — we don’t know that for sure, but that’s a theory — then that could be what we would perhaps look at.”


‘The central bank rates in Denmark had been negative for five years or so before mortgage rates got to zero.’


— Danielle Hale, chief economist at Realtor.com

In other words, the aging populations in Western Europe and Japan could explain the slower economic growth those regions have seen. And it would take a serious, prolonged downturn in GDP or labor market growth in the U.S. for the Fed to feel comfortable moving rates into the negative territory.

Yet, even if that happens, rates could still stay above 0% — and that’s because of the role investors in mortgage-backed securities play. “Mortgage rates are determined by investor demand for mortgage bonds,” said Matthew Speakman, an economist at Zillow
ZG,
+2.83%
.

“A precipitous drop in rates would likely prompt a surge in refinancing demand, and loans that only generate a few payments before being refinanced aren’t profitable for investors,” Speakman added. “This dynamic would weaken investor demand and result in higher rates.”

Plus, mortgages carry some risk, since homeowners could miss payments and go into default. That risk comes with a premium that translates into a higher interest rate compared with the yield on the 10-year Treasury and other investments, Speakman said.

However unlikely it is that mortgage rates fall to 0% on average, that isn’t to say one or two lenders might not flirt with the idea. United Wholesale Mortgage, for instance, has begun advertising a 30-year fixed-rate mortgage at only 1.99% — though the low interest rate comes with steep fees.

“When we survey lenders we see a variety of interest rates,” Kiefer said. “It may be very beneficial for them to shop around because they may get very different quotes, depending on who they talk to.”



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This $20 billion bond fund produced outsized returns by capitalizing on market turmoil, and is set to do it again


With bond prices high and yields low, an income-seeking investor might wonder if it is even worth owning a bond fund these days.

There are several reasons, underlined by the performance and characteristics of the Guggenheim Total Return Bond Fund, along with the possibility that interest rates may keep falling and stay low for many years.

This year has turned out to be a paradise for borrowers, with record-low interest rates in the U.S., but it has also become a difficult environment for fixed-income investors. You simply have to get used to much lower yields than you enjoyed in years past.

Then again, money managers can take advantage of market turmoil to scoop up discounted securities, setting up gains and relatively good yields for the long term.

Anne Walsh, chief investment officer for fixed income at Guggenheim Investments, explained how the $19.6 billion Guggenheim Total Return Bond Fund
GIBAX,
-0.10%

has outperformed its benchmark by a wide margin this year. She co-manages the fund with Scott Minerd, Guggenheim’s chairman and global chief investment officer, and Steven Brown, senior managing director of the firm.

First, here’s how the fund’s Class A
GIBAX,
-0.10%

and institutional shares
GIBIX,
-0.13%

have performed, with dividends reinvested, against its benchmark, the Bloomberg Barclays U.S. Aggregate Bond Index, and three exchange traded funds that aim to track the same benchmark:

Ticker

Total return – 2020 through July 31

Total return – first quarter, 2020

Total return – second quarter, 2020

Average return – 3 years

Average return – 5 years

Guggenheim Total Return Bond Fund – Class A

GIBAX,
-0.10%
11.53%

2.97%

5.63%

6.16%

5.52%

Guggenheim Total Return Bond Fund – Institutional

GIBIX,
-0.13%
1.68%

3.08%

5.70%

6.45%

5.86%

Bloomberg Barclays U.S. Aggregate Bond Index

7.72%

3.15%

2.90%

5.69%

4.47%

iShares Core U.S. Aggregate Bond ETF

AGG,
-0.11%
7.69%

3.10%

3.08%

5.62%

4.39%

Schwab US Aggregate Bond ETF

SCHZ,
-0.07%
7.87%

2.03%

4.29%

5.62%

4.38%

SPDR Portfolio Aggregate Bond ETF

SPAB,
-0.06%
7.64%

3.33%

2.77%

5.61%

4.38%

Source: FactSet

What really stands out this year is the fund’s second-quarter performance. The Federal Open Market Committee lowered its target for the federal funds rate to a range of zero to 0.25% on March 15, and also announced it would increase the size of its balance sheet by buying bonds. The Federal Reserve’s massive bond-buying activity has also pushed down long-term interest rates. Ten-year U.S. Treasury notes
TMUBMUSD10Y,
0.568%

were yielding 0.55% on July 31, down from 1.92% on Dec. 31.

Taking advantage of the turmoil in March and afterward

During an interview, Walsh explained how the fund has outperformed this year. At the end 2019, the fund was “very conservatively positioned,” with a high percentage of the portfolio in U.S. government bonds and only about a third in corporate bonds, she said. The portfolio had almost no securities that lacked investment-grade ratings. There were two reasons for such a position: Walsh and her team thought that with long-term interest rates already low, investors “weren’t compensated for risk,” and “there were signs of a coming recession.”

Walsh expected “a risk-off event,” a period during which investors would sell corporate bonds in a panic, setting up a buying opportunity. The previous major event of this type had been the credit crisis of 2008, with “some mini-cycles in 2011 and 2016,” she said.

Anne Walsh, chief investment officer for fixed income at Guggenheim Investments.


Guggenheim Investments

So after taking advantage of the market turmoil starting in March of this year, by selling highly liquid government securities and buying discounted corporate bonds, as well as asset-backed securities with attractive yields, Walsh said the portfolio is now about 60% corporate bonds, with 10% of that portion securities with ratings that are below investment grade. (The fund’s total portfolio is typically at least 80% investment-grade securities.)

Prices for residential mortgage-backed securities fell during March, as investors feared loan default risk. But this is another area where the market reality can outweigh investors’ worries. The U.S. housing market is now on fire, with homes in many markets not only selling immediately, but having their prices bid considerably higher than the asking prices. This action was described in a recent New York Post article.

The Guggenheim Total Return Bond Fund’s class A shares have a 30-day SEC yield of 1.91%, while the institutional shares have a yield of 2.27%. Those yields might seem low, but they are very good compared to 10-year U.S. Treasury notes (0.52% early on Aug. 4) and a yield-to-maturity of 1.07% for the Bloomberg Barclays U.S. Aggregate Bond Index, according to FactSet.

Walsh discussed the fund’s “carry advantage,” which means the higher rates are locked in for a relatively long time. The weighted average effective duration for the fund as of June 30 was 7.4 years, compared to 6.0 years for the index.

Looking ahead, she expects more buying opportunities as we head into the November elections, because of investors’ uncertainty.

Dire prediction

Lengthening the fund’s duration points to the Guggenheim team’s macroeconomic expectations. Walsh said the firm’s “base case” was that an economic recovery from the effects of the pandemic would take two to three years, with a “permanent change” for retail and other industries affected by the accelerating transition to online commerce.

And that long recovery means even lower interest rates. Walsh expects the yield on 10-year U.S. Treasury notes to fall further to around 40 basis points “in fairly short order.” The Guggenheim team’s longer-term prediction is for the 10-year yield to go negative by 2022.

Fund’s advantage

Walsh said Guggenheim is “unique in the industry” in its team approach to constructing and managing income portfolios, in contrast to “a lot of other asset managers that have a star system,” in which one portfolio manager who pretty much makes all the important decisions on strategy and portfolio makeup.

In a $40 trillion U.S. fixed-income market, Walsh believes “being expert in everything is beyond human ability.”

So Guggenheim has teams focusing on various sectors, asset classes, the economy, portfolio allocation and construction. This enables an “iterative process to build portfolios,” and for the team to “make much more thoughtful decisions on risk budgeting, allocation and portfolio assemblage,” Walsh said.



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10-year Treasury yield plunged to its lowest in 234 years, says Deutsche Bank


Photo by RADEK MICA/AFP via Getty Images

The slide in the U.S. bond market’s benchmark yield is one for the history books.

The 10-year Treasury note yield
TMUBMUSD10Y,
0.539%

fell as low as 0.520% in overnight trading on early Friday, matching levels last seen in March 9 when the benchmark maturity rate to an all-time low after worries about the COVID-19 pandemic sent investors scurrying into safe haven assets.

According to Deutsche Bank, this record low stretches farther back than most might expect. They calculated the current nadir in the 10-year yield went back 234 years, based on data spliced together from the various times the U.S. government has borrowed money in the past.

“The U.S. has been through depressions, deflations, wars, restrictive gold standard regimes, market crashes and many other major events and never before have we seen yields so low back to when the Founding Fathers formed the country,” said Jim Reid, Deutsche Bank’s chief credit strategist, in a Friday note.

The relentless slide in the 10-year note reflects how the bond market’s bull run has defied prognostications by pundits that interest rates and yields would eventually rise, as the economy grew before the pandemic or on potential inflation caused by the Federal Reserve’s money printing this year.

But years of steady economic growth and low inflation have pushed the Federal Reserve’s benchmark fed funds interest rate progressively lower, leaving less room for the central bank to ease monetary policy further.

As the Fed’s policy interest rate fell after economic downturns in 2008 and in 2020, the central bank has been forced to adopt other unconventional monetary policy tools such as outright bond purchases to support economic growth.

Ultra-low bond yields point to trepidation over the U.S. economy’s health as the tally of coronavirus infections marches higher in many American states.

By contrast Wall Street stocks have shrugged off the economic devastation and pinned their hopes on a free-spending government and an accommodative central bank.

Read: Dr. Osterholm: Americans will be living with the coronavirus for decades

Reid noted the S&P 500 index
SPX,
+0.76%

was trading up more than 18% since March 9, while the yield compensation offered for sub-investment grade corporate bonds
HYG,
+0.18%

had also narrowed 150 basis points over the same stretch, reflecting the sharp recovery in prices of so-called risky assets.



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His fund is up 60% this year after he called the March bottom — now, he sees potential for a ‘severe collapse’


Michael Gayed says he’s not trying to scare anyone, but you wouldn’t know it from his latest take.

Back in May, the fund manager warned of the possibility of two crashes: first bonds, then stocks. With his ATAC Rotation Fund
ATACX,
-0.06%

continuing to deliver the goods — it’s up almost 60% so far this year to rank among the best in its category — he’s still waving the yellow flag.

“It is a wild time in the markets,” said Gayed, who also runs the Lead-Lag Report. “Despite a crippling global pandemic, where the U.S. is failing miserably at a response with daily record after daily record cases being broken, and a U.S. economy that seems to be teetering on the edge of yet another Fed Monetary Policy response, stock markets have not seemed to blink when recovering.”

Yes, 2020 is certainly unique, considering, as he pointed out, that stocks crashed by more than 30% at one point, only to rally almost 50% from there. All that in less than eight months.

After having been bullish near the March bottom, Gayed now says that leading market indicators could very well be signalling a “severe collapse” in stocks.

The yield on the 10-year Treasury
TMUBMUSD10Y,
0.534%

, for instance, is looking at around 0.5%, while the yield on the 30-year
TMUBMUSD30Y,
1.197%

is under 1.5%., which he says is setting up for a potential reversion to the mean.

“It’s often said that bond-market investors are the smart money and tend to lead the stock market in anticipating economic activity,” Gayed explained. “The fact that yields have not risen meaningfully (quite the opposite) in the very short term is quite troubling as historically such short-term movement has tended to precede major periods of equity stress.”

Add to that, action in the utilities sector, which is seen as a recession-proof, safe-haven investment, could spell trouble for the broader market, he said, pointing to this chart showing how the defensive investments have managed to outperform the S&P 500 in the past month:

“That should raise some red flags as an equity investor, and frankly this alone gives me pause,” he said. “A similar movement occurred right before the COVID crash this year.”

Lastly, complacency could become a serious issue, with Gayed pointing to several factors, including the wild recent trading antics of Robinhood traders.

“The S&P 500 is now positive in a year that is expecting economic catastrophe. The Nasdaq is flying. And no one seems to think the market can ever go down,” he wrote in a recent note. “It sure feels like everyone forgot that investing in stocks carries risk — and the conditions are changing so rapidly right now, it looks like risk might come back into full force.”

No big crash Monday, with the Dow Jones Industrial Average
DJIA,
+0.43%

, S&P 500
SPX,
+0.76%

and Nasdaq Composite
COMP,
+1.48%

all starting off the week in the green.



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