September 2, 2022
Short and to the point. That’s how Chairman Powell’s annual speech was described. Not known for his brevity, and expected to speak for thirty minutes, the Chairman spoke for a little over eight minutes and the message was clear. Expect higher rates, for a longer period, potentially causing economic pain. With that, the idea of a Fed pivot was quickly removed from the markets and short and long term rates moved higher.
Looking at the CME Fed Watch Tool (Below) the market expects a 75 basis point increase to the overnight Fed Funds in at the September meeting, followed by another 50 basis points in November and 25 more in December. That should bring us to a range of 3.75%-4.00% to close out the year.
Yet despite all the rate increases, inflation reports, and Fed speak, the 3.19% yield to maturity (as of 10:00 am this morning) on the ten-year US Treasury remains below the 3.47% high on June 14th. Well below the 3.39% yield on the two-year US Treasury. Why is this? It seems counterintuitive to lend money for longer and get less return on it, right? The two-year responds to quickly to any changes in short term rates, be they overnight or 3 months. With an HP12c (Yes, I still use one) or a spreadsheet, you can quickly compound the other shorter rates and come up with what you can earn over two years and compare that to the yield on the two-year US Treasury. However, over longer periods, like ten-years, there are more cycles to consider, other risks and most importantly the value of your investment, when you get it back (i.e. Inflation).
Looking forward, we see three scenarios that could further bring down long term rates. The Fed is successful and slows the rate of inflation, the economy enters a recession, or volatility increases because of war or other fears. The scenario that long term rates don’t do so well? Despite the Fed’s best efforts or it’s just the new normal, inflation remains hot and continues above 2-3% for an extended period (i.e. The 70’s).
There is risk with extending out the curve. Indeed, in the short run we may be wrong and be heading for higher long-term rates, however, we think this risk is balanced by the risk of lower rates in the intermediate term. By accepting rate risk now, you lock in reasonable yields and perhaps avoid needing to take credit risk in the future if we re-enter the low inflation – low rate environment the Fed is seeking.
-Peter Baden, CFA
Chief Investment Officer
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CME Fed Watch Tool
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William (Kip) Weese
SVP, Intermediary Sales
Northeast & South West
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VP, Intermediary Sales
North Central & North West
Indexes used for AAA Municipal Yields
2 Year: BVAL Municipal AAA Yield Curve (Callable) 2 Year (Symbol: CAAA02YR BVLI)
5 Year: BVAL Municipal AAA Yield Curve (Callable) 5 Year (Symbol: CAAA04YR BVLI)
10 Year: BVAL Municipal AAA Yield Curve (Callable) 10 Year (Symbol: CAAA10YR BVLI)
30 Year: BVAL Municipal AAA Yield Curve (Callable) 30 Year (Symbol: CAAA30YR BVLI)
Indexes used for US Treasury Yields
2 Year: US Generic Govt 2 Year Yield (Symbol: USGG2YR)
5 Year: US Generic Govt 5 Year Yield (Symbol: USGG5YR)
10 Year: US Generic Govt 10 Year Yield (Symbol: USGG10YR)
30 Year: US Generic Govt 30 Year Yield (Symbol: USGG30YR)
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