One of the most evident trends to emerge in financial markets since the US Presidential Election has been climbing rates on US treasuries and widening credit spreads with increased term premiums. While not unprecedented, the increase in 10 year Treasury rates has been the sharpest since May 2013.
Discussing these trends and the reasons behind them, Andrew Johnson, head of Investment Grade Fixed Income for Neuberger Berman, recently spoke with Rick Santelli.
To explain why rates are increasing Mr. Johnson points to expectations for increased deficit spending under a Trump administration. As to why deficit spending would cause treasury rates to rise now, when perennial deficits haven’t in the past, Mr. Johnson notes that unlike after the financial crisis “the economy is (now) strong, growing at full potential… We are at full employment for sure, or very close if we are not at full employment, and therefore from here deficit spending is going to be inflationary and that leads to uncertainty about term premiums.” Mr. Johnson goes on to explain that raised expectations for tightening Fed policy will similarly support higher yields.
What does that mean for fixed income investors? According to Mr. Johnson, for many foreign investors “before they step in, they need to feel comfortable that our rates are not going to get higher, because higher rates mean prices come down and you lose money… At some point though Rick, if those spreads get to be too wide.. you will see foreign investors come in and bring those spreads in.”
Looking forward Johnson notes, “whats been happening though is that, at least in my opinion, investors have gotten chased out of their preferred habitat. As sovereign rates came down to negative in the Eurozone, 1.4 % on 10s here, investors needed yield. Where could they go? They had to go to credit, they had to go to high yield, emerging markets. That’s not really where they want to be long term and so as some point, as rates get higher and higher on US Treasuries they are going back to their preferred habitat. I don’t think that’s now, but as we get to rates say 3% on 10’s God forbid 3.5% credit could be in trouble…”
And there in lies the key. Rising Treasury rates, if the trend truly is to be sustained, poses a big risk to credit markets as the capital which has been chased into less desirable credit concludes that there are now better places to be. But perhaps the greater risk is that the losses holders of US treasuries experience from sustained rising rates will cause them to exit Treasuries in a big way, supercharging the whole process and, in a world drowing in sovereign debt and politically adjusted to low rates, creating significant broader market risk.
The assumption underlying the whole scenario however, is that the US economy really is on sound footing, an assumption which may not stand up to real scrutiny for now. In a round about way, that might not be all bad in the short term.
Check out the full interview below for more.