Breaking Good

|
 |  Includes: GMMB, GOVT, ITM, MLN, MUB, MUNI, PLW, PRB, PVI, PZA, RVNU, SHM, SMB, SMMU, SUB, TFI, VRD, XMPT
by: Scott Minerd

Summary

Structural factors driving strong demand for fixed-income products.

Most areas of U.S. fixed income are overvalued.

ABS, municipals and bank loans still offer good value.

This week, 10-year U.S. Treasury yields broke out of their recent trading range to drop below 2.5 percent, their lowest level since October of last year. I believe, for a number of reasons, that yields could trade significantly lower, perhaps dipping as low as the 2.0 to 2.25 percent range in the coming months.

Over the past few weeks I have written about the role capital flows from overseas have played in keeping U.S. interest rates low. Tensions in Ukraine and China's devaluation of the renminbi have caused a flight to safety, which has put downward pressure on U.S. Treasury yields. The reality is, however, that these events alone do not explain the declining trajectory of interest rates.

Structurally there is very strong demand for fixed-income products that is not being satiated. This demand, which is especially robust among pension funds and insurance companies, is likely to play a leading role in driving yields lower. At the same time, U.S. corporations are holding a substantial amount of cash and not feeling any great pressure to borrow money. That dynamic has caused the new corporate debt issuance calendar to lighten up. With lots of cash waiting to be invested, there is a supply-demand imbalance which is pushing the prices of everything from investment-grade corporate bonds to U.S. Treasuries higher. Most areas of U.S. fixed income, with the notable exception of asset-backed securities, municipals and bank loans, are now overvalued. Triple-C rated credit is particularly overvalued but, overall, current spreads of both investment-grade bonds and high-yield bonds have further room to compress.

There is nothing significantly negative to say about prospects for the U.S. economy, especially given that interest rates are on a declining path. Mortgage rates are likely headed lower, making housing more affordable and thereby boosting consumption. Employment levels are trending higher and we are headed into the first summer in years where there is no talk of battles over the U.S. debt ceiling or of a potential federal government shutdown. Finally, several years of buoyant equities markets have boosted the wealth effect among U.S. consumers. After a tough first quarter, the U.S. economy is poised to post much stronger economic growth in the second quarter, possibly 4 percent or higher. U.S. GDP growth for the full year should come in at 3.0 to 3.5 percent.

Of course, with much of the U.S. fixed-income market now overvalued, we must guard against the pitfalls of overvaluation, but, as I have said before, markets that are overvalued and then become even more overvalued are called bull markets.

Improving U.S. Budget Deficit to Cut Treasury Supply

Driven by strong tax receipts and continued spending cuts, the U.S. federal government budget deficit is on a rapidly improving trend. This has important economic implications over the longer term, but the near-term effect might be felt most acutely in the Treasury market. With less need to borrow, the U.S. Treasury Department will likely decrease its issuance of securities over the coming months, adding to downward pressure on yields. Our projections forecast that Treasury issuance could fall to about $350 billion over the next two quarters, about 40 percent lower than one year ago.

U.S. FEDERAL BUDGET BALANCE AND TREASURY ISSUANCE

Source: Haver, Guggenheim Investments. Data as of 3/31/2014. Note: Data seasonally adjusted by Haver Analytics.

This material is distributed for informational purposes only and should not be considered as investing advice or a recommendation of any particular security, strategy or investment product. This article contains opinions of the author but not necessarily those of Guggenheim Partners or its subsidiaries. The author's opinions are subject to change without notice. Forward looking statements, estimates, and certain information contained herein are based upon proprietary and non-proprietary research and other sources. Information contained herein has been obtained from sources believed to be reliable, but are not assured as to accuracy. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Guggenheim Partners, LLC. ©2014, Guggenheim Partners. Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information. Past performance is not indicative of future results. There is neither representation nor warranty as to the current accuracy of, nor liability for, decisions based on such information.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.