Credit Market Week In Review For June 11-15

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Includes: BIL, DFVL, DFVS, DLBL-OLD, DLBS, DTUL, DTUS, DTYL, DTYS, EDV, EGF, FIBR, GBIL, GOVT, GSY, HYDD, IEF, IEI, ITE, PLW, PST, RISE, SCHO, SCHR, SHV, SHY, TAPR, TBF, TBT, TBX, TLH, TLT, TMF, TMV, TTT, TUZ, TYBS, TYD, TYNS, TYO, UBT, UST, VGIT, VGLT, VGSH, VUSTX, ZROZ
by: Hale Stewart

Summary

The Fed raised rates an additional 25 basis points.

The 10-year FF spread is once again approaching 1%.

The Fed has increased the low end of its PCE projections.

Obviously, the big news this week was the Fed voting to raise rates 25 basis points, which raised the target Federal Funds rate to 1.75-2%. I looked at its statement in detail earlier this week. The key takeaway is that it's possible that we'll see two more rate hikes from the Fed by December 31, which would take the target rate to 1.25-1.5%.

Let's place this into a yield curve context by looking at the 10-year Federal Funds spread:

After last week's move, the spread is (once again) approaching 1%. If the Fed raises rates two more times and the 10-year stays at current levels, the 10-year Fed Funds spread would be about 50 basis points.

That begs the question: what about the 10-year? I've previously written that under the current economic situation, there is little reason to think it will move beyond the lower 3% range. Nothing has changed since I wrote that article to change my analysis. But let's assume the world experiences some type of shock between now and December 31. For example, there's a political (like an event in the Middle East) or economic event (such as the ratcheting up of trade tensions) that sends investors into the arms of safe investments. That would tighten the yield spread, moving it closer to inverted territory.

So long as we're looking at various government yield spreads, let's look at the 30-year-Fed Funds spread:

Like the 10-year-Fed Funds spread, this number is also tightening. In fact, it is also near the 1% level. That's due to the very tight spread at the long-end of the curve:

The difference between the 30-year and 10-year is less than 20 basis points. Think about this from a risk perspective: for taking an additional 20 years of risk, investors are compensated less than 20 basis points in additional compensation. Put another way, there is little difference in the amount of risk between a 10- and 30-year government bond. That tells us that inflation expectations are very contained.

Finally, let's place this information into a historical context:

Before a recession, most of the movement in the Treasury market comes from the short end as the Fed is raising rates. If you look at the last few years, you'll see the exact same situation. This explains why analysts continue to write about the compression yield curve: it's following the traditional, late-cycle economic pattern.

Finally, let's look at the progression of the yield curve this year:

The top chart shows the different yield curves from May 1 to June 15 while middle chart shows the yield curve from June 1 to June 15. Neither has moved that much in real terms. The bottom chart shows the yield curves from January 1 to Friday; this is where all of the movement has come from over the last 6 months. Put more succinctly, the bond market moved a great deal earlier in the year but has stabilized over the last six weeks.

Finally, let's take a look at the Fed's economic projections from its latest meeting:

The top line shows its GDP projections, which barely changed between meetings. This is actually a bit odd; several previously dovish Fed governors have voted for the recent rate hikes, arguing that increased federal spending and last year's tax cuts would stimulate growth. Yet, the range of GDP projections hasn't moved between meetings. The more meaningful changes have occurred in the PCE projections. The low end of its PCE projections for 2018 increased .2 and the high end of the PCE price projections for 2018 increased .1. This will more than likely happen:

Both the core and overall PCE indexes are (finally) approaching the Fed's 2% target.

Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.