Rate Normalization Begins

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At the beginning of 2017, we expected the Federal Reserve Open Market Committee (FOMC) to increase short-term rates and move to a more normal monetary policy during the year. While we were not certain whether the FOMC would make 2 or 3 interest rate increases, we did anticipate the yield curve would flatten with short-term rates increasing more than the intermediate and long maturities. The FOMC made three 25 basis point moves this year, increasing the overnight borrowing rate from 0.75% to 1.50%. As can be seen in Chart 1, the shorter end of the yield curve increased as a result of the moves but the intermediate and long end remained fairly stable and traded in a very narrow range throughout the year. The minimal movement on the longer end of the yield curve was attributable to extremely low global rates and benign inflation.

Treasury Yield Curve Chart

Investors who were willing to accept more risk than is characteristic of government securities were rewarded again this year. Spreads (the difference between a security’s yield and the equivalent maturity treasury yield) continued to tighten during the year, providing favorable returns for higher risk asset classes such as high yield and emerging market bonds as shown in Chart 2. Concerns about the level of spread tightening and when the trend will change and lead to more risk are discussed frequently. At this point in the economic cycle, spreads may not tighten significantly but we are not concerned with a trend reversal to widening spreads. Typically, spreads widen when there is an impending recession, which we do not believe is on the horizon. In a flat to rising rate environment, spread product provides greater income and a better return profile leading us to remain overweight in this segment relative to government securities.

Bond Asset Class Performance Year to Date

The recently passed Tax Cuts and Job Acts will increase deficit spending and lead to higher government debt issuance. Greater supply in tandem with the Federal Reserve shrinking its balance sheet has the potential to put pressure on interest rates during the next year. In addition, the risk for slightly higher inflation over the next year has increased due to the possibility of wage pressures from the tight labor market and stronger global economies, increasing demand for commodities. While we believe inflation will be higher in 2018, we are not expecting a dramatic increase from the current level of 2% to somewhere in the neighborhood of 2.5%. An additional concern regarding interest rates is the potential decline in accommodative monetary policy across the globe, leading to higher global rates and putting pressure on U.S. interest rates.

Municipal bonds had a favorable return for investors. Large issuance during the last quarter was met with an equal level of demand, resulting in level rates. Potential changes to tax exempt issuance qualifications in the House version of the tax reform bill resulted in private activity bond issuers hurrying to market in order to ensure the bonds qualified as tax exempt investments. In the final bill, private activity bonds were saved from losing the tax exempt status. As we move into 2018, the Tax Cuts and Jobs Act lowered corporate tax rates from 35% to 21%, which could make tax exempt bonds look less attractive to large financial institutions which have been strong buyers of municipals during the last few years. High income individuals will still benefit from investing in municipal bonds with the tax law change.

To summarize our thoughts, we continue to favor spread product such as corporates, high yield and emerging market investments in light of the risk on environment. We also remain slightly short on our target benchmark maturity in anticipation of slightly higher rates.

 

Elizabeth Pierson 

Elizabeth S. Pierson, CFA Senior Vice President & 
Chief Investment Officer with Alpine Trust & Investment Group  

 

Investment and insurance products are: not products of Alpine Bank; not FDIC insured; not guaranteed; and, may be subject to investment risk, including possible loss of principal.

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