Volatility has been completely stripped from the fixed income markets. As such, spreads have narrowed considerably across all sectors of the bond markets. Agency bullets offer little to no spread, with callable agencies only offering spreads that historically belong to bullets. On the bright side though, a little relief can be found in longer bonds, such as in the 10+ year maturity area of the curve, which still offer a bit more yield.
What then does the forecast look like for the longer end of the yield curve? The spread between 2’s and 10’s has been compressed to just 65 bps today. Also, keep in mind that when the Fed implemented its first 25 bps rate increase of the overnight rate, the 10-year treasury was about 2.65%, and now it’s 2.35%. The point here being that we have been experiencing a non-parallel flattening of the yield curve, with the front end rising much faster than the back, which has actually fallen slightly.
It is hard to imagine the Fed actually succeeding in raising the overnight rate by a total of 75 bps in 2018, which is what their current guidance suggests, without the longer end of the curve also moving higher. Unless we are going to experience a completely flat or even inverted yield curve around 2.30%, then the long end of the curve simply has to move higher from this point. This leads me to believe we may experience more of a parallel rate movement than we have thus far. Of course, this would begin after the Fed’s expected rate increase in December of this year, as that move is already largely priced into the market, with implied odds of 92% for an increase in December.
Eric Swanson, CFA