We have been intrigued over the past several months by total return trends in US bond markets. It has been a rough first half of the year for bonds so far with the Bloomberg Barclays US Aggregate Total Return index contracting 1.95% year-to-date through June 22, 2018. What is interesting to us is prices have fallen to a greater degree in US investment grade corporate bonds as measured by the iBoxx Very Liquid index, (-4.78%) as compared to with the Bloomberg Barclays US Treasury Index (-1.43%). This has occurred while US corporate fundamentals are quite strong.

What concerns us is that interest rate spreads (depicted in the chart) between US investment grade corporate credit and US Treasuries have climbed from levels we last experienced during the pre-crisis era. This could just be a pause and spreads resume their tightening path that began several years ago, ultimately approaching lows reached in 2007. Or we could see further widening that could signal economic and market deterioration. There are many dynamics at play – central bank activity across the globe is a major factor – and this is one simple measure, yet we believe it is a critical one.

US Treasury Spreads Continue to Narrow

Interest rate spreads in the US Treasury market are continuing — a major concern for investors over the past several quarters. This week’s chart shows the difference between 10-year and 2-year US Treasury yields with the shaded areas marking recessionary periods. As these two yields converge, or when the yield on the 2-year surpasses the 10-year yield, recessions often follow. The current spread is 37 basis points, but it is heading towards parity rapidly. It is difficult to forecast an imminent recession because of the positive trends in employment, consumer and business spending, benign inflation and expansionary fiscal activity. Yet this indicator has strong predictive power and should not be ignored. One major difference in this cycle versus previous ones is the amount of central bank activity throughout the world and as a result treasury spreads might not have the same predictive force as before.

Ooooh. Color! This week’s focus is on major central bank activity with the European Central Bank (ECB), the US Federal Reserve and the Bank of Japan (BoJ) all scheduled to make policy announcements at the conclusion of their respective meetings. Beginning Wednesday with the US Fed, market observers are widely expecting a further 0.25% increase in the Federal funds rate but the focus will be on which words are selected and projections going forward. The ECB follows on Thursday and the key to their statement will be any adjustments they intend to make regarding the bond buying program and the impact on the balance sheet, pictured below. The BoJ closes out the week on Friday and market participants are largely expecting no change to current policy given inflation is below target and the tightening labor market does not appear to be adversely impacting prices.

We’re back to charts after a holiday week hiatus, but Italy didn’t take a break. Another Euro-related crisis may be lurking in Italy as the populist coalition government, consisting of the Five Star Movement and the far-right League parties, have formed an administration. Although the parties have dropped some of their most alarming campaign rhetoric concerning exiting the Euro and EU, investors have re-focused on Italy’s sovereign debt levels now surpassing 130% of GDP (well beyond EU budget rules) and the limitations it imposes on fiscal flexibility.

Not surprisingly, the Euro has weakened considerably — particularly against the US Dollar. The cause of the softening Euro likely spans beyond Italy’s contribution of 15% EU GDP. Several key Eurozone economic indicators such as industrial production, business sentiment and consumer confidence appear to be losing momentum.

The yield on the widely followed benchmark 10 Year US Treasury bond eclipsed 3.05% Tuesday morning May 15th and now stands at levels last seen in 2011. The rise in April’s retail sales report showing further expansion likely helped push rates higher. Stronger economic activity and the potential for inflation are forces potentially putting upward pressure on interest rates, but record Treasury bond issuance is also a highly influential factor in the other direction.

We believe interest rates will continue to rise as the US Federal Reserve pursues monetary policy normalization and the economy expands. As a result, our fixed income positions remain short duration. Bloomberg’s survey of 58 analysts projects the yield on the 10 Year US Treasury bond should reach 3.19% by the end of 2018 which would imply further price declines in longer duration fixed income.

Last week’s unemployment figures released by the US Bureau of Labor Statistics were further signs that the labor market as well as the overall economy continue to improve. Headline unemployment is at the lowest level since the technology boom fueled 1999-2000 period. Unemployment including part time workers is approaching levels experienced during that same timeframe. While this is good news for the American worker, the market is concerned that labor scarcity could place upward pressure on wages, inflation and ultimately interest rates. Right now, nominal wage inflation is contained at 2.6%, a level the Federal Reserve has indicated to be tolerable.