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Members of D.A. Davidson & Co.

We May See Investment-Grade Corporates Become the Signaling Device

“The Fed: Jay Powell spoke [08/27/2020] and made it clear that the singular focus on inflation suppression that dominated the Fed’s thinking from 1978 to 2006 has ended.


…How comfortable is the FOMC with rising long-term interest rates? If the Fed wants to support the financial system, it will let long-term rates rise and steepen the yield curve. A steeper curve should support bank lending and encourage investors back into the fixed income markets.  However, there is likely a limit to how high of a rate the Fed will tolerate.


…Simply put, this news today is bad news for long-duration bonds.


…Is there a rate level on bonds that would trigger yield curve control? The Fed may prefer a steeper curve, but how steep and how fast it steepens is an issue. Let’s say the Fed wanted to allow the fed funds/10-year T-note spread to widen to its non-recession average of 1.41% observed since 1981. Assuming fed funds of 9 bps, that would require a 10-year T-note yield of 1.32%.. 


…What are potential market effects? We do expect the Fed to eventually engage in yield curve control because a sharply rising long end will thwart its employment goals. As a consequence, the policy change will tend to reduce the diversification power of long Treasuries.


…It has been our position that the protective impact of duration to a portfolio has likely been exhausted. The policy announcement appears to have confirmed our position.  We may see investment-grade corporates become the signaling device for the financial markets. That would mean we could see credit spreads rise in the absence of credit problems but due to rising inflation.”


(Daily Comment dated 08/28/20 by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez of Confluence Investment Management LLC)


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