There are a number of mitigating factors keeping a lid on the 10-Year Treasury Note yield: “monetary offset,” global yield differentials and the possibility that Trumpflation may disappoint in actuality.
Thus far, the legislative accomplishments of President Trump and a unified Congress have been underwhelming. After demonizing Obamacare for the past seven years, Speaker Ryan and the Republican House of Representatives couldn’t even muster enough partisan votes to bring the hastily prepared American Health Care Act up for vote, blocked by hard-core conservatives on their own side of the aisle. Aside from ideology, there was apparently a procedural rationale for trying to enact AHCA before taking on tax reform. AHCA would have reduced the deficit for the current fiscal year allowing for easier targets for the next fiscal year (and bigger tax cuts). The failure to pass AHCA has certainly put a ding on that supply-side dream as was acknowledged by House Speaker Ryan on March 24th when he said, “Yes, this does make tax reform more difficult. But it does not, in any way, make it impossible. We will proceed with tax reform”
In the most recent Minutes of the Federal Open Market Committee there was a section titled “System Open Market Account Reinvestment Policy,” where the staff briefed the Committee on what to do with its $4.5 trillion balance sheet and the participants deliberated on details. The participants in the Committee generally seemed sanguine about the economy going forward (while inflationary pressures were kept in check) and they anticipated both continued increases in the federal funds rate and the potential start of balance sheet reduction by the end of 2017. Never mind that the Committee has been overly optimistic, intentionally or unintentionally, about both the improvement in the US economy and the pace of rate hikes; assuming that the Committee embarks on reducing its balance sheet, a large buyer of long-dated Treasuries and agency MBS would be out of the market place auguring declining prices and higher yields (and a steepening yield curve if reducing the balance sheet replaces raising the federal funds rate). Or does it?
According to Michael Darda, Chief Economist at MKM Partners, “The consensus view remains that any prospective balance sheet shrinkage will send long rates higher, perhaps appreciably. But this may turn out to be wrong. Yes, there would be a short term ‘liquidity effect’ from asset sales/the cessation of reinvesting interest and maturing securities. But the long term ‘income and inflation effects’ tend to dominate the liquidity effects, meaning a tighter monetary policy (relative to a looser one) will tend to be associated with 1) slower NGDP growth than would otherwise be the case; 2) lower inflation than would otherwise be the case, and 3) lower nominal bond yields than would otherwise be the case.”
Propelled by prospects for Trumpflation, the S&P 500 Index advanced 6.1% during the quarter; however, bond markets tell a different story as the yield on the 10-Year Treasury Note actually fell 5 bps. While REITs finished flat for the quarter, given (i) a reasonable cash flow yield above a riskless rate of return, (ii) share prices below break-up values and (iii) supply held in check in most markets, prospects for REITs for the rest of 2017 does not seem all that dire.