We expect the Federal Reserve to cut its policy rate by 25 basis points at its meeting on Thursday to a range between 4.5% and 4.75%.
We expect the Fed to cut its policy rate by 25 basis points on Thursday to a range between 4.5% and 4.75%.
We anticipate an uneventful meeting given its proximity to the presidential election and the flexibility that the Fed will need heading into its December meeting given the fundamental strength of the domestic economy.
Despite the 2.9% terminal rate implied by the Federal Reserve’s most recent Summary of Economic Projections, we think that outlook may be a bit optimistic. It would appear more probable that central bank will continue to cut its policy rate toward a terminal rate of 3.5% next year because of economic outperformance.
This prospect has sent investors looking at U.S. corporate bonds with higher rates of return and longer-duration alternatives to the front end of the Treasury yield curve.
The yield on three-month Treasury bills has already dropped by 78 basis points to 4.5% in the six weeks since the Fed cut its policy rate by 50 basis points.
Read more of RSM’s insights on the economy and the middle market.
Two-year yields have fallen to 4.20%, a drop of 19 basis points. We can anticipate those yields to continue to drift lower as the Fed continues to ease monetary conditions and the yield curve returns to its normal, upward-sloping shape.
Farther out the curve, and after a 130 basis-point rally in anticipation of the first rate cut, the yield on five-year Treasury bonds has returned to 4.2%, with the 10-year back to 4.35%.
Although it is hard to reconcile price moves with the election so close, it appears that investors are absorbing the positive news from an economy growing at a 3% yearly rate over the past four quarters.
That growth should support consumer spending and corporate profits to the extent that corporations will look to expand by issuing debt.
With short-term money-market rates set to move lower, that outlook has investors looking to the corporate bond market to extend duration and for higher rates of return.
Corporate issuance is increasing
In fact, corporations have already issued more than $1.4 trillion of investment-grade corporate bonds this year, putting them on track for the second-busiest issuance year ever, according to a report from Goldman Sachs.
The Securities Industry and Financial Markets Association reports corporate issuance of $503.9 billion in the third quarter, an increase of 16% compared with the second quarter and nearly 52% compared with the third quarter of last year.
Year to date, SIFMA reports corporate issuance of nearly $1.6 trillion of investment grade plus high-yield debt, which is 33% higher than the same period last year.
Corporate yield spreads are decreasing
At the same time that corporate issuance in increasing, the interest rate spread between investment-grade corporate bonds and 10-year Treasury bonds has continued to narrow since 2012. We see this as the result of two factors.
In the 10 years before 2022, the compression of all interest rates by the near-zero setting of policy rates resulted in a narrowing of the spread between riskier corporate bonds compared with the safety of Treasury bonds.
But since 2022, U.S. corporate bonds yielding nearly 5.75% are 145 basis points more attractive for domestic investors than a 10-year Treasury bond yielding 4.35%.
And for foreign investors who can augment the yield spread differential with currency returns of a stronger dollar, corporate bonds have become that much more attractive than the lower returns in their home markets.
The takeaway
Investors are looking at an economy in which inflation continues to recede toward the Fed’s 2% target at the same time that the labor market is at full employment.
The subsequent increase in household income is likely to encourage household spending and corporate expansion to meet the increased demand for goods and services.
The narrowing of corporate yield spreads is an indication of the attractiveness of U.S. private-sector debt for domestic and foreign investors.
And for corporations whose bond rating qualifies as investment grade, the narrowing of corporate yield spreads compared with the Treasury market is an opportunity to fund that expansion through the issuance of debt.
