Top of the Street: The eight things you need to know to trade fixed income in 2018

The Street has started delivering its annual gaze into the future, with some running more than 400 pages. Although much of it seems like a forced march through every possible topic in every possible market, there are nuggets of insight. Here is what you need to know, with contributions from Barclays, DB, GS, JPM, MS and Milepost.

1. The economy: growth, but rising risk of recession
The Street is looking for real GDP to run between 2.0% to 2.5%. Strong consumer spending and business investment lead the way with modest growth in housing and government spending and little from trade. Tax reform and post-hurricane rebuilding edge the numbers up slightly. Unemployment drops toward 3.5% and wage pressure helps push inflation toward the Fed’s 2.0% target. Of course, no one seems to have a good explanation for the low inflation of 2017, so that should temper any confidence in inflation predictions for 2018.

Beyond 2018, the risks of recession start to rise if the labor market keeps heating up and the Fed needs to cool things off with more tightening. Both the Fed and fiscal policymakers could find their options limited. The Fed could push funds a few percentage points above zero, but that’s not much room to ease by historical standards. And both the House and Senate tax bills would add a net $1 trillion to deficits over the next 10 years, taking national debt as a share of GDP from 80% currently toward 100% by 2030. Rising debt could limit any new fiscal stimulus. Constraints on monetary and fiscal policy could make it harder to climb out of the next recession.

2. The Fed: up in rates, and out of QE
The Fed hikes once a quarter next year or possibly more, according to consensus, although that seems to depend on a credible rebound in inflation. The Street’s economists seem to expect that rebound, but a little humility might serve well here. Inflation for now is a puzzle, and the market is pricing in less than two hikes. The truth is probably somewhere between the economists and the market. Uncertainty around inflation is a clear risk. The Fed’s exit from QE also picks up steam until as much as $50 billion a month is rolling off in the fourth quarter.

3. Rates: flat and stable
The yield curve flattens significantly in 2018, with 2-year rates rising as much as 85 bp and 10-year rates going up by only half that amount, according to JPMorgan. The Fed and heavy new Treasury supply help push up short rates while expectations of modest inflation and low real growth keep longer rates stable. Implied forward rates have the 2-year up a more modest 30 bp and 10-year up 15 bp. But Morgan Stanley expects inflation to continue running below the Fed target by 30 bp to 60 bp and the 10-year rate to finish around 2.00%.

The outstanding balance of Treasury debt rises by more than $1 trillion, mainly in 5-year and shorter maturities. The spread between the swap and Treasury curves narrows inside the 5-year mark. The outstanding balance of Fannie Mae debt drops by $15 billion and Freddie Mac by $30 billion while outstanding Federal Home Loan Bank debt rises by $65 billion.

Volatility, after sinking to historic lows in 2017, stays low or drops further. Limited economic surprise, reasonable liquidity and programmatic selling of options by portfolios that need income suppress any bounce to higher volatility.

4. Credit: stronger and tighter
Another year of tighter spreads on US corporate debt will owe thanks to rising GDP, rising corporate earnings and higher yields on US than on Euro corporate credit. Rising earnings should help credit quality by trimming leverage and lifting interest coverage. Buying of investment grade Euro credit by the European Central Bank into mid-2018 should help, too. But spreads are already tight, so opportunity is limited. Investment grade, high yield, leveraged loan and CLO markets all grow. A surge in supply from M&A or slowing growth, however, could sting.

5. MBS: replacing the Fed
Nothing matters more in this market than the Fed’s shrinking agency MBS portfolio. More than $150 billion should flow out of the Fed next year. Combined with natural growth of around $250 billion in outstanding MBS, conventional wisdom calls for wider mortgage spreads. But conventional wisdom has been wrong so far, with tighter spreads since the Fed officially announced its exit. Banks and REITs have taken up the Fed’s slack. That could continue, with mutual funds joining the parade if spreads on corporate debt continue to narrow. The best predictor of risk-adjusted MBS spreads in 2018: exactly where they are now.

Fannie Mae and Freddie Mac credit-risk transfers should continue feeding demand for fresh RMBS credit exposure, with securitization of non- and re-performing loans complementing the risk transfers. Home prices look reasonable, up from their 2009 low by 40% while commercial real estate has jumped 85%. Rising prices have generally tracked rising income. However, studies by the Cleveland Fed and PwC estimate that reductions in the mortgage interest deduction could cut home prices in some metro areas by as much as 10%. Recent tax legislation, which cuts the deduction, could soften the resi credit markets next year and beyond.

6. CMBS: adjusting to the new retail
Changes in the retailing business should matter to CMBS in 2018 since loans to malls season many of the private deals. Brick-and-mortar malls are under attack. Loans secured by retail properties hurt private CMBS performance in 2017. Expect more pain in 2018.

More broadly, prices on office, industrial, retail and apartment properties stand 20% or more above pre-crisis peaks. Property income has been strong and growing, interest rates low and most alternative investments expensive, so higher prices are not unreasonable. But, with many assets, the margin for error is small.

The CMBS backed by Fannie Mae, Freddie Mac and Ginnie Mae now have $500 billion outstanding, well above the $350 billion in outstanding private CMBS. Agency CMBS includes more affordable apartment building than the private market, and agency occupancy rates are near 95%. Agency CMBS issuance should keep outpacing private. Agency CMBS outperform private.

7. ABS: the strong consumer
Spreads in credit card, auto and student loan deals last year reached the tightest levels since the 2008 financial crisis, and the Street expects stable or possibly even tighter spreads in 2018. Household debt-to-income has dropped since the 2008 financial. Home prices are up, unemployment down. Steady economic growth and even lower unemployment next year should support stable-to-tighter spreads on consumer debt. The risks to the consumer rise as the risks of recession pick up beyond 2018.

8. Municipal debt: tested by tax reform
Tax reform reshuffles the muni debt market in 2018. Elimination of advance refunding of muni bonds drives issuance down by 10% to 20%, and spreads tighten. Elimination of deductions for state and local taxes raises concerns about the credit of high-tax issuers as those areas face a higher local cost of living, less disposable income and cloudy prospects for population growth. Local demand from wealth investors for the debt from high-tax issuers nevertheless surges. Lower corporate taxes cut demand for muni debt from banks and insurers, which currently hold 23% of the market.

For more detail on these and other themes, please see the following: Barclays, 2018 Municipal Outlook: Opportunity Knocks, 1 Dec 2017; Deutsche Bank, The Outlook: MBS and Securitized Products, 21 Nov, 2017; Goldman Sachs, US Economic Analyst: 2018 Outlook: Too Much of a Good Thing, 17 Nov 2017; Goldman Sachs, 2018 US Housing and Mortgage Outlook, 21 Nov 2017; JPMorgan, US Fixed Income Markets 2018 Outlook, 22 Nov 2017; Morgan Stanley, 2018 Global Rates Outlook: Toward the First Flat Curve, 1 Dec 2017; Morgan Stanley, 2018 Global Securitized Products Outlook: Cherry Picking, 27 Nov 2017.