The Tax Cuts and Jobs Act of 2017 (TCJA) was signed into law on December 22, 2017. Most provisions of the new law affecting individuals and businesses went into effect on January 1, 2018, including new tax brackets and new standard deductions. One of the most dramatic changes is the approach to corporate taxes. TCJA lowers the corporate income tax rate to 21% and moves the United States from a worldwide to a territorial system of taxation.

The volatility in weather conditions stands in stark contrast to the level of volatility in financial markets. During 2017, the yield on the 10-year maturity U.S. Treasury note rarely ventured out of a 25 basis point band, and ended the year only 8 basis points higher than where it began. Even more notable was the lack of volatility in domestic equity markets, where the VIX inched lower as stock prices surged. 

Against a backdrop of generally positive economic news, enthusiasm over potential tax cuts, a roaring equity market, and an upward move in oil and commodity prices, the Treasury market had yet another month of limited volatility. Ten-year yields fell six basis points (bps) before rising to a 2.43% yield at month-end, just a few bps higher than the October close.

It was another month of low volatility despite a considerable amount of news. The outlook for global growth has improved, as demonstrated in recent PMI releases, which included a surprisingly strong US ISM manufacturing number. Payroll data early in the month reflected the consequences of the summer’s hurricanes, but by mid-month, jobless claims suggested that this was a short-term phenomenon. Durable goods orders were up as well. The equity market continued its march forward. The Fed’s balance sheet normalization process began with (ultimately) little fanfare.

Tax rates are an important consideration in fixed income asset allocations. Many investors in high tax brackets assume they should be invested entirely in tax-free municipal bonds, while tax-exempt investors (e.g. foundations, pensions funds) ignore tax-free bonds altogether. In both cases, investors would be better served to consider a more balanced approach, focusing on the potential after-tax return and risk of all fixed income sectors.

After four rate hikes, beginning in December 2015, the federal funds rate stands at a range of 1.00% to 1.25%. The September FOMC meetings concluded with no change to rates. However, the hawkish tone delivered by the Fed through its “dot plots” showed continued support for a third rate hike in 2017 by 12 of the 16 FOMC members. This sent the implied probability of another rate hike this year up to 70%, from a low of 30% at the end of August. 

Although the economic data were mixed, the theme for the month was ultimately stable growth but weak inflation. Retail sales, consumer confidence, and GDP all were positive; housing releases disappointed. Corporate earnings topped 10% for the second consecutive quarter. Most importantly, inflation has clearly remained below market expectations as well as the Federal Reserve’s 2% target.

During the month, Fed Chair Yellen provided the semiannual testimony to Congress, which appeared to align with recent meeting minutes. The takeaways indicated an inclination to begin allowing the Fed’s balance sheet to decline in a gradual manner starting in late September or October. As a result, no change in interest rates is expected in September, with December being data and market dependent. 

The Federal Reserve has reemerged front and center in the debate over interest rates. While the Fed never takes a backseat in the minds of bond investors, the preeminence of Fed activity had been overshadowed by the fiscal policy implications of the new Administration’s tax cutting and infrastructure spending plans. Fed policy makers moved forward with another rate increase, the second this year and the fourth in the current tightening cycle, along with an outline for the potential tapering of bond purchases.

Treasury yields declined modestly during the month and the yield curve flattened, a continuation of trends seen for most of 2017. Ten-year yields initially rose to 2.41% early in the month, before falling to 2.23% at monthend. The 2- to 30- yield curve spread has declined by 30 basis points since the beginning of the year.