2018 Year End Fixed Income Review
Aside from U.S High Yield, fixed income markets generally had positive performance in 2018 despite U.S. yields increasing in the wake of four Federal Funds rate increases and stronger U.S. growth overall.
Below are some 2018 Bloomberg Barclays index returns:
The ten-year U.S. Treasury note experienced a volatile year ending 2018 with a yield of 2.67%, an increase from 2.41% at the end of 2017.
During 2018, the ten-year yield hit an intra-year low of 2.45% early, with the annual high of 3.24% this past November. U.S. Treasuries rose in price during the last few weeks of the year in a “flight to safety” trade as U.S. equities experienced heightened price swings and negative performance for the year.
In addition, the U.S. Treasury (UST) yield curve “flattened” during 2018 as short-term yields rose more than longer-term yields. The 2-10-year yield spread, an often-cited measure of the slope of the yield curve, ended 2018 at 20 basis points. That same yield spread was 52 basis points at the end of 2017, hence the term “flattening.”
The flattening trend has continued since the start of 2019 with the current spread at about 14 basis points.
The chart below shows the changes in the UST yield curve from the FOMC’s first tightening in December 2015 (gold line) and the last FOMC tightening this past December (green line). The bar graph at the bottom shows the changes in yields for select maturities.
Since December of 2015, the Federal Reserve Open Market Committee (FOMC) has raised its target Federal Funds rate nine times, with four quarterly rate increases during 2018, each by 25 basis points. At present, the Federal Funds target rate stands at 2.25-2.50%.
At their December 2018 meeting, the FOMC trimmed the previously forecast number of interest rate increases during 2019, from three to two. In their December statement, the FOMC softened key language stating “the Committee judges that some further gradual increases” in rates will likely be needed. In comparison, the FOMC September statement reflected a more hawkish stance pointing that “further gradual increases” would be required.
One reason for the change in sentiment during the last quarter is that the Federal Reserve’s median estimate for GDP in 2019 was adjusted downward to 2.3% from 2.5%. In addition, the Federal Reserve’s median estimate for the core Personal Consumption Expenditures index, the Federal Reserve’s preferred inflation gauge, remains at or near their stated target of 2.00%. In following, it is expected that inflationary pressures will remain benign for at least the near term and the Fed will continue to exhibit flexibility in adjusting its policy while closely monitoring the economy.
Of note, the federal funds interest rate futures market is currently not forecasting any interest rate increases during 2019. Indeed, financial conditions have very recently become less favorable for future rate hikes due to factors that include heightened foreign trade concerns, continued political uncertainty and rancor in Washington, increasing volatility in the equity markets, a pronounced oil price slump, as well as ongoing concerns over the health of the global economy.
A flattening yield curve, as we are currently experiencing, normally portends market expectations of a slowdown in economic activity. Historically, an inverted yield curve in the U.S. (where short-term rates are higher than long-term rates) has preceded an eventual recession nearly 100% of the time. Experience reminds us to monitor the Treasury yield curve and other important measures for signals of a possible economic downturn. At the same time, the U.S. continues to borrow at an ever-increasing clip to finance record deficits while the cost of servicing that debt continues to rise. In following, we are not recommending the purchase of longer-term U.S. Treasuries in core fixed income portfolios.
Foreign sovereign bond yields were generally lower in 2018 (see the one-year change in last column) as many European countries, and Japan, continue to sport markedly lower yields than the U.S. as their own central banks continue to hold short term interest rates at historically low levels. In contrast, our own central bank, the Fed, has been removing artificial stimulus by raising short term rates and actually shrinking its balance sheet.
Below are ten-year bond yields in blue from several foreign countries (sorted from low to high). Note the wide difference between the yield of the bellwether German Bund (the German ten-year note) at .16% compared to the U.S. ten-year note at 2.67% at year-end. This marked disparity in yields is indicative of divergent monetary policies and differing economic outlooks.
We continue to recommend our core fixed income portfolios maintain high credit quality and shorter durations while always seeking opportunities during periods of market stress. We believe a core fixed-income strategy utilizing high quality individual bonds evenly “laddered” over several years, and replacing maturing bonds with longer maturities, provides a good offset for riskier assets or strategies in a well-diversified portfolio.
Along with this “volatility dampening” characteristic, a laddered bond portfolio also provides dependable cash flow and a source of liquidity which may be accessed as more lucrative opportunities arise. In addition, as yields have increased over the past twelve months, the income component of bonds has become more generous than in the last several years.
For more information about the commentary found in this newsletter, please contact one of the following:
- Sam Boldrick, Director of Fixed Income, Argent Trust – sboldrick@argenttrust.com
Hutch Bryan, Senior Portfolio Manager, Argent Trust – hbryan@argenttrust.com
Oren Welborn, Portfolio Manager – owelborn@argenttrust.com
