3rd Quarter 2019 Fixed Income Review
Fixed income markets had positive performance in the 3rd quarter of 2019 due to slowing global growth, trade policy uncertainties, geopolitical risks (Brexit, Iran, Hong Kong), and benign inflation. Additionally, world central banks, including the U.S. Federal Reserve, signaled more accommodative policies, with the latter cutting the overnight rate twice. The fixed income performance occurred despite U.S. equity markets being near all-time highs.
Below are some 3rd quarter Bloomberg Barclays fixed income index returns:
The 10-year U.S. Treasury (UST) Note, a bell-weather measure used in the fixed income markets, ended the third quarter with a yield of 1.67%, a marked decrease from the 2.00% available at the end of 2Q 2019. Early in September, the same bond posted a low yield of 1.46%, the lowest yield level since 2016. In addition, the U.S. Treasury (UST) yield curve “flattened” during the quarter as short-term yields declined less than longer-term yields with heavy buying in longer maturities from numerous investor segments. The 2-10-year UST yield spread differential, an often-cited measure of the slope of the yield curve, ended 3Q 2019 at 5 basis points. That same yield spread was 25 basis points at the end of the second quarter and has averaged almost 100 basis points for the past five years.
Since May, the 3-month T-bill and the 10-year UST yields have been “inverted,” meaning that the 10-year bond yields less than the 3-month T-bill, the first time since 2007. Although not always accurate, an inversion of the Treasury yield curve has historically been viewed as a harbinger of recession. We will continue to monitor this condition as well as several external factors which we believe are influencing the current inversion.
The chart below shows the changes in the UST yield curve from one year ago (gold line) and the end of the third quarter 2019 (green line). The bar graph at the bottom shows the changes in yields for select maturities.
Following several years of overtly hawkish interest rate guidance, the Federal Reserve Open Market Committee (FOMC) signaled a complete shift in monetary policy earlier this year, citing deteriorating economic conditions and continued low inflation (below their 2% target). As such, the FOMC reduced its Federal Funds target rate at their last two meetings in July and September, each by 25 basis points. The Federal Funds target rate currently sits at 1.75-2.00%.
Following their most recent meeting in September, the FOMC highlighted that household spending had been rising at a strong pace while business investment and exports had weakened. Therefore, the FOMC stated that “it will continue to monitor the implications of incoming information for the economic outlook and will act as appropriate to sustain the expansion.” Of note, the federal funds rate futures market is currently forecasting a 74% probability of another interest rate decrease at the FOMC’s meeting in December.
At their September meeting, the FOMC updated predictions for GDP, inflation and unemployment. The Fed’s median estimate for the core Personal Consumption Expenditures (PCE) Index, the Fed’s preferred inflation gauge, is expected to be 1.90% in 2020, an increase from 1.80% reported in September. By 2021, core PCE is projected to rise to 2.00%, in line with the Fed’s stated target of 2.00%. In addition, the median estimate for GDP in 2020 is 2.00%, compared to near 2.50% year-to-date in 2019, and the median estimate for GDP in 2021 is just 1.90%. Fed estimates for unemployment are expected to be slightly higher at 3.70% and 3.80% for 2020 and 2021, respectively.
Foreign sovereign bond yields continued to move lower in Q3 2019 on dovish messages from most central banks and continued open market purchases from both the European Central Bank (ECB) and the Bank of Japan (BOJ). The bond rally at the end of the quarter sent outstanding negative-yielding debt above $16 trillion globally. The U.S. fixed income markets have yet to witness the negative yield phenomenon and most domestic pundits currently are not including them in their forecasts, although the possibility looms under the right economic conditions. At present, the use of negative interest rates is an extraordinary monetary tool being implemented by some central banks with untested results and unknown long-term repercussions. The premise that normal investors would intentionally participate in a bond purchase resulting in a loss of principle is extraordinary indeed. We continue to watch the actions and communications from the FOMC as well as foreign buying in our markets in order to gauge the potential of an occurrence in the U.S. market
Below, in blue, are 10-year bond yields 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 -0.58%, which had a record low yield of -0.74 in early September, compared to the U.S. ten-year note at 1.67% at quarter-end. This marked disparity in yields is indicative of divergent monetary policies and differing economic outlooks domestically and abroad.
While always seeking opportunities during periods of market dislocation, we continue to recommend that our core fixed income portfolios maintain high credit quality and shorter, more defensive, durations. Potential purchases are always screened for sustainable financial strength, conservative debt coverage ratios and other favorable characteristics. 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 become available.
These are unusual times in the financial markets. Dealing with unprecedented central bank intervention, historically low (and even negative) interest rates, and overt political pressure for added accommodation at a time when sovereign deficits balloon to historic levels globally creates challenges not encountered before. We currently embrace broad diversification of fixed income strategies, both conservative and more opportunistic, as a means of preserving capital, creating cash flow, and pursuing positive risk-adjusted returns. We hope you will contact your portfolio manager or any member of our fixed income team with questions or to discuss our thoughts further.
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