Fixed Income Commentary – July 2019

  • July 9, 2019

2nd Quarter 2019 Fixed Income Review

Fixed income markets generally had positive performance in the 2nd quarter of 2019 as fears of a slowdown in global growth appeared and world central banks, including the U.S. Federal Reserve, signaled more accommodative policies. The fixed income performance occurred despite U.S. equity markets being near all-time highs.

Notably, U.S. High Yield performed well given strong demand, light new issuance, low default rates, and a continuation of steady corporate earnings. Below are some 2nd quarter Bloomberg Barclays index returns:

The 10-year U.S. Treasury (UST) Note, a bell-weather measure used in the fixed income markets, ended the second quarter with a yield of 2.00%, a marked decrease from the 2.40% available at the end of 1Q 2019. Although currently above 2.00%, the 10-year yield did close below 2.00% for a single day toward the end of the quarter, the lowest yield level since 2016. In addition, the U.S. Treasury (UST) yield curve continued to “flatten” during Q2 2019, as short-term yields declined less than longer-term yields, with heavy buying of 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 2Q 2019 at 25 basis points. That same yield spread was 14 basis points at the end of 1Q 2019 and has averaged almost 100 basis points for the past five years.

Currently, the 3-month T-bill and the 10-year UST yields are “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 a number of 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 second quarter 2019 (green line). The bar graph at the bottom shows the changes in yields for select maturities.

Since 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. The Federal Funds target rate currently sits at 2.25-2.50%.

Following several years of overtly hawkish interest rate guidance, the FOMC signaled a complete shift in monetary policy earlier this year, citing deteriorating economic conditions and continued low inflation (below their 2% target). Following their most recent meeting in June, and clearly responding to escalating trade rhetoric
from the Trump administration, the FOMC highlighted that the economy continues to expand, but that “uncertainties about this outlook have increased.” Additionally, the FOMC stated “in light of these uncertainties and muted inflation pressures, the committee will closely 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 100% probability of an interest rate decrease at the FOMC’s next meeting later this month.

As mentioned earlier, one reason for the change in sentiment during the last quarter was the lack of inflation. The Fed’s median estimate for the core Personal Consumption Expenditures (PCE) Index, the Fed’s preferred inflation gauge, is expected to be just 1.50% in 2019, down from 1.80% as recently as March. By 2020, core PCE is projected to rise to 1.90%, still below the Fed’s stated target of 2.00%. The second reason for the “dovish” shift in monetary policy is a slowing GDP. The median estimate for GDP in 2019 at the Fed is 2.1%, compared to 3.00% in 2018. In addition, the Fed’s median estimate of GDP in 2020 was recently lowered to 2.00%.

Foreign sovereign bond yields were also lower in Q2 2019 on dovish messages from central banks in Europe and the U.S. The bond rally at the end of the quarter sent outstanding negative-yielding debt to above $13 trillion, a record amount. Below are 10-year bond yields in blue from several foreign countries (sorted from low to high). Note the wide difference between the yield of the bell-weather German Bund (the German ten-year note) at -0.33%, which slipped below zero for the first time since 2016, compared to the U.S. ten-year Note at 2.00% 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 as the meager yields available in longer dated maturities appear uncompelling from a risk/reward standpoint. Focusing upon safety of principal and liquidity for most clients in such a low interest rate environment is paramount.

We believe a core fixed-income strategy utilizing high quality individual bonds evenly “laddered” over several years, and actively 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.

Our Investment Strategy Committee continues to monitor the global fixed income markets working to identify opportunities we feel will enhance both diversification and long term returns for our clients.