Q3 2018 Fixed Income Review
U.S. fixed income markets generally experienced mixed performance during the third quarter (Q3) of 2018. Bond yields traded in a narrow range for the first 2 months of the quarter but increased during September as the U.S. currently has accelerating economic growth and rising inflation expectations. As you can see from the chart below, most fixed income returns are negative YTD, except short term Municipal bonds and U.S. High Yield.
The bellwether 10-year U.S. Treasury (UST) note started the third quarter at a yield of 2.86%. During the last week of September the 10-year UST yield rose quickly (bond yields move in the opposite direction of bond prices) to a peak of 3.11%, the highest rate since May 2018. The 10-year Treasury note ended Q3 with a yield of 3.06%.
The U.S. Treasury (UST) yield curve “flattened” during Q3, once again, as short-term yields rose more than longer-term yields. The 2 to 10-year yield spread, a measure of the difference in yield between the 2-year Treasury Note and the 10-year Treasury Note, ended Q3 at 24 basis points, the tightest spread since 2007. This is a significant observation as that same yield spread measurement has averaged 128 basis points over the last 5 years. The chart below shows the changes in the UST yield curve during the recent quarter. The green line is the UST yield curve as of 9/28/18 and the gold line is the UST yield curve as of 6/29/18. The bar chart at the bottom shows yield changes for select maturities during the quarter.
Yield curve flattening is mostly the result of the FOMC’s (Federal Open Market Committee of the U.S. Federal Reserve) current rate tightening cycle. In September, the FOMC, as expected, increased its target Federal Funds rate by 25 basis points to 2.00% – 2.25%, the third rate increase this year and the highest level since October 2008. In the FOMC’s statement, they cited strong job gains with inflation remaining near the central bank’s 2% target as supportive of a policy of gradual rate hikes. Since December of 2015 there have been a total of eight increases in the overnight rate.
Continuing to use “data dependent” verbiage in their September policy statement, the FOMC forecast one additional interest rate increase during 2018 and three additional rate increases in 2019. If the FOMC continues on its current path, the Federal Funds target rate will be in the range of 3.00% – 3.25% by the end of 2019.
Foreign sovereign bond yields were mixed during the third quarter as many European countries, and Japan, continue to sport markedly lower yields than the U.S. Below are 10-year bond yields from several foreign countries (sorted from low to high). Note the three month change in yields shown in the last column as well as the wide difference between the yield of the bellwether German Bund (the German 10-year note) at .46% compared to the U.S. 10-year at 3.06%. Given the sizable yield advantage, foreign demand for U.S Treasuries continues to be strong.
Of interest, a flattening yield curve, as we are currently experiencing, may portent market expectations of a slowdown in economic activity. Historically, an inverted yield curve in the U.S. (where short-term rates are actually 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 a possible signal to consider extending duration in our core fixed income portfolios.
At present, we continue to recommend our core fixed income portfolios maintain high credit quality with shorter durations while always seeking opportunities during periods of market dislocation. 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 other areas of the financial markets. Further, as market yields continue to rise, the income component of bonds has increased materially over that which has been available for a number of years. For accounts which are not using a separately managed laddered strategy, a mix of shorter duration high quality bond funds should experience similar performance.
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
