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Fixed Income Report 1Q19

The Federal Reserve Bank (Fed) shifted its forward monetary policy expectation from additional tightening to a more data dependent stance during the first quarter of 2019. They also downgraded the economic and inflation outlook at their March Federal Open Market Committee meeting (FOMC). After the December rout in financial markets, it was anticipated that the FOMC would begin to take a more patient and measured approach toward normalizing interest rates. While Fed Chairmen Powell attempted to emphasize confidence in current economic conditions after the last Fed meeting, he indicated that additional rate increases in 2019 were unlikely given decelerating growth in Europe and the potential drag associated with a bevy of continuing uncertainties (trade talks, Brexit and the transitory impact of the government shut down). The Fed also confirmed that they would finish their balance sheet reduction program by September, completing what was construed as an overall “dovish” message. Despite a strong subsequent recovery in risk asset performance, Treasury bond investors interpreted the message as expressing a lack of economic confidence and a buying frenzy ensued.

Treasury yields fell sharply during the quarter, with the 2-year Treasury note yield declining 23 basis points from 2.49% to 2.26%. Ten-year Treasury yields dropped from 2.68% to 2.41% for a 27 basis point decline. Falling yields and narrowing credit spreads resulted in strong positive bond returns for the quarter. The Bloomberg/Barclays Aggregate Index® and the Bloomberg/Barclays Intermediate Government/Credit Index® generated returns of 2.94% and 2.32% respectively.

Looking ahead we’re tasked with assessing just where we are in the current business cycle. While GDP managed to grow at 3.00% in 2018, a number of headwinds are likely to slow the pace of growth in the first half of 2019. The lagged effects of temporarily higher interest rates on housing and stockpiled inventory built during the threat of higher tariffs serve as examples. Concerns over these headwinds has exerted a powerful influence on flattening the shape of the U.S. Treasury yield curve. Much has been written about the current configuration of 3-month Treasury bills offering a higher yield than 10-year Treasury notes (a so-called “inverted yield curve”) signaling imminent recession. While we are ever respectful of the historical significance of past yield curve inversions, we don’t see imminent signs of recession.

Indeed, several highly correlated economic indicators point toward continued economic growth. While there is no denying that we are nearing the later stages of an already lengthy economic expansion, the timing and inevitability of a downturn are far from certain. It’s likely that a more accommodative -- or less restrictive – Federal Reserve, and stimulus maneuvers introduced by the Chinese government, will give a boost to global growth. With U.S. labor market conditions still quite tight and some early indications that interest rate sensitive sectors have responded positively to lower rates, we suspect that economic growth will firm in the second half of 2019.

There is little doubt that the Fed’s change from systematic rate tightening to a more gradual, data dependent, policy path, along with well anchored inflation expectations, has raised the bar for further rate hikes in this cycle. Nevertheless, current market expectations that the next move will be a rate cut, or cuts, appear premature in our view. While the terminal Federal Funds rate for this tightening cycle has likely fallen, as opposed to what markets anticipated just a few months ago, we suspect that interest rates are prone to reverse some of their recent decline. In fact, the recent drop in yields creates a more accommodative financial environment regardless of future policy directives.

Ongoing trade negotiations with China and the unfolding Brexit saga remain significant global uncertainties. However, there is more upside than downside associated with their ultimate resolution. While Brexit is very hard to handicap, markets have priced in much of the uncertainty and any finality is likely to provide relief. Domestically, our sense is that, as the focus sharpens on the 2020 election, both parties will be keen on striking a deal that would enhance prospects for economic growth.

While interest rates are likely to peak at a lower level than we would have initially expected, the current level of rates represent an overly pessimistic economic view. Therefore we expect continued bouts of volatility with interest rates settling in at least modestly higher yield levels. We will continue to maintain a lower overall duration posture but will be aggressive managing the yield curve. We will also opportunistically extend maturities at higher yields and with emphasis on higher quality issues as the best approach to enhance returns and safeguard your capital.

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  • “Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC, and Madison Investment Advisors, LLC, which also includes the Madison Scottsdale office. Madison Funds are distributed by MFD Distributor, LLC. Madison is registered as an investment adviser with the U.S. Securities and Exchange Commission. MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer, and is a member firm of the Financial Industry Regulatory Authority.

    Although the information in this report has been obtained from sources that the firm believes to be reliable, we do not guarantee its accuracy, and any such information may be incomplete or condensed. All opinions included in this report constitute the firm’s judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. 

  • In addition to the ongoing market risk applicable to portfolio securities, bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally, the longer a bond’s maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which allows the issuer to retain the right to redeem the debt, fully or partially, before the scheduled maturity date. Proceeds from sales prior to maturity may be more or less than originally invested due to changes in market conditions or changes in the credit quality of the issuer.

    Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only, and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance.

    Bloomberg Barclays U.S. Government/Credit Bond Index includes securities in the Government and Corporate Indices. Specifically, the Government Index includes treasuries (i.e., public obligations of the U.S. Treasury that have remaining maturities of more than one year) and agencies (i.e., publicly issued debt of U.S. Government agencies, quasi-federal corporations, and corporate or foreign debt guaranteed by the U.S. Government).

    Bloomberg Barclays US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market.

  • “Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC, and Madison Investment Advisors, LLC, which also includes the Madison Scottsdale office.  Madison Funds are distributed by MFD Distributor, LLC.  Madison is registered as an investment adviser with the U.S. Securities and Exchange Commission.  MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer, and is a member firm of the Financial Industry Regulatory Authority. 

    Madison Investments shares all personnel and resources at their Madison, Wisconsin location. Statistical data is for the consolidated Madison organization. The Madison organization consists of its holding company, Madison Investment Holdings, Inc. and its affiliates: Madison Asset Management, LLC; Madison Investment Advisors, LLC; and Hansberger Growth Investors, LP. Asset information presented includes non-discretionary assets. Refer to each entity’s Disclosure Brochure for more information.

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