Treasury yields continued to move higher during the third quarter. The 2-year Treasury yield rose 29 basis points (bps) during the period, closing near a decade high level of 2.82%. Longer-term yields also rose. The benchmark 10-year Treasury Note, which began the quarter at 2.86%, advanced 20 bps and closed at 3.06%. As a result, three month returns were mixed, with most high quality bond indices ranging from slightly positive to slightly negative depending on maturity and quality characteristics. The Bloomberg Barclays Intermediate Government Credit Index® posted a 0.21% result during the quarter, while the Bloomberg Barclays Aggregate Index® generated a total return of 0.02%.
After impressive economic growth of 4.2% annualized in the second quarter, the Blue Chip economic consensus expects a still solid rate of 3% to be reported for the third quarter. Continued gains in the labor market and steady consumer spending support this projection. The Federal Reserve Bank’s (Fed) estimate for growth was revised slightly higher at the September Federal Open Market Committee (FOMC) meeting from 2.8% to 3.1% for 2018. FOMC growth estimates for 2019, 2020 and 2021 are 2.5%, 2.0% and 1.8% respectively. As Fed Chairman Powell likes to remind us, longer-term projections are nebulous at best, but it is noteworthy that the Fed currently sees no signs of recession on the forecasting horizon.
Wage growth continues to grind higher as average hourly earnings rose to an annual 2.9% rate of increase in August. Overall inflation measures remain well-grounded, with the Fed’s preferred core Personal Consumption Expenditure Index (PCE) remaining at their 2.0% target and the Consumer Price Index (CPI) slowing to 2.7% annually in their August readings. The Fed’s outlook for inflation remains tame as well, with the PCE’s rate of advance at about 2% over the next three years. Based on the Fed’s current growth outlook, inflation forecast and updated dot plot, another Fed Funds Rate increase in December with an additional three moves in 2019 is the general consensus. This would bring the Fed Funds rate to 3.00%-3.25% by the end of 2019, a level that is higher than most current estimates of the neutral (neither restrictive nor accommodative) rate.
In addition to ongoing short-term rate increases, we’re reminded that the Fed continues to reduce its’ balance sheet at a time when federal borrowing is rising. The European Central Bank (ECB) is also positioning itself for a less accommodative monetary policy. With the ECB’s bond buying program ending in December and President Mario Draghi’s term ending next year, it is widely believed that the ECB will begin raising its short-term overnight funding rate in 2019. This should continue to set the backdrop for a gradual increase in global interest rates.
No doubt there are plenty of forces that could slow global growth. While the economy has thus far weathered the initial effects of tariffs, the full impact has likely not yet been felt. The threat of additional tariffs and sustained protectionist policies remain a potential headwind. New concerns about Italy’s defiant budget approach to European Union guidelines and worries over some emerging markets, while contained thus far, could morph into periodic bouts of risk-off trading pressures. Political posturing in the U.S. as we approach mid-term elections could weigh on confidence as the economy absorbs higher interest rates and their impact on the rate sensitive consumer and housing sectors.
While we are closer to the end of the interest rate cycle than the beginning, we still see economic momentum taking yields higher. In our view, the Fed has more work to do and we expect the yield curve to shift higher and a little flatter. As the boost from last year’s tax reform measures fades, the status of trade negotiations and tightening of financial conditions will become key influences on the resilience of the current business cycle. We continue to opportunistically position your portfolio, remaining highly selective about the credits we hold. Further, we believe that a shorter maturity positioning, particularly in a flat yield curve environment where little additional yield is available by lengthening maturities, is key to protecting capital.
“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.
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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.