Treasury yields navigated a wide range during the quarter as the market’s view on Federal Reserve (Fed) monetary policy shifted significantly. Beginning the quarter at 3.06%, the 10-year Treasury traded just above 3.23% in early October (and again in early November) before closing the year at 2.69%. The two-year Treasury note was also well travelled, beginning the quarter at 2.82%, peaking at 2.97% in early November and closing the year at 2.49%. The sudden shift resulted in positive quarterly returns in most bond indices, pulling some out of negative territory for the full year. The Bloomberg Barclays Intermediate Government Credit Index posted a quarterly return of 1.65% and a total return of 0.88% for all of 2018. Meanwhile, the Bloomberg Barclays Aggregate Index generated a quarterly return of 1.64% and a 2018 return of 0.01%.
Why the sudden shift in opinion? In October, Fed Chairman Jerome Powell indicated that monetary policy was still accommodative and that we were a long way from a neutral Federal Funds rate. This hawkish tone pressured interest rates across the yield curve higher in October and November as investors anticipated multiple rate hikes into early 2020. Both the equity markets and the White House expressed displeasure with that view, the latter in a very unconventional and public fashion. While the Fed pressed on with an additional rate hike to a range of 2.25%-2.50% and reiterated its balance sheet reduction plan at their December Federal Open Market Committee (FOMC) meeting, they struck a more cautious forward guidance tone by lowering their expected number of rate hikes to reach a new and currently lower view of neutral. The less hawkish tenor of December’s Fed statement paved the way for the steep decline in yields headed into year-end.
As the adage goes, expansions do not die of old age but rather at the hand of policy errors. While the current expansion is the second longest in post WWII history, a more cautious approach by the Fed reduces the odds of such an error on that front. Yet markets are pricing in a higher degree of concern as the ongoing U.S./China trade dispute, lingering Brexit negotiations and political discord at home and abroad continue to weigh on potential economic growth.
In our view, the bond market appears to be premature and overly anxious in its response. While a more cautious approach by the Fed -- and perhaps a lower end point for the Fed Funds rate -- is likely, an examination of forward rates suggests that Treasury yields are now priced for no additional rate increases in 2019 and increasing odds of an actual rate cut in 2020. We see that as unlikely without a corresponding and significant decline in global growth. This is not to say that concerns for a slower pace of economic growth in 2019 are wrong. Higher financing rates and the drawn out trade dispute between the world’s two largest economies are headwinds to growth. Conversely, labor market conditions remain firm, wages are rising, tax refunds are likely to be higher and household balance sheets remain in reasonable shape.
With this in mind, we anticipate that even a more cautious and, perhaps, pausing Fed is likely to implement more rate hikes than the market currently expects. We’re also fully aware that an expanding budget deficit and corresponding borrowing needs by the Treasury will stress intermediate- and longer-term maturities. Taken together, we expect Treasury yields to reclaim higher levels and the yield curve to steepen as market sentiment adjusts to a less gloomy outlook. Stability in equity markets and credit spreads would be powerful signals that investors have refocused on reasonably sound underlying economic fundamentals.
We expect that this adjustment will be a bumpy process in the early weeks of 2019 and that portfolio opportunities will emerge. Until the adjustment is complete, we will maintain a conservative, shorter and more defensive duration positioning in portfolios, as well as an up-in-quality bias with respect to corporate bond positioning. As always, the protection of your capital is first and foremost in our mind.
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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.
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.