The period of continuously climbing equity markets, range bound interest rates and tightening credit spreads finally came to an end during the first quarter of 2018. There were many reasons why volatility soared back into the markets. Increasing federal deficits due to tax cuts will push U.S. debt issuance to historically high levels in coming years. The possibility of a trade war with the China, the largest non-U.S. holder of treasury securities, also rattled investor psyche. Or perhaps investors simply decided to take profits after a historic multi-year run. Whatever the reason, market volatility has returned and investors need to carefully analyze the risks in their portfolios. The period of low volatility is most likely over.
The tight 50 basis point (bps) trading range that the ten-year Treasury exhibited during much of 2017 finally broke during the first quarter. As the market digested the impact of the massive tax cut along with a greatly increased budget deficit, yields gradually, then rapidly, moved higher during the quarter. The key technical trading level of 2.62% was breached and the ten-year Treasury nearly reached 3.00% before settling back near 2.75% at quarter’s end. In addition to longer Treasuries moving higher in yield, front-end interest rates moved sharply higher as well. The two-year Treasury increased by 38 bps to 2.27% and traded as high as 2.35% during the quarter. This is the highest level since 2008. The move in front-end rates was mostly a function of expectations for continued rate hikes by the Federal Reserve (Fed). The Fed increased the Federal Funds Rate by 25 bps during the first quarter and has stated publicly it expects to raise rates two more times in 2018, with additional hikes in 2019.
Another result of more aggressive Fed policy and tax reform has been a move higher in the London Interbank Offered Rate (LIBOR) which is a widely-used short-term unsecured borrowing rate. Three-month LIBOR increased 62 bps to 2.31%, and its spread versus short Treasury rates widened to levels not seen since the financial crisis. Many pundits have argued that this movement is the first sign of a crack in the financial markets. We disagree. First, the increases have been mainly in the U.S. and not around the world.
If there were truly cracks developing in the financial system, movement in non-U.S. dollar LIBOR would be seen as well. Second, there have been large movements in U.S. dollar dominated assets due to the change in tax policy.
Corporations have been selling shorter investments to repatriate cash back into the U.S. As more bonds are sold, the price that buyers are willing to pay falls and yields increase. This has in turn increased the rate corporations need to pay to issue commercial paper and other short-term obligations, thus pushing LIBOR higher. In our opinion, these effects are transitory and should not have meaningful long-term consequences for the financial markets. In fact, futures are currently pricing in a tightening of LIBOR versus Treasury rates by year-end.
The increase in volatility, both in interest rates and equity markets, moved credit spreads wider during the quarter. The spread over Treasuries of the Bloomberg Barclays U.S. Corporate Index hit a post financial crisis low of 85 bps in early February before climbing to 109 bps by quarter-end. As interest rates increased, equities fell and spreads widened - a rare occurrence in recent financial history. Historically, the correlation between interest rates and risk assets is negative, meaning that, as yields increase, spreads tighten and equities move higher. However, given that interest rates are at historically low levels, any marginal move higher in interest rates could have an impact on risk assets in a way many investors have never experienced. Many strategies, such as risk-parity, make assumptions based upon historical correlations and volatility. A significant and sustained break-down of these relationships could cause market movements to become more severe and prolonged.
Moving forward, our insurance clients will continue to be positioned conservatively with respect to interest rate risk. Given how flat the yield curve is between the two-year and ten-year Treasury, we are focusing positioning on the three to five year portion of the curve, where most of the yield is captured, but interest rate risk is moderate. Tax-exempt bonds are still unattractive vs. taxable alternatives due to tax differentials between individuals and corporations brought about by tax reform.
Bonds are subject to certain risks including interest-rate risk, credit risk and inflation risk. As interest rates rise, the prices of bonds fall. Long-term bonds are more exposed to interest-rate risk than short-term bonds. 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 the report constitute the authors’ 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. Madison Scottsdale is the Insurance Asset Management Division of Madison Investment Advisors, LLC © May 30, 2018.
“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.