4th Quarter 2019 and 2019 Fixed Income Review
Fixed income markets had mixed performance in the 4th quarter of 2019, although returns for the year were quite good considering the historically low rates available and U.S. equity markets being near all-time highs. A better outlook for global growth, trade policy progress, and continued benign inflation were contributing factors. Additionally, world central banks, including the U.S. Federal Reserve, signaled more accommodative policies, with the latter cutting the overnight rate three times in the second half of the year.
Below are some 4th quarter and 2019 Bloomberg Barclays fixed income index returns:
The 10-year U.S. Treasury (UST) Note, a bell-weather measure used in the fixed income markets, ended 2019 with a yield of 1.92%, a marked decrease from 2.68% the previous year. However, that yield was quite a bit higher than the 2019 10-year UST yield low of 1.46%, which was the lowest yield level since 2016. In addition, the UST yield curve “steepened” during the quarter as short-term yields increased less than longer-term yields as global bond yields rose in general. The 2-10-year UST yield spread differential, an often-cited measure of the slope of the yield curve, ended 2019 at 35 basis points, the widest since 2018. That same yield spread was 5 basis points at the end of the third quarter (and in fact briefly inverted for a period of about a week) and has averaged almost 100 basis points for the past five years.
The chart below shows the changes in the UST yield curve from the end of 2018 (gold line) and the end of 2019 (green line). The bar graph at the bottom shows the changes in yields for select maturities.
Following several years of overtly hawkish interest rate guidance, the Federal Reserve Open Market Committee (FOMC) signaled a complete shift in monetary policy earlier in 2019, citing deteriorating economic conditions and continued low inflation (below their 2% target). As such, the FOMC reduced its Federal Funds target rate three times, each by 25 basis points. The Federal Funds target rate currently sits at 1.50-1.75%.
In their most recent meeting in December, the FOMC left interest rates unchanged and signaled that they would keep them on hold through 2020 amid a solid economy. The FOMC highlighted that while factory gauges have weakened, they expect consumers to keep the expansion going. In following, the committee stated that they will continue to monitor the implications of incoming information for the economic outlook, “including global developments and muted inflation pressures."
At their December meeting, the FOMC updated predictions for GDP, inflation and unemployment. The Fed’s median estimate for the core Personal Consumption Expenditures (PCE) Index, the Fed’s preferred inflation gauge, is expected to be 2.00% in 2021, unchanged from the prior projection. In addition, the median estimate for GDP in 2020 is 2.00% and 1.90% in 2021, both unchanged from the last estimates. The unemployment rate is expected to remain near an historically low 3.50% in 2020, the same as it is now.
Foreign sovereign bond yields moved higher in Q4 2019, on better global growth expectations, and global negative yielding debt has decreased to around $11 trillion from almost $18 trillion earlier in the year. The U.S. fixed income markets have yet to witness the negative yield phenomenon and most domestic pundits, including the Federal Reserve, do not expect negative interest rates in the U.S. At present, the use of negative interest rates is an extraordinary monetary tool being implemented by some central banks with untested results and unknown long-term repercussions.
Below, in blue, are 10-year bond yields from several foreign countries (sorted from low to high). Note the wide difference between the yield of the bellwether German Bund (the German ten-year note) at -0.23%, which had a record low yield of -0.74 in early September, compared to the U.S. ten-year note at 1.87% currently. This marked disparity in yields is indicative of divergent monetary policies as well as differing economic outlooks domestically and abroad.
We would be remiss not to mention a marked increase in Federal Reserve overnight operations to address an ongoing liquidity issue which recently came up toward the end of the third quarter. To avoid a “cash crunch” in the overnight lending markets, the Fed has been injecting billions of added reserves in the form of repurchase agreements or “repos” to offset intermittent spikes in the overnight lending rate. There are several explanations for this recent development, with the most plausible pointing to a combination of larger reserve requirements at the money center banks and increased Treasury issuance to fund burgeoning deficits at the federal level, all exacerbated by more lucrative overnight lending opportunities in the other markets. Recent statements by the Fed Chair, Jerome Powell, downplayed any structural weaknesses in the domestic financial system. He further stated he expected the Fed’s intervention to gradually wane toward the end of the first quarter of 2020. While no obvious problems were indicated in overnight operations at year-end, we will continue to monitor and report upon this ongoing development.
While always seeking opportunities during periods of market dislocation, we continue to recommend that our core fixed income portfolios maintain high credit quality and shorter, more defensive, durations. Admittedly, a more aggressive duration posture would have returned a bit more in 2019 but we continue to feel the potential upside is outweighed by paltry cash flows available in longer dated bonds with interest rates at current levels. We believe a core fixed-income strategy utilizing high quality individual bonds (where appropriate) 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 individual bond portfolio also provides dependable cash flow and a source of liquidity which may be accessed as more lucrative opportunities become available in other sectors. As always, potential individual bond purchases are screened for sustainable financial strength, conservative debt coverage ratios, and other favorable characteristics.
As mentioned in our previous quarterly review, these are very unusual times in the financial markets. An unprecedented amount of central bank intervention with historically low (and even negative) interest rates, as well as overt political pressure for added accommodation at a time when sovereign deficits balloon to historic levels globally, is a challenging environment to traverse. In following, for most fixed income accounts, we currently recommend a broad diversification of strategies, both conservative and more opportunistic, as a means of preserving capital, creating cash flow, and pursuing positive risk-adjusted returns. We hope you will contact your portfolio manager, or any member of our fixed income team, with questions or comments, or to discuss our thoughts further.
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