The Fed Yields
Interest rates declined and inverted along the yield curve during the first quarter as domestic and global economic outlooks signaled slower growth ahead. As anticipated, the estimate of fourth quarter GDP growth was revised lower (2.2% vs. 2.6% initial estimate). This report reinforced the market’s view of a moderate pace of growth for 2019 and beyond. In hindsight, the benefits of last year’s fiscal stimulus (tax cuts and increased spending) appear to have been short lived. The government shutdown and colder-than-usual weather also played a part in downshifting expectations for 2019. Economists cut their consensus forecast of real growth for 2019 to 2.4% and 1.9% for 2020, reflecting growing concern the economy does not have enough momentum to counter the next set of policy mistakes.
Led by lower than expected 1.8% year-over-year inflation and slowing growth, the backdrop was set for rates to decline for bonds with maturities from one to 30 years. Declining rates provided a boost to bond prices as evidenced by the quarterly return of 2.9% for investment grade bonds. This compares to a 0.01% return for all of 2018. A leadership shift occurred within the bond market this quarter, as bond investors who gained their best returns last year from U.S. Treasury bonds and a focus on short duration yielded to superior outcomes from corporate bonds and longer maturities. As memories of the fourth quarter faded, investors jumped back into corporate bonds, pushing this segment to provide a return of 4.9%. Longer maturity bonds also provided superior returns as long-term yields dropped during the quarter.
Easing Off the Brakes
Another key driver for lower rates was the Federal Reserve’s announcement to support future economic growth by decelerating its monetary policy tightening actions. This action pushed the yield curve to further invert, where short-term rates are higher than longer-term rates. All points along the U.S. Treasury curve now carry a two handle in terms of yield as the 30-year issue dropped below its year-end level of 3.02%.
Dispelling the widespread market narrative, we find that inversion of the yield curve isn’t a perfect indicator of a U.S. recession. Two of the five inversions in the past 30 years didn’t spark an imminent recession. Further, in past inverted curve environments, the Fed kept pushing rates higher even after the inversion occurred. With the Fed easing off the brakes, a positive environment for corporate and mortgage backed securities now exists.
And finally, as investors in high-tax states are finding out, tax cuts may not have cut their tax bill. This has made municipal bonds an attractive option for some, as income not subject to tax is not diminished by changes in the level of an investor’s deductions. We specifically view longer municipal bonds as providing a competitive return relative for those investors to other bond investing.
Source: BTC Capital Management, Bloomberg LP, Ibbotson Associates, FactSet.
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