It’s All About the Fed
In 2019, the Federal Reserve (Fed) cut interest rates three times to the current upper bound of 1.75%. Bond yields across all maturities fell as this transpired. The Fed has recently signaled a pause and a high hurdle to move in either direction in their coming meetings. The 10-year Treasury yield ended the year at 1.92%, which was well above the low of 1.46% reached in September.

As we move forward in time, we suspect fixed income markets will continue to decouple from the fundamentals. The Fed injected large amounts of money to alleviate repo market issues, and the federal deficit is set to explode in coming years. This comes at a time when foreign governments are buying fewer U.S. Treasury securities at the margin, especially China, driven by trade balance dynamics. How the Fed responds to ballooning deficits is likely one of the largest determinants to near-term market performance. Currently, they appear to be in a “do whatever it takes” mentality, which supports risk assets, helps move inflation higher and is generally supportive of a steepening yield curve. The Fed balance sheet is set to hit new highs in the first half of 2020 if the current pace is maintained.

Given the speed of descent in the scary fourth quarter of 2018 timeframe, the increasing size of the stock market relative to the economy, and comments made by current and former officials, we think the Fed understands the dilemma and will support markets in a pre-emptive fashion.

Same Narrative, Different Facts
From a fundamental standpoint, we were not as bearish on the economy as the headline Institute of Supply Management numbers would suggest, as one of our key corroborating indicators failed to confirm the downside outlook. Recently, some leading indicators suggest a more optimistic global and domestic perspective. This is highlighted by easier financial conditions both domestically and globally. Right now, most forecasters have punted their recession call a couple quarters forward. What happens if we are at the start of cyclical upswing amid a secular growth super-cycle driven by computing power?

Lastly, we think the inflation narrative offers a skewed risk-reward dynamic. Bond yields fell when the Fed said it required sustained inflation readings to hike interest rates. However, this willingness to tolerate higher inflation is not good for bond holders. Also, the prevailing narrative is such that inflation is nowhere to be found, which seems misplaced given the median Consumer Price Index is up 2.9% versus the prior year. This is a 10-year high and almost one standard deviation above the 20-year average. Global civil unrest has been very high in the last couple of months, which is driven by an inflationary backdrop and not “good” deflation. And lastly, 24 states will raise their minimum wage in 2020.

We are currently underweight duration but think the range of potential returns in 2020 is very high. We are optimistic on corporate bonds as risk assets remain well supported amid a perfect storm of accelerating growth, heavy central bank support and still defensive positioning among fixed income managers. The most likely path for a change in outlook would be if the Fed backs away from support or shows any signs of concern about inflation. We will be closely monitoring developments related to this potential scenario as the year unfolds.

Source: BTC Capital Management, Bloomberg LP, Ibbotson Associates, FactSet.
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