What market conditions had a direct impact on the bond market this quarter?
The U.S. economy appeared to lose momentum in the third quarter, with Institute of Supply Management (ISM) readings hitting new lows and Non-farm Payroll hiring settling into a 157,000 average pace vs. 2018's 223,000 monthly average. Investor sentiment is being challenged by slowing U.S. and global growth, declining confidence a Chinese trade deal will be negotiated and the launch of an impeachment inquiry against President Trump.
Economic Activity - Third quarter U.S. Gross Domestic Product (GDP) is forecast to grow in the 2% range, matching the second quarter's 2.0% pace. September's ISM Manufacturing Index unexpectedly fell to 47.8 from August's 49.1 reading - the lowest level since June 2009. The September ISM Non-Manufacturing Index fell to a three-year low reading of 52.6, well below consensus expectations of 55.0. On balance, the ISM data do not indicate current recessionary conditions but have increased the risk of a U.S. contraction in 2020. While a large portion of the decline in U.S. manufacturing levels can be attributed to Chinese trade disputes, low growth rates in Japan and Europe are also negatively impacting the sector, particularly in U.S. exports. For the most part, employment conditions remained robust with September's U3 Unemployment Rate falling to 3.5% - the lowest level since November 1969. Even more heartening, over the last five months the U3 rate decline has been driven by Household Employment growth of 1.624 million - outpacing a healthy Labor Force increase of 1.569 million. Non-farm Payrolls averaged 157,000 job gains in the quarter, above the level needed to sustain current unemployment rates. The least encouraging aspect of September's employment report was the decline in year-over-year Average Hourly Earnings to 2.9% from August's 3.2%, which is counter-intuitive given the 50-year low in unemployment rates. Inflation remains stubbornly below the Fed's 2.0% target level, although August's U.S. PCE Core Price Index reading - the Fed's preferred measure of inflation - rose to 1.774% from May's 1.483% print. The headline U.S. PCE Deflator remained at 1.40% over the same period. The five-year TIPS vs. Treasury spread - a proxy for inflation expectations - ended the quarter at 1.33%, down 21 basis points (bps) from the end of June.
Monetary Policy - The Fed cut the federal funds target range 25 bps at both the July 31st and September 18th meetings to a new target range of 1.75% - 2.00%. The Fed Dot Plot median forecast called for no additional cuts in 2019 and 2020, although there were several individual dots calling for one additional cut in 2019, which analysts believe belong to key decision makers including Chairman Powell, Vice Chairman Clarida and New York Fed President Williams. The Fed did not announce any plans to allow its balance sheet to grow at either meeting. Speculation over whether the Fed has allowed bank reserves to shrink too much increased after the Secured Overnight Financing Rate (SOFR) spiked 300 bps to 5.25% on September 17th on a combination of factors including: $54 billion in U.S. Treasury settlements, corporate tax payments draining reserves from the system and Saudi Arabia withdrawing several billion dollars to support its economy after attacks on its oil production facilities. There was general agreement among analysts that the spike in funding costs was not a symptom of financial crisis where counterparties refused to lend to each other, but rather was technically-driven by a confluence of events exacerbating existing financial strains from lower overall bank reserves in the system and regulations inhibiting large banks from entering the repo market. The Fed conducted a series of temporary overnight and term open market operations which effectively stabilized repo rates. Given fears of future dislocation in the funding markets, we expect the Fed will develop more permanent open market facilities to manage SOFR and to allow its balance sheet to grow again after the October 30th meeting.
Fiscal Policy - U.S. / China trade tensions have clearly sapped strength in the U.S. manufacturing sector, illustrated by the collapse of the ISM Manufacturing number and its export component. In tweets, President Trump attacked the Fed for not being aggressive enough with rate cuts and quantitative easing and, in turn, for keeping the U.S. dollar too high and uncompetitive for U.S. exporters. Washington will likely be dominated by impeachment hearings and positioning for the 2020 Presidential election, further weighing on investor sentiment and virtually eliminating the potential for legislation designed to stimulate the economy.
Credit Markets - Yield curve levels continued to decline as the economy decelerated and the Fed cut rates twice in the quarter. The three-month to ten-year portion of the yield curve remained inverted for over four months, save a brief exception in mid-July. Importantly, the longer the duration of an inversion, the more reliable the signal is of future recession.
Yield Curve Shift
*The yield spread between 3-month and 10-year U.S. Treasuries was -14.2 bps at the end of the quarter. The yield curve shifted lower across the maturity spectrum and remained inverted for the majority of the quarter.
Duration Relative Performance
*Duration estimate is as of 9/30/19
Credit Spread Changes
Countering the inverted yield curve, credit spreads have remained relatively stable with one- to three-year BBB spreads actually tightening in the quarter. Further, U.S. corporations enjoyed robust access to debt market capital. A record 130 issuers came to market in September for over $196 billion in new funding. September's investment-grade issuance of $158.3 billion was the third highest monthly volume on record.
Corporate Credit Relative Performance of BofAML Indexes
Declining yields boosted the absolute returns of all investment-grade, fixed-income indexes. Credit spreads tightened in the quarter with a general trend of lower-rated credit outperforming higher-rated credit. Credit handily outperformed Treasuries on both higher coupon income and incremental price appreciation from spread tightening. Non-financials mildly outperformed their financial counterparts. Agencies outperformed Treasuries by 4.8 bps in the quarter, but Treasuries have outperformed agencies by a surprising 11.1 bps year-to-date in the one- to three-year sector.
What strategic moves were made and why?
Taxable Portfolios - The continued decline in U.S. Treasury yields supported the absolute returns of fixed-income portfolios, but negatively impacted relative performance for portfolios positioned short to their benchmark durations. The decline in market yields reflected slow global growth, stubbornly low inflation measures and the two Fed rate cuts in July and September. Credit was a strong performer in the quarter vs. Treasuries on both incremental coupon income and price appreciation from tighter spreads, with triple-B credit outperforming its A-rated counterpart. Investment-grade credit quality remained solid with few negative ratings actions in the quarter. USBAM views the idiosyncratic risk associated with individual company mergers and acquisitions as a threat to public ratings rather than to principal.
Tax Exempt and Tax-Efficient Portfolios - Our assessment of current economic conditions and near-term outlook remained conflicted with market pricing, with yields lower than our fair-value assessment. As a result, trading activity was focused primarily on income generation. For municipal-only mandates, we increased variable-rate demand note (VRDN) allocations. VRDNs have been somewhat surprisingly resilient to the Fed and other forces that have led fixed-income yields lower. To a lesser extent, we were also selective in adding to fixed-rate positions, mostly as yields approached the upper end of recent ranges. These purchases are valuable insurance vs. outcomes involving slower economic growth and more aggressive Fed easing - though that is not currently our base case. Relative yield ratios of municipal securities vs. comparable Treasuries climbed higher toward the end of the quarter. For many short maturities these valuations reached 75% - 80%, at or near the highs for the year. Although these municipal yields had become more compelling, corporate bonds continued to be favored for tax-efficient accounts based on higher tax-adjusted impact to portfolios.
How are you planning on positioning portfolios going forward?
Taxable Portfolios - After cutting rates twice in the third quarter, the Fed's Dot Plot and a growing consensus on Wall Street suggest the Fed's easing cycle is due for a pause. That said, we expect the Fed to lower rates at the October 30th meeting and feel current yield curve levels have almost fully priced in a cut, implying a more balanced risk to a significant move in bond prices. In this situation, managers can add value by methodically adding duration to portfolios to maintain them at 90% - 100% of benchmark duration while taking advantage of higher-yielding short rates in repo and LIBOR. For credit and spread product, credit spreads reflect fair valuation but are reaching the lower end of our targeted spread range, particularly for the high-quality liquid issuers found in separately managed portfolios. In environments where the compensation for credit risk is reduced, USBAM strives to increase overall portfolio credit quality by focusing on higher quality / rated issuers and shortening the maturity tenor of low-A and BBB-rated companies. Additionally, tighter credit spreads and a lower Treasury yield curve provide an opportunity to sell positions in issuers who may have fallen out of favor or been recently downgraded, providing dry powder to re-engage credits at wider spreads or to re-invest in higher-quality debt. Asset-backed securities (ABS) backed by prime credit cards, auto loans and large equipment loans continue to be a favored sector with AAA-rated ABS tranches typically offering higher yields and lower event risk than mid-A industrials. ABS are also an excellent method to increase exposure to U.S. consumers, who are benefitting from low unemployment and growing wages. The spread between three-month LIBOR and two-year Treasuries has widened since early 2019, making LIBOR-based floating-rate notes a more compelling investment opportunity given the higher up-front coupon yields.
Tax Exempt and Tax-Efficient Portfolios - Uncertainty around Fed policy and trade developments will likely result in continued swings in interest rates and general volatility over the coming months. It's not difficult to envision scenarios where two-year levels could move 25+ bps higher - and quickly. We would view those targeted levels as a more reasonable opportunity to extend durations of all portfolios closer to benchmarks. This low interest rate environment also requires discipline regarding credit quality. Similar to our strategy in taxable portfolios, our plan for credit will be to focus purchase activity on issuers with debt rated single-A or better to increase overall portfolio credit quality.
Federal Reserve, FOMC Statement and Projection Materials, September 18, 2019
Federal Reserve, FOMC Statement, July 31, 2019
United States Treasury, Calculated New Cash/Pay Down Amounts, www.treasurydirect.gov