3Q 2018 — It’s the Final Countdown…

Jamie Mullen
Senior Portfolio Manager
Eric Kazatsky
Portfolio Manager

As we head into the fourth and final quarter of 2018, the U.S. fixed income market finished September on slightly weaker ground. Rates crept up steadily throughout the past month, putting downward pressure on both the taxable and tax-free indices, leaving both indices solidly in the red.

The Bloomberg Barclays US Aggregate Index is down -1.60% year-to-date (YTD) compared to the Bloomberg Barclays Municipal Aggregate Index, which has declined by just -0.40% YTD. Despite the losses, tax-free bonds remain the clear winner YTD, outperforming their taxable counterparts by almost 120 basis points. For the remainder of 2018, future uncertainty may come from various corners such as the upcoming mid-term elections, continued trade/tariff talks, as well as the pace of future Federal Reserve (the Fed) rate adjustments.

Maybe we’ll come back to Earth, who can tell?

While the 10-year U.S. Treasury rate breached the 3% level during the second quarter, the feeling of “higher rates” lasted only less than a week before rallying back to a low of 2.81% on August 24th. The recent march higher pushed the 10-year rate to 3.06%, marking the longest sustained period above the 3% threshold since earlier this year, indicating that higher rates may be here to stay. The U.S. Treasury 2s10s curve experienced additional flattening over the quarter as the 2-year U.S. Treasury rate topped 2.82%, driven to higher levels as the Fed continues along their path of tightening monetary policy.

Higher rates can be a mixed bag for investors. On one hand, higher rates can adversely impact the current price of bond holdings. On the other hand, this singular focus on bond prices ignores the new-found potential to reinvest cash flow from bond portfolios at higher rates, which can potentially help drive future total returns. Furthermore, the increase in short-term rates can be a positive net benefit to savers. For example, the U.S. Treasury 3-month treasury bill money market yield has increased over 60 basis points this year to 2.16% after nearly a decade of rates in the single basis point range. We believe tactical bond management can help investors continually take advantage of duration allocations that will help navigate the Fed tightening cycle.

We’re leaving ground…Will things ever be the same again?

Top of mind for many investors and market participants is how long the Fed tightening cycle will last. While the future of many policy decisions is rarely certain or clear, several indicators shed some light on the future. The economy has met the Fed’s 2% inflation gauge and the unemployment rate, which is already low, continues to fall. These indicators point to the expectation of future rate increases.

Current estimates based on Bloomberg’s World Interest Rate Probability (WIRP) place the odds of a December 2018 rate hike above 70% with analysts expecting additional rate hikes to continue in 2019. The market is somewhat expecting an end to monetary tightening in 2020, which coincided with the removal of “accommodative” language in the Fed’s September post-meeting statement.

Portfolio allocations using barbell strategies remain poised to perform well in the current flat yield curve environment. The benefits of a barbell portfolio include the ability to reinvest the proceeds (liquidity) of shorter-term bonds at higher rates, thus providing the opportunity for higher yields than a traditional bulleted portfolio approach. The strategy also provides the potential for higher yield income from longer dated bonds. With long duration bonds more sensitive to price fluctuations, diversification on both ends of the yield curve can provide price protection.

Source: Bloomberg, Ned Davis Research

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