Asset Class: U.S. Fixed Income

March 2019 Fixed Income Market Update

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Economic and market perspective

Trade tensions between the United States and China appeared to improve somewhat in February. The Trump administration delayed the implementation of increased tariff rates, which had been scheduled to rise from 10% to 25%, citing “substantial progress” in negotiations. Discussions have led to memoranda of understanding on six disputed points, but no final deal has been reached. Progress on the trade negotiations contributed to improved market sentiment in the month.

Outside the U.S., economic data generally remained weaker. For example, Germany’s fourth quarter GDP showed 0% growth after a -0.2% decline in the third quarter. IHS Market’s Euro Zone Composite Final Purchasing Managers’ Index (PMI) declined to 51.0 in January from 51.1 in December; these figures still showed modest expansion, but the reading was the lowest since mid-2013. Japanese GDP improved in the fourth quarter to 1.4% annualized growth from -2.6% in the third quarter, avoiding consecutive negative quarters which would represent a technical recession.

With limited progress in negotiating Brexit, Prime Minister Theresa May suggested a brief delay to reach an agreement; French President Macron suggested the EU could block the delay. The head of the opposition Labour party called for a second referendum. The next parliamentary votes are expected for mid-March with the current deadline of exit set for March 29.

December U.S. retail sales, which had been anticipated to increase modestly, declined by 1.2%. The report, which had been delayed by the prolonged government shutdown, surprised markets with more negative data than expected and was the largest decline in holiday season retail sales in 9 years. However, due to the shutdown, there has been some skepticism about the accuracy of the report.

The U.S. producer price index (PPI) rose 2.0% for the trailing twelve months ended in January; this figure declined from 2.5% in December and marked the slowest increase since mid-2017. Core PPI increased 2.5% for the same period, a decline from 2.8% the prior month. These figures further support our view of a benign inflationary environment.

Minutes from the Federal Open Market Committee (FOMC) that met on January 29-30th were released in February. In the minutes, the Fed restated their patient approach on policy. Of note, the minutes reflected Fed discussions about ending the balance sheet run-off later this year. Further, in the minutes the FOMC members suggested that keeping the Fed Funds rate in its current range of 2.25% – 2.50% “posed few risks at this point.” As of February 28, Fed Funds Futures project neither rate hikes nor rate cuts in 2019.

Chairman Powell presented the Fed’s Semiannual Monetary Policy Report to Congress on February 26 and 27. In the report, he highlighted healthy economic conditions, but remarked that the conditions are “less supportive of growth than they were earlier this year.” He noted current limited inflationary pressures as allowing increased flexibility on rate hikes and again reiterated the Fed’s patience with regard to policy. In reminding Congress of the Fed’s independence, Powell indicated Fed actions would proceed “without concern for short-term political considerations.”

Outlook and conclusions

In our view, the notable recompression in credit spreads across the quality spectrum represents an indicator of risk markets’ constructive outlook for the U.S. economy. However, not all indicators are as enthusiastic. For example, the more limited reaction from Treasuries yields and the term premium for U.S. Treasuries remaining negative offer a less positive outlook. Previously, the market perception was that the risk of a Fed policy error was growing, and that the central bank’s forward guidance for interest rate hikes were outstripping the underlying economy’s need for more restrictive policy. However, with the release of the Fed’s most recent minutes, and Chairman Powell’s recent comments before Congress, the Fed is emphasizing its patience and is acutely aware of not over-tightening. While some data has surprised to the downside, other data such as the recent GDP and confidence numbers show that the U.S. economy maintains momentum and has yet to show signs of meaningfully slowing in the immediate horizon. As such, we maintain a constructive view on non-governmental assets and while interest rates have been slower to react than other markets, the balance may be tipping more in favor of higher benchmark rates once again.

 

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