The Federal Reserve and global central banks were in the spotlight this quarter. As global and U.S. growth and inflation prospects weakened, central banks promised to become more accommodative. This tug of war between two titanic forces, bankers and the economy, can result in more than a little volatility, which is what we witnessed the past three months.
The treasury market rallied hard in the second quarter, with the 10-year note yield falling 41 bps and the 2-year falling 51 bps. Clearly the markets began to discount slower growth and inflation. With this rally the yield curve inverted, and now the 10-year is approximately 40 bps below the Fed funds rate. This is a deep inversion and usually a sign a recession is on the horizon.
With the rally in rates and central bank support, all major investment grade fixed income sectors and maturities generated positive returns during Q2.
2Q19 Total Return*
1-5yr Index 1-10yr Index Total Market Index
Treasury 1.83 2.32 3.06
Municipal 1.10 1.59 2.34
Corporate 2.14 3.13 4.35
*ICE/BAML Index Return Data
There were several factors impacting muni returns in the second quarter. Most importantly there continued to be more buyers than sellers, a trend that continued from Q1. Recent tax law changes have not only reduced the supply of municipal bond offerings, but have also increased the demand for tax-free income, particularly from individuals in high-tax states.
Municipals lagged other sectors somewhat in Q2, as this asset class often reacts slowly to sharp changes in rates. Moving forward, we expect the supply and demand imbalance to take hold and improve relative performance throughout the remainder of the year.
After a very strong first quarter, corporates experienced some choppiness in April and May before turning around in June.
Corporate earnings expectations ticked down, leverage continued to leak higher and, consequently, spreads started to widen. At one point in the quarter spreads were 21bps wider from the tights. But then the Federal Reserve and other central banks indicated they would move to ease, and this was the signal for corporates to tighten.
Corporate spreads have been gradually widening since early 2018, as markets anticipate slower growth and higher leverage in conjunction with stretched valuations. It is hard to see a reversal of this slow widening trend, as we are skeptical the Fed has the power to suspend the business and credit cycles. However, even with modest widening, corporates can still produce positive returns vs. treasuries due to their yield advantage.
The markets are placing faith in the power of central banks to keep this recovery alive and growing while simultaneously keeping inflation within the target range.
For now, the markets seem to have suspended judgement, and there is a rare simultaneous rally in most all asset classes: stocks, bonds, oil and gold. Even bitcoin is getting into the act. However, we are not going to count on this rally continuing.
We think rates are likely closer to a bottom. The way to bet is for a range bound market as central banks try put a floor on growth and plump up inflation. Yet we believe they will continue to find these efforts challenging.
Risk assets like corporates will operate in choppier markets in the near term, as the Fed and other central banks roll out rate cuts or other stimulative measures in the 3rd quarter. We will all be looking for the proverbial green shoots to verify central bank success. But until we see some evidence, we prefer staying conservative and liquid with the conviction there will be better opportunities ahead.
Sources: Federal Reserve, Bloomberg