At one point in August we quipped that our popularity as bond investors was on the rise. It was then that the 2yr/10yr Treasury curve inverted, which has historically been a leading indicator of a recession. We started getting a lot of phone calls from worried investors about the state of the economy.
The inversion was driven by a sharp decline in longer-term interest rates during August as growth expectations stalled. And while rates rose somewhat in September, they will end the quarter at lower levels than where they began, which is driving positive performance across high quality bond markets during Q3.
Interestingly, despite all the noise and concern caused by the bond market, stocks are poised to end the quarter slightly higher.
Stock investors are pointing to certain strengths in the economy. From a top-down view many believe the Fed is at least neutral (if not accommodating) after a decade of zero interest rates. Fiscal support (government deficits) has reached extraordinary levels for a non-recessionary period; banks are lending, the capital markets are open, and unemployment is at a 50-year low.
Bond investors are likely looking at the clouds building on the horizon. For example, the Fed may have raised rates too fast (a policy mistake). Furthermore, we are seeing negative economic impacts from trade wars, corporate profit growth has slowed, and geopolitical risks are high.
So who is right?
Moving forward, we think that the answer will be revealed by watching corporate behavior closely. Corporate America has begun to slow capital spending in recent months. Should C-Suites also decide to start trimming jobs, the consumer, which has powered through the recent market volatility, could come under pressure. Then, all bets are off.
The investment grade bond market is behaving as expected given the recent bout of volatility. Treasuries and other high quality (AA and AAA rated) bonds are performing well, while bonds on the lower end of the ratings spectrum have come under pressure. Though municipal returns have lagged, which is typical when Treasuries have sharp moves, we expect them to catch up. In all, now is not the time to try to hit home runs. We plan on continuing to collect our coupon payments and watch how this all plays out as we assess current and potential opportunities.
Source: ICE/BAML, S&P