Fixed Income Outlook  |  Q4 2019

Bond rally reflects economic uncertainty

Fixed Income Team

Bond rally reflects economic uncertainty

  • Treasury yields swing as recession fears ebb and flow.
  • Trade rift and politics continue to weigh on financial markets.
  • We predict the Fed will cut rates further by the end of 2019.

Global growth has cooled in 2019 as trade conflicts have taken a toll on international manufacturing, investments, and financial markets. Despite multiple headwinds, the likelihood of a recession — while rising — remains relatively low in the short run. The U.S. economy is likely to continue expanding at a more moderate pace this year compared with 2018. The Federal Reserve lowered its policy rate twice during the quarter to safeguard the economy against future risks. Fed officials remain divided on the trajectory of future interest rates. Still, we predict there are more cuts to come.

Market worries drove many investors to bonds. Government bond yields in the United States and Europe fell sharply in August, and then rose and fell again in September. Different parts of the U.S. Treasury yield curve inverted during the quarter. The yield on the benchmark 10-year note fell below the 2-year note yield in August for the first time since 2007. Besides the Fed, other central banks around the world addressed market worries by also cutting borrowing costs. The European Central Bank (ECB) lowered one of its policy rates to a record low and rolled out a broader package of monetary stimulus.

Within an environment of declining intermediate- and long-term interest rates, the Bloomberg Barclays U.S. Aggregate Bond Index advanced 2.27% during the quarter. Investment-grade corporate bonds registered a strong return of 3.05% as measured by the Bloomberg Barclays U.S. Corporate Index. Municipal bonds, mortgage-backed securities, and high-yield bonds trailed the aggregate index. Non-U.S. bonds trailed further behind.

President Trump was in the spotlight again as the House of Representatives initiated a formal impeachment inquiry against him. While we are uncertain about the outcome, the whole episode cannot be dismissed as political theater with no important implications for markets. At some point, asset markets — both equity and fixed-income — may have to price in political uncertainty and changes in the policy agenda.

U.S. economy decelerates modestly

This year marks the 10th anniversary of the U.S. economic expansion. The economy grew at a seasonally adjusted 2.0% annual rate in the second quarter of 2019, after expanding 3.1% in the first quarter. The jobless rate is near an historic low, consumer spending remains strong, and housing market activity is picking up. In short, the economy is decelerating modestly. Strength in housing is helping to offset, in part, the weakness from the global trade war and the end of the fiscal stimulus. But the economy is not heading unavoidably into a recession. The Fed now expects growth of 2.2% this year, up from the 2.1% rate it forecast in June 2019.

Meanwhile, job creation remains steady despite some uneven gains this year. Employers added 136,000 jobs in September, and the jobless rate fell to 3.5%. Still, there has been some pullback in manufacturing, which slumped to its lowest level in more than 10 years in September, according to data from the Institute for Supply Management.

Fed sends mixed signals on rates

The Fed in September cut its main interest rate — for a second time this year — by another 25 basis points to a range of 1.75% to 2.00%. And in response to stresses in the short-term borrowing markets, the Federal Open Market Committee (FOMC) also lowered the rate it pays on bank reserves. The interest on excess reserves rate (IOER) now stands at 1.8%, after a 30-basis point cut. Fed chair Jerome Powell, however, said little on the outlook for rates. Recent commentary from FOMC officials suggests there remains a possibility rates will be cut further this year. The Fed also plans to look into whether it should resume "organic growth" in the balance sheet (or holdings of Treasury securities).

Investors tend to seek the stability of bonds when they are worried about growth. The recent rally in bonds has sent yields, which fall as bond prices rise, toward record lows. The Treasury yield curve inverted multiple times during the quarter. The yield on the 10-year note finished the quarter at 1.68%, down from 2% at the end of the second quarter and about a full percentage below where it stood at the end of 2018. In addition, the 1-year, 2-year, and 10-year note yields have been trading below the 3-month yield for months.

ECB turns on stimulus tap

The eurozone's economy continues to be at risk from domestic and global developments. But with interest rates already at record lows and an inflated balance sheet, the ECB has limited policy tools to boost growth. The ECB lowered its rate for deposits to -0.5% in September. The central bank will also restart its quantitative easing (QE) program in November, with 20 billion euros per month of net asset purchases for as long as it deems necessary. ECB president Mario Draghi referred to "downside risks" in the outlook as Germany teeters on the brink of recession, trade tensions linger, and Brexit drags on.

Politics are also back in focus. New British Prime Minister Boris Johnson says the United Kingdom plans to leave the European Union without an agreement if EU officials refuse to negotiate a new deal. The ongoing impasse — ahead of the October 31 deadline — has frayed the nerves of investors and dampened business activity. The U.K. economy unexpectedly contracted in the second quarter of 2019. In Italy, Prime Minister Giuseppe Conte has formed an unlikely new coalition government that includes the Five Star Movement and the Democratic Party. The alliance still has to contend with overhauling the economy and reining in rising debt levels.

China tries more stimulus

China, the world's second-largest economy, has adopted a string of fiscal and monetary measures to cushion its cooling economy. This includes billions of dollars in infrastructure spending and tax cuts for companies. In early September, the central bank also reduced the amount of money commercial banks are required to set aside (reserve requirement ratio) to promote lending. The economy grew 6.2% in the second quarter of 2019, the slowest pace in 27 years, as the trade war took a toll. We are now less sanguine about the resilience of global financial markets and financial flows should a more serious Chinese downturn materialize.

The exchange rate has also come into play, and this is making us a bit nervous. The trade tensions with the United States escalated over the summer when Beijing allowed its tightly controlled currency to weaken against the dollar to its lowest level in more than 10 years. This yuan weakening is a message to Washington about the trade war. Months of trade negotiations between Beijing and Washington have resulted in deadlock.

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Global growth has cooled in 2019 as trade conflicts have taken a toll on international manufacturing, investments, and financial markets.