On September 15, 2008, Lehman Brothers, what was then the fourth largest investment bank, filed for bankruptcy. Much of that event was occurring over the previous weekend, but at shortly after midnight, the filing set in motion a dramatic sell-off in the stock market and credit markets that froze as investors learned quickly just how interconnected the financial markets were at the time. And Lehman Brothers was not the only news to rattle the markets and the global economy. Earlier in the month, Bank of America’s purchase of Merrill Lynch, AIG, Washington Mutual, Fannie Mae and Freddie Mac (two government agencies), among others, were all in the headlines.
Through the U.S. Treasury, several backstops to the banking industry were put in place, and through the Federal Reserve, an era of zero percent short-term interest rates began. Most backstops have been lifted and the Fed is now raising rates again, but questions remain as to whether a financial crisis of that magnitude can reappear. The debate may never end, though the fact of the matter is that banks are much safer now than ten years ago. Capital requirements have been raised. Big banks no longer just freely get bigger. Funding sources are more stable coming from a growth in deposits. And banks have turned back to more typical lending instead of trading risky assets. With the crisis behind us, the Fed has squarely returned its attention back to its dual mandate of maximum employment and stable prices.
The Federal Reserve did not disappoint as it used the September 25 FOMC meeting to raise short rates an additional ¼ percentage point. The fed funds rate, now 2.25%, has followed a rather predictable path this year of rising ¼ percentage point per quarter. Currently, and once again reflected by the markets, we expect the final ¼ percentage point increase for 2018 to occur at the FOMC meeting on December 19. Looking ahead, the Fed’s projections show a probability of three rate increases in 2019 and a final increase in early 2020.
We have dedicated a fair amount of time in this year’s commentaries to the flattening yield curve due to the Fed raising short-term rates while intermediate and longer yields have held steady. It is important in that an inverted yield curve has been a good predictor of recessions. Without going into a lot of detail, we saw the curve flattening continue in the third quarter.
The spread between the 2-year Treasury Note and the 10-year Treasury Note finished the quarter at 24 basis points. At the end of the second quarter it was 33 basis points. This spread is commonly used by traders and commentators, though it is not the only combination possible. Recently the Federal Reserve of San Francisco published an economic research paper on the predictability of using the 3-month Treasury Bill and 10-year Treasury Note. Its data show that combination as a better choice and while it is still almost 1% from being inverted, it would be a lessened predictor of a near-term recession. The Fed is going to great lengths to assure us a recession is probably not in the cards and while we are not necessarily agreeing upon which combination is the best, we do agree there is a low chance of recession.
Economic reports from the third quarter back up our expectations for continued growth. We are taking a little liberty here discussing second quarter growth, but we must wait until the third quarter for the data. First released in late July and later revised, GDP surged to an annualized 4.2% for the second quarter. That is up from 2.2% in the first quarter and the highest reading since late 2014. Retail sales are strong, and unemployment is near generational lows. Tax reform stimulus is waning but there is enough strength remaining in the economy to keep quarterly GDP above the past few years.
The reports also show contained inflation both in the economy and wages. At the Fed’s target of 2%, annualized inflation gives it little wiggle room, but we believe inflation will not heat up to the point of causing a faster or greater tightening cycle. Some in the markets think it may be just the opposite.
For the third quarter, the broadest market index, the Bloomberg Barclays U.S. Aggregate Index, was slightly positive though year-to-date it is still down 1.6%. The Intermediate Government/Credit Index, our benchmark, returned a positive 21 basis points for the third quarter. A rough start to 2018 (Q1 was down .98%) still weighs on the Index but that has now been followed by two slightly positive quarters. The credit side of the Index, which was the main driver for the negative performance in the first quarter, was up 73 basis points in the third quarter as spreads tightened and new issue supply was met with strong demand. We expect spreads to continue to tighten as a robust economy keeps investors comfortable with owning corporate debt.
The Bloomberg Barclays U.S. Corporate High Yield Index had positive returns each month, leading to an impressive third quarter returning 2.40%, as quarterly new issuance was the lowest since 2015. A strong equity market and rising oil prices also helped the high yield market return the best performance of the sectors. The high coupon and short relative duration of the high yield market has it in a unique spot for outperformance, though we remain cautious as history has shown volatility can return quickly.
Switching to the tax-exempt market, the Bloomberg Barclays Municipal Bond Quality Intermediate Index returned a negative 11 basis points for the third quarter following a strong second quarter. For the year, the Index is now at negative 21 basis points. Heavy new issuance in September negated positive July and August returns. 10-year municipal bonds rated double-A ended the quarter at 2.81% (Bloomberg), above the 2.65% at the end of the second quarter. On a taxable equivalent basis (35% tax bracket), municipal bonds provide a good relative value to corporate securities past a five-year maturity and should remain attractive for investors as the last income tax shelter following the federal curb on SALT deductions. Along with a steepening yield curve out to a 15-year maturity, we still believe the best value for our clients is in the intermediate maturities. Looking ahead, fourth quarter supply will be dominated in October and November with full year 2018 issuance similar to lower historical levels seen in 2013/2014. The municipal bond market is a very high-quality asset class and whether on a taxable equivalent basis or through taxable municipal bonds, it remains a top choice for our clients’ portfolios.
Based on the strong economic data and contained inflation in many ways cancelling each other out, volatility in the bond market was generally lower in the third quarter than in previous quarters. Lower volatility allows us to comfortably position our clients’ portfolios across the intermediate maturities of the yield curve. We expect gently rising rates for the remainder of the year. We feel our current strategy of over-weighting credit and quality is still appropriate, and as such, we continue to seek out the optimal maturities to capture the most income without introducing undue risk to the portfolios.
