Bonds Commentary
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Bonds: Rookie Move

November 2018

Comments by FOMC Chair Jerome Powell related to the Fed funds rate being a “long way from neutral at this point” rattled markets during October as investors took this to mean that the FOMC was indeed on a path destined for a policy mistake. Chair Powell reiterated prior statements that the FOMC doesn’t know exactly what the long run neutral rate should be, but expressed a willingness to go beyond it if necessary. The neutral rate is the rate at which monetary policy neither stimulates nor restrains economic growth – thought to be between 3% and 3.5% on Fed funds at present. Chair Powell’s remarks were unsettling for markets and a rookie move from the FOMC chair in our view, but that doesn’t mean he’s mistaken, or that he communicated anything beyond what the dot plot was trying to tell us. This may serve as a valuable lesson as Powell must be cognizant of how even the most innocuous comments in his eyes can move markets, and when less is more as it relates to forward guidance.

We kicked off November with the release of the October nonfarm payrolls report, as addressed in greater detail in the Economics section of this outlook. In October, payrolls grew by 250,000 jobs, easily besting the consensus estimate of 190,000, while the unemployment rate remained unchanged at 3.7%. The overall strength of the report pushed bond yields higher across the curve, with the benchmark 10-year yield up 7 basis points on the day of the release. Talking heads have posited that the U.S. economy was perhaps weaker beneath the surface than meets the eye, which might provide the FOMC with the necessary cover to delay its next hike into 2019. The payrolls report throws cold water on those espousing the economic slowdown theory. The issue at hand is whether the data is so good that it’s bad for investors as a tight labor market keeps the FOMC in play and on a path to hike rates an additional two or three times in 2019 after another quarter-point hike in December.

With the 10-year portion of the yield curve settling into a trading range between 3.08% and 3.25% over the past month, we wouldn’t be surprised if the curve gradually flattens into year-end. Shorter-term bonds, asset-backed securities, and U.S. dollar-denominated emerging markets debt continue to be areas of interest for us. Amid the sell-off across global equities in October, high yield corporates experienced a flight to safety, with the Bloomberg Barclays U.S. High Yield Index generating a -1.6% return during the month. Through October, the high yield index remained one of the few fixed income indices to post a positive total return year-to-date. While high yield spreads remain tight relative to historical norms, the yield to worst on the index at month end was 6.86%, a much more attractive level versus where it entered the month. With our expectation that defaults will remain around current levels well into 2019, it’s difficult to forego the yield/carry on high yield by moving into another pocket of the fixed income market. The time to trim or jettison high yield is coming, we just don’t think it’s right now

Source: Bloomberg

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