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In the context of low inflation and a stable dollar that means savers can finally expect some real return without having to own riskier assets.

Jan 2019
Julianna Donovan

As the Fed continues to push short-term interest rates higher, we see both opportunities and some potential for caution.  The opportunity is that after nearly a decade of zero percent interest rates the return on money market instruments is now above 2%.  That may not sound like a lot, but that means savers can finally expect some real return without having to own riskier assets. At the same time that short-term rates have been rising long-term rates have been falling.

One reason for this dynamic may be that the market is increasingly discounting the possibility of further rate hikes by the Fed.  This is instead of betting the Fed may pause, with recent pricing indicating a possible rate cut in 2019. Another reason could be that inflation remains low around 2% and the economy is slowing.  Both of which tend to keep market expectations for long-term yields anchored.

Yield Curve

Will the U.S. Treasury yield curve “invert” and what is the implication if it does? Normally, long-term bonds offer higher yields than shorter-term notes, resulting in a positive slope to the yield curve.  While there are points along the yield curve that trade at a very slight inversion, the traditional inversion is measured by the comparison between two year and ten year bonds.

Currently, that yield difference is 0.18% with:

The 2 year note yielding 2.50%

The 10 year note yielding 2.68%

This pretty meager difference is evidence of a very “flat” curve, consistent with slowing growth and rising short-term policy rate.

 

Our view is that we are close to a near-term peak in the Fed Funds rate and we do not expect the yield curve to invert in the next few months.  Rather, we see the current environment as reminiscent of 1995-2000.  The yield curve stayed flat for an extended period of time but did not foreshadow an imminent recession. Against that backdrop, we have been adding high-quality municipal and corporate bonds to portfolios. We are focusing on short and intermediate maturities ranging from three to seven years.  This way client portfolios receive attractive market rates of income without the added price risk of longer bonds.

As always, we focus on high rated bonds supported by strong balance sheets and financial flexibility that offer a margin of safety.

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