Fixed income market update. April BMO Fixed Income Brickell Bay Dr. Suite 2100 Miami, Florida bmogam.

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1 Fixed income market update April 218 BMO Fixed Income 11 Brickell Bay Dr. Suite 21 Miami, Florida bmogam.com/usfixedincome

2 Fixed income market update For the quarter ended March 31, 218, the Bloomberg Barclays U.S. Aggregate Bond Index returned -1.46%. U.S. Treasuries returned -1.18% during the quarter as the yield on the 1-year U.S. Treasury rose to 2.74% from 2.41% at the end of December. For the quarter, long Treasuries (-3.29%) underperformed intermediate Treasuries (-.75%). Mortgage-backed securities (MBS) returned -1.19% during the quarter, underperforming duration-matched Treasuries by 39 basis points. The option adjusted spread (OAS) of the Bloomberg Barclays U.S. Mortgage Index widened four basis points, ending the quarter at 29 basis points. (bps) (%) Fixed Income Sectors Total Returns Treas. U.S. Agg. Agencies ABS CMBS MBS Credit Source: BBG Barclays 1-Mo 3-Mo YTD (3/31/218) Fixed Income Sectors Excess Returns U.S. Agg. Agencies ABS CMBS MBS Credit Source: BBG Barclays 1-Mo 3-Mo YTD (3/31/218) 2

3 Fixed income market update (continued) Credit securities returned -2.13% for the quarter, underperforming Treasuries by 66 basis points on a duration-adjusted basis. The OAS of the Bloomberg Barclays U.S. Credit Index ended the period at 13 bps, 14 basis points wider than at the end of December. For the quarter, long credit (-3.83%) underperformed intermediate credit (-1.36%) by 53 basis points on a duration-adjusted basis. For the quarter, on a duration-adjusted basis, noncorporates delivered -1 basis point of excess returns, outperforming industrials, utilities, and financials by 66, 86 and 98 basis points, respectively. AAA rated securities delivered -17 basis points of excess return for the quarter, outperforming AA, A and BBB rated securities by 12, 81 and 4 basis points of excess return, respectively. High yield delivered -17 basis points of excess return for the quarter. (bps) (%) Subsector and Quality Total Returns Industrial Utility Financial Non-Corp Aaa Aa A Baa HY Source: BBG Barclays 1-Mo 3-Mo YTD (3/31/218) Subsector and Quality Excess Returns Industrial Utility Financial Non-Corp Aaa Aa A Baa HY Source: BBG Barclays 1-Mo 3-Mo YTD (3/31/218) 3

4 Economic update Percentage (%) The final reading of fourth quarter U.S. gross domestic product (GDP) reported growth of 2.9%, above expectations and.4% higher than the prior estimate. Consumer spending was revised higher to a 4.% rate, the highest since 214. The Atlanta Fed s GDPNow estimates 2.4% growth for the first quarter of 218, down meaningfully from its estimate of 4.2% at the end of January and down slightly from the 2.6% estimate at the end of February; broader consensus is for about 2.8% growth in the first quarter, though recent first quarters have disappointed in terms of GDP growth Consumer Price Index (YoY) Jan 7 Jul 7 Jan 8 Jul 8 Jan 9 Jul 9 Jan 1 Jul 1 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Jan 14 Jul 14 Jan 15 Jul 15 Jan 16 Jul 16 Jan 17 Jul 17 Jan 18 CPI YOY Index Source: Bureau of Labor Statistics Percentage (%) Gross Domestic Product (GDP) Mar 7 Sep 7 Mar 8 Sep 8 Mar 9 Sep 9 Mar 1 Sep 1 Mar 11 Sep 11 Mar 12 Sep 12 Mar 13 Sep 13 Mar 14 Sep 14 Mar 15 Sep 15 Mar 16 Sep 16 Mar 17 Sep 17 Source: Bureau of Economic Analysis The Consumer Price Index (CPI) rose.2% in February, after a.5% increase in January; for the past year, CPI rose 2.2%. Core CPI, which excludes the impact of energy and food, rose by.2% for the month. Core CPI rose 1.8% for the trailing year, the tenth consecutive period of a 1.7% or 1.8% increase. Owner equivalent rents slowed to a.2% increase, while new car pricing decreased.5%. Core personal consumption expenditures (PCE), the Fed s preferred inflation gauge, rose.2% in February, down from.3% in January, and increased 1.6% for the full year. 4

5 Economic update (continued) Non-farm payroll data for February increased by 313, jobs in the month, and revisions to the prior two months increased job gains by 54,. The unemployment rate remained at 4.1%, the lowest level since 2. Notably, wages rose.1% for the month and 2.6% for the trailing year, after last month s figure of 2.9% sparked inflation concerns. That figure was revised down.1% to 2.8% as well. Labor force participation rose to 63.% from 62.7%, while the underemployment rate remained unchanged at 8.2%. Percentage (%) Jan 9 US Average Hourly Earnings All Employees Total Private Yearly % Change SA Jul 9 Jan 1 Jul 1 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Jan 14 Jul 14 Jan 15 Jul 15 Jan 16 Jul 16 Jan 17 Jul 17 Jan 18 Points ISM Manufacturing PMI Jan 7 Jul 7 Jan 8 Jul 8 Jan 9 Jul 9 Jan 1 Jul 1 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Jan 14 Jul 14 Jan 15 Jul 15 Jan 16 Jul 16 Jan 17 Jul 17 Jan 18 Source: Institute for Supply Management Source: Bureau of Labor Statistics According to the Institute for Supply Management, the ISM Manufacturing index rose to its highest level since 24 in February. The index rose to 6.8, above expectations of 58.7, with any level above 5 indicating growth. ISM s service sector measure exceeded expectations, but declined in February as the employment gauge fell from a particularly high level the prior month. The measure of new orders rose to its highest level in over 12 years, suggesting continued underlying strength. 5

6 Economic and market perspective Following the passage of tax reform in the fourth quarter, which has provided an economic tailwind, in March, fears of protectionism surfaced as President Trump announced tariffs on steel and aluminum. While the tariffs themselves impact a relatively small segment of global trade, they raised the specter of additional restrictions on free trade. The tariffs were raised as a trade issue at the World Trade Organization, where they were roundly criticized by the European Union, Japan and China among others. After the significant international pushback, the tariffs were narrowed, with many countries receiving exemptions. Of note, China did not receive the exemptions. In response, China implemented tariff countermeasures, prompting fears of a trade war. Gary Cohn, President Trump s National Economic Council Director, resigned shortly after the announcement of the tariffs, which he opposed. Additional changes among the president s senior advisors, including replacing the Secretary of State, Rex Tillerson, amidst tensions with Iran and North Korea, increased the market s perception of political uncertainty. The President s new nominees for Secretary of State, Mike Pompeo, and National Security Adviser, John Bolton, are considered more hawkish than their predecessors. At the same time, North Korea invited the United States to meet, which President Trump has accepted. In parallel, the U.S. announced a renegotiated bilateral trade agreement with South Korea as talks with the North are approaching. During March, Bank of Japan (BOJ) Governor Haruhiko Kuroda made comments suggesting that the BOJ could begin some degree of normalization next year. The possible shift is significant as many of the major central banks such as the Fed and Bank of England (BOE) have already raised rates, while the European Central Bank s (ECB) bond buying program is set to expire in September of this year. The ECB s staff projections show purchases being wound down over the remaining three months of the year; the Governing Council removed language indicating it would be willing to increase monthly bond purchases if needed, both are being interpreted as additional signs of coming normalization. Markets project the first rate hike from the ECB in mid

7 Outlook and conclusions The March 2-21 meeting of Federal Open Market Committee was closely watched as Jerome Powell s first as the new Chairman, with expectations of a 25 basis points increase in the Fed Funds rate priced in by markets. As expected, the Fed delivered a 25 basis point hike, the sixth hike of the current cycle, bringing the Fed Funds rate to a range of %. The dot plot projections showed an increase in the median projection of the Fed Funds rate for each of the next three years as well as the long-run forecast increasing by.1% to 2.9%. Similarly, median GDP projections increased by.2% to 2.7% in 218 and by.3% to 2.4% in 219, however, inflation views remained more subdued at 1.9%. The new Fed Chairman, Jerome Powell, emphasized that these projections do not represent a singular Fed view, but the aggregation of individual members. The market is not projecting a rate hike at the Fed s May meeting, but projecting approximately a 75% probability of a hike at the June meeting. In our view, after the hot start to the year in terms of economic data, data in March returned to a positive, but more realistic trend. More moderate wage and inflation data along with increased political uncertainty led to interest rates declining, while the prospects of a trade war and increased volatility led to wider spreads for non-governmental sectors. We view fears of a tariff-driven trade war as overwrought, but the concerns have served as a healthy reminder to markets to price in risk even with a strong economic backdrop. The moderate widening offers higher yields for those sectors and provides greater cushion for investors, while fundamental economic data remains solid. The Fed s rate hike was fully expected and priced in, thus having a limited impact on the market, while other central banks seem to be leaning, albeit slowly, towards normalization. Nonetheless, monetary policy both in the U.S. and globally remains accommodative, supporting fixed income as a sector, and with broad market fixed income yields above 3%, the highest level in almost eight years, the asset class offers opportunity for investors. 7

8 Fixed income returns as of March 31, 218 Index Returns as of March 31, 218 Total Return (%) Excess Return (%) Month-to-Date Quarter-to- Date Year-to- Date Month-to-Date Quarter-to- Date Year-to- Date U.S. Aggregate U.S. Treasury Intermediate Long TIPS Agencies U.S. MBS U.S. Credit Intermediate Long Industrial Utility Financial Non-Corporate Aaa Aa A Baa High Yield Floating Rate Notes Source: Bloomberg Barclays 8

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