Barbara Williams, CFA
Managing Director
Bridgebay Financial, Inc.
The economic data releases of personal consumption, auto sales,
personal income, and home prices during May were generally positive. The market
expected that the Fed would raise rates in July, however, at the June 15 FOMC
meeting, the Fed postponed raising rates due to global uncertainty, a weak
labor-market report in June and the pending “Brexit” vote.
Economic data was improving and yields had been rising until the June
23, 2016 “Brexit” referendum results stunned the markets. The UK vote to leave the European Union (EU)
threw global financial markets into turmoil and engendered a flight to quality.
Treasury yields dropped precipitously and the yield curve flattened.
Treasury Yields
The global markets have had a critical impact on the Treasury market movements.
Most of the world’s sovereign rate markets are now generating negative yields
making the Treasury yield curve one of the few offering positive yields. With
negative government debt yields in Germany, Switzerland and Japan, global
investor appetites for U.S. credit and Treasuries have risen sharply causing
the U.S. yield curve to flatten.
Bond market estimates show that nearly $11 trillion of bonds have
yields below zero. Another study concludes that over 60% of the world’s bonds
with positive interest rates are denominated in USD. This has caused global
investors to rush into the U.S. fixed income market.
Before the “Brexit” vote the expectation had been for the yield curve
to steepen. Instead, the uncertainty
and fear in the market has led to the flattening of the U.S. Treasuries yield
curve, bringing the 10-year yield down to 1.37%. This high demand for USD fixed income pushed
rates down to exceptionally low levels.
Demand for U.S. equities and bonds made the USD stronger as a safe haven
currency.
Inflation
A firming labor-market, positive wage growth, service sector inflation,
a tight housing market, and energy price increases may lead to modestly higher
core inflation.
U.S. Federal Reserve
The Fed decision in the U.S. to not raise rates was anticipated as the
economic data after the March Federal Open Market Committee (FOMC) meeting was
weak. The FOMC Summary of Economic
Projections indicated that the Fed would be restrained in 2016. The Fed also mentioned uncertainty in raising
rates before the June 23 “Brexit” vote.
There are some market participants that believe the Fed may move to
lower rates rather than raise them. This
appears highly unlikely because the U.S. economy is stable and not showing
signs of recession. Personal income and
spending demonstrate that the consumer’s financial condition is in good shape.
Following the FOMC’s meeting and accompanying statement on April 27,
economic expectations remain subdued.
FOMC, in April, concerned by international developments and volatile
risk markets, further slowed its approach to gradually raising rates. The Fed reduced its planned trajectory for
raising rates and will be slower than previously indicated. Concerns over the “Brexit” vote also delayed
any actions at that time.
U.S. Credit
Investment grade corporate bonds and spread product lagged in the June
rally, though it was a risk-on market for the quarter. High yield corporate bonds performed well
over the second quarter of 2016. Rising
energy and commodity prices improved results in addition to industrial sector.
Regulatory changes continue to impact the short end of the yield
curve. There has been an increase in
commercial paper issuance to meet the increased demand from money market
funds.
Financial institutions whose earnings are limited by persistent low
interest rates recovered from 1Q 2016 to outperform Treasuries. Asset-backed bonds and commercial
mortgage-backed securities followed the same pattern, resulting in positive
excess returns for the quarter. Mortgage-backed fixed rate paper managed to
produce returns similar to Treasuries, helped by the carry but naturally
lagging in price performance during the rally.
Global Central Banks
Central banks around the world adopted a wait-and-see approach in
April. The European Central Bank (ECB),
Bank of England (BOE), and Bank of Japan (BOJ) all chose to forgo adding
further monetary stimulus at their most recent central bank meetings. They opted to maintain current policies and
wait for their impact to flow through to growth and inflation.
Central bank involvement continued to focus on regulatory reforms and
open market operations in the securities markets. During the quarter the ECB announced
additional quantitative easing, revealing its intention to directly purchase
non-financial Euro corporate bonds.
Central banks have been desperately lowering rates and using
accommodative measures with the ECB buying corporate bonds, and investors
looking for yield globally. The technical bid for U.S. bonds continued strong
while the fundamental strength of the U.S. economy remained steady yet
slow.
Continued Volatility
Global malaise, pockets of financial uncertainty, geopolitical risks,
and terror concerns all influenced investor anxiety and fueled the need for
safe-haven investments. All of these
factors enable central banks to generate negative sovereign bond yields. In the wake of “Brexit” and with the U.S.
presidential election looming large, investors will increasingly focus on
political factors. The appetite for taking on risk may be subject to abrupt
changes with risk-on/risk-off transactions.
Markets continue to adjust to the global central bank extensive
participation and hope for interest-rate normalization.
