Nicholas Zaiko, CIMA
Bridgebay Financial, Inc.
Since the February, 2017 FOMC meeting the labor market continued to strengthen and economic activity continued to expand at a moderate pace. The pace of job creation remained robust in February, with payrolls rising by a seasonally adjusted 235,000 new jobs per the Labor Department report. Initial ADP numbers for March showed 268,000 new jobs, dramatically beating the consensus expectation of 185,000.
Household spending rose moderately while business fixed investment firmed. In recent quarters, inflation has increased, approaching the Fed’s 2% longer-run objective. Excluding energy and food prices, inflation was unchanged and is slightly less than the 2% target. The unemployment rate moved lower to 4.7%, as both employment and workforce participation rose. Evidence of continued health in the U.S. labor market likely cleared the way for the Federal Reserve to raise short-term interest rates at the March FOMC meeting. Labor market and wage growth has strengthened, helping to support consumer activity.
Consumers are steadily increasing spending, while confidence levels suggest buying will continue to grow at a moderate pace. The real estate market continues to improve, with home prices rising 5% this year amid increasing demand. At the same time, inflationary pressures have remained relatively subdued, providing a positive tailwind for businesses and individuals.
US Federal Reserve
The Fed raised the federal funds rate to 0.75%-1.0% on March 15, 2017, a move that was widely expected by the market. The Fed indicated that there will be two more rate hikes in 2017 and three more in 2018. The Fed forecast a steeper path for borrowing costs in 2017.
The Fed will keep long-term holdings on its balance sheet. It will hold Federal agencies, agency MBS and Treasuries on its balance sheet and reinvest principal payments until the Fed Funds rate reaches its normalization level.
Core inflation (excluding food and energy costs) was 1.7% in January. The Fed’s new forecast for core inflation for 2017 is 1.9% up from 1.8% as of December, 2016.
There are numerous variables that will impact the economy in 2017 stemming from the Trump administration’s plans for infrastructure spending, tax cuts, and budgetary plans. In response, the Fed has made the tactical decision to wait to see which programs are implemented. Once the programs are approved and more clarity is available then the Fed will respond to any inflationary expectations.
Federal Reserve Balance Sheet
The Fed holds $4.5 trillion in bonds on the central bank balance sheet that were acquired during 3 rounds of quantitative easing (QE). The QE program was a monthly bond-buying program implemented in response to the financial crisis. The cashflows from the holdings of Treasuries and MBS have been reinvested in bonds without shrinking the balance sheet. The Fed indicated that some balance sheet reduction this year may come from stopping the reinvestment of cashflows.
According to the FOMC minutes of the March, 2017 meeting, the Fed acknowledged that unwinding the balance sheet would itself amount to a rate hike. A change to the Committee's reinvestment policy may occur in late 2017 although there was little consensus on how the operation would be implemented.
The ECB announced on January 19, 2017 that they would leave rates unchanged and continue the accommodative asset purchasing program. Currently the plan is to taper asset purchases after April, 2017, decreasing to €60 billion per month, down from €80 billion. The ECB explained the rationale for extending the program by citing elevated levels of political uncertainty in 2017 with several contentious elections occurring throughout the year in France and Germany.
European bonds were volatile throughout the quarter on speculation over the European Central Bank (ECB) quantitative easing (QE) plans.
Overall, 2017 is expected to see a slowdown by global central banks in implementing additional accommodative measures to keep interest rates down. Central banks globally are reaching the limits of monetary policy and are seeing diminishing economic benefits and increasing risks with negative interest rates.
The UK invoked Article 50 on March 30, 2017 to initiate the 2-year process of exiting the European Union. Europe has critical elections in France and Germany that are facing pressure from populist candidates. Netherlands’ elections re-buffed the populist candidate and restored the status quo.
The Netherlands election followed the re-election of Prime Minister Mark Ruttes centre-right party which defeated the populist, extreme candidate.
Oil prices rallied as several OPEC members commented about possibly extending the production freeze agreement when the group meets in May. There is a reduced outlook for inflation as oil prices have settled in the $50/barrel range in March while inventory levels and drilling rig activity increased.
U.S. 10-year Treasury yields have fluctuated from a low yield of 1.36% in July, 2016 to 2.40% on March 31, 2017. The yield curve is expected to flatten as short-term interest rates rise and the 5-10 year portion of the yield curve remains steady. Although the expectation for the 10 year has been for it to rise to 3-3.5% by year-end 2017, demand for US fixed income securities due to the strong US dollar and shortage of high quality, global bonds may key those yields down.
Short-term rates under 12 months rose directly in response to the increase in Fed Funds rate in March, 2017 ranging from 18 bps. to 30 bps. 3 month LIBOR is 1.15%. quarter-end. Money market funds continue to have seasonal outflows. Corporate credit spreads have continued to narrow. When rates rise, over time, higher reinvestment rates will offset the decline in bond prices, and become the primary driver of total return.
1-3 year BBB credits were the best performing investment grade fixed income sector during 1Q2017. The US economy is providing a stable footing for corporate credits.
Accommodative monetary policy and positive economic data have provided a stable backdrop for the US corporate fixed income market. US GDP continues to grow at a slow pace. Currently, there appears to be limited capacity for credit spreads to narrow in 2017. Amid stable fundamentals, strong demand for US credit has driven spreads tighter year-to-date in the face of heavy issuance. Investment-grade supply topped $1 trillion in 2016, making it a record-setting year.
In the current low rate environment, traditional high-quality US buyers are pushing into lower-quality credits in search of additional yield. Outside the US, over a quarter of all government debt is trading in negative territory. The lack of attractive opportunities in local foreign markets is driving strong flows into US corporate bonds, Treasuries and agencies. More recently, they are increasingly finding attractive opportunities in investment-grade corporates, which have boosted returns. Additionally, corporate buying programs in the Eurozone and Japan are providing a positive technical for high-quality global bonds, including US bonds.