Over the course of the last five years, we as bond investors have grown accustomed to reading annual market outlooks and commentaries that predict the long-awaited end to the bull market in bonds. At this time last year, the assumed trigger for a bond market selloff was the Fed raising rates. In early ’14 it was the improvement in the labor market. Back in 2010, bond prices were expected to fall as the “green shoots” that were emerging in the post financial crisis global economy. In reality, events have widely differed from predictions as intermediate-term bonds, measured by the Bank of America Merrill Lynch 1-10 year Gov’t/Corporate Index, have posted positive returns during 4 out of the last 5 years, and the average annual gain of nearly 2.5% has kept well ahead of the rate of inflation.
In 2015, fixed income investors were reminded that bond market returns aren’t determined entirely by the monetary policy decisions enacted by the Federal Reserve. Despite the Fed discussing its plan to raise the Federal Funds Rate throughout much of the year, and then actually doing it in December, returns across investment grade bond markets were positive. Why? Longer-term bond yields, which are impacted more by inflation, economic growth, events overseas and market volatility than by Fed policy, rose only slightly. Short-term bond yields rose more, resulting in a “flatter yield curve.” However, in the case of both short and long bonds, interest generation more than offset the small price declines caused by the rise in yields.
So what can we expect in 2016? With the caveat that financial markets are predictably unpredictable, it remains likely that, similar to this year, bond returns will come in around the yield at which they start the year. Unless economic fundamentals change significantly, investors are expecting, and the market is pricing in, another year of low growth and low inflation here at home and around the world. But—and this is where it could get interesting—for the first time in a long time, the futures market is pricing in a vastly different outlook than the Fed. Specifically, the Fed anticipates raising the Fed Funds Rate another four times in 2016, while the market is pricing-in only two additional increases (see chart below). In addition, the Fed is breaking away from other major developed market central banks by tightening monetary policy, while the Bank of Japan, European Central Bank and Peoples Bank of China are loosening. This divergence in policy has created volatility in currency markets, which has in turn caused dislocations in other financial asset markets. Whether or not the Fed can truly embark on and sustain its tightening cycle alone is a major unanswered question.
In sum, how these two items, the market versus the Fed and the Fed versus the rest of the world, play out is likely to be the biggest determinant as to whether the “steady as she goes” thesis actually comes true.
Interest Rate Path Expectations
Blue Line = FOMC Median, Red Line = Market Median
At the start of 2016, we here at SNW are focused on adding value in ways other than trying to time the notoriously unpredictable level and direction of interest rates. Specifically, our work on sector relative value, security selection, and client specific portfolio construction remains our main focus, and ample opportunities will continue to present themselves in what, for all of the reasons listed above, is likely to be a volatile market environment. We look forward to the many opportunities that 2016 should bring, and hope you do as well.
Sources: Bloomberg and BofA/Merrill Lynch