When we published our 2016 fixed income outlook back in January, we opined that bond market returns would be driven by the answers to two big questions. First, would the Fed really be able to achieve its public guidance of four rate increases during 2016 when the market was pricing-in less than two? We felt that the convergence of those views would have a profound impact on the direction and level of interest rates. Second, would the Fed really be able to “go it alone” and hike rates when other major developed market central banks were engaging in massive monetary easing campaigns? The Fed tightening while other central banks were easing would put upward pressure on the dollar (potentially hurting exports and economic growth) and downward pressure on inflation (by making imported goods cheaper).
Fast forward to mid-March and the Fed essentially answered these questions by lowering its expectations for 2016 rate hikes to two and including language in its statement and post-meeting press conference that articulated concern over low inflation and global economic turmoil. This admission that its 2016 forecasts would not be met was a major driver of the positive returns investment grade bond investors experienced during the first quarter. Interest rates have fallen across the yield curve, but particularly for rates that are most sensitive to future monetary policy expectations (for example, 5-year and 7-year Treasury yields declined more than 50 basis points during Q1).
U.S. Treasury Rates (12/31/15 – 3/31/16)
Of course, Fed policy was far from the only interesting market event that occurred during Q1. The drop in crude oil well into the mid-$20/barrel range, a sharp devaluation of the Chinese Yuan and a significant decline in equities during February all had a hand in driving financial market volatility higher. This can be seen on the VIX Index, which measures equity market volatility, and the MOVE index, which measures Treasury market volatility. It stands to reason that when central banks around the world are engaging in highly unconventional monetary policies (aka negative interest rates!) to stimulate growth, periods of financial market volatility are likely to occur.
At SNW, we believe that volatility generally presents opportunities, and February’s was no different. For client portfolios that allow for investment in corporate bonds, we were busy increasing our clients’ exposure to the corporate sector to take advantage of spread widening and attractive yields. For our municipal clients, the new issue market has presented opportunities to capture attractive yields in the housing, toll-road, and, more recently, corporate-backed sectors of the municipal market.
In sum, our call for a continuation of the range-bound interest rate environment with pockets of market volatility remains in place. Over the past two years, we’ve made incremental increases to the risk profile of our portfolios to capture the higher yields associated with credit sensitive sectors and issues. We expect these portfolio additions to add value for years to come, and will continue to look for new opportunities in these volatile markets.