When we penned our 2016 Fixed Income Outlook Letter in January, we felt that 2016 returns in the Investment Grade Bond Market would be driven by the answers to our two big questions. First, would the Fed really be able to achieve its public guidance of four rate increases this year 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?
Mid-way through the year, those questions have been decidedly answered.
The Fed hasn’t raised interest rates this year, and as of today the financial markets are not pricing-in a full rate hike until 2018. What happened, and why has the Fed been so off the mark relative to its original expectations? We think it is a combination of below trend economic growth (1Q US GDP was a mere 1.1%), inflation that hasn’t reached the Fed’s target (core PCE stands at 1.6% y/y versus a 2% target), weakening job growth (nonfarm payroll gains have taken a step back in recent months), and most importantly, tighter financial conditions (think lower stock prices and wider corporate credit spreads) driven by heightened levels of market volatility. This volatility has been caused not by domestic events, but by events overseas that have shaken the global financial marketplace.
To combat this volatility, central banks around the world have stepped-up their easy money policies. As a result, an almost inconceivable amount of global developed market sovereign bonds are trading with negative yields. The table below shows just how much debt global investors are actually paying to own (red means negative rates):
Easy monetary policies and negative global bond yields affect the U.S. bond market in two ways:
- They put pressure on the Fed to avoid raising rates as that may put upward pressure on the U.S. dollar, thereby depressing inflation and hurting exports and economic growth.
- They make our rates attractive for overseas investors, which causes global funds to flow into our bond market and helps support U.S. bond prices.
Given these events and the extraordinary environment we live in, how is SNW positioning portfolios and what do we expect to happen moving forward? In short, our call for a range-bound interest rate environment remains in place. We don’t currently see a compelling reason for bond yields to move appreciably higher or lower in the coming months after what has been a sharp rally thus far in 2016. As we’ve mentioned in prior notes, we think bond investors win in this environment by capturing additional yield in sectors and securities that offer positive fundamental and technical backdrops. In the municipal space, this means overweighting sectors such as housing finance authorities and toll roads. In corporates, it means overweighting bonds issued by financial institutions and select industrial companies. The technical backdrop for taking risk is compelling for short-term bonds, which is why much of our BBB-rated exposure is held in bonds that mature within the next 3-4 years. It also means continuing to focus heavily on credit research and security selection. As we’ve seen with Puerto Rico’s recent default, staying out of the issuers with poor credit fundamentals can be just as important as being in the good ones. We’re working hard on both.
Source: Bloomberg, Fidelity Capital Markets