Economic Review 2Q 2016
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.
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.
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.
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.
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.