Although the Federal Reserve raised the fed funds rate target by 0.25% again in December, the real driver of higher interest rates since the election has been the notion that increased fiscal spending and tax cuts will drive up the deficit, causing Treasury issuance and interest rates to rise.
Eight years after the Great Recession, the entities exerting the most influence on economic growth have perhaps begun to change. The baton is being passed from central bankers to the executive and legislative branches of government. After years of monitoring what the Fed does, the focus is now moving to policy makers. For example, strict government oversight following the collapse of Lehman Brothers in 2008 may soon give way to less restrictive policies when it comes to the energy and financial sectors. Likewise, inflation has finally begun to percolate and move very close to the Federal Reserve’s 2% target, making the Fed less likely to engage in aggressive monetary policy change.
Investors have grown quite optimistic that economic growth will finally accelerate past the anemic 1%-2% rate that has prevailed over the past several years. However, the Fed may be placed in the awkward position of having to tamp-down optimism for fear that excessive fiscal stimulus, tax cuts, and deregulation might cause the economy to grow at such a high rate that the Fed’s 2% inflation target could be exceeded.
Although the Federal Reserve raised the fed funds rate target by 0.25% again in December, the real driver of higher interest rates since the election has been the notion that increased fiscal spending and tax cuts will drive up the deficit, causing Treasury issuance and interest rates to rise. Going into the presidential election, the bond market was priced for a Clinton win, projecting another eight years of 2% annualized GDP growth.
On election night, investors went to bed with a tortoise and woke up with a hare. The election results turned the bond market on its head. The initial thought was that if Trump won, rates would drop to 1.50% and the stock market would tumble 10%. Indeed, that was the initial response for about two hours. But the fear trade quickly reversed when investors realized that lower taxes, increased fiscal spending, and decreased regulation might invigorate economic growth.
Much of the interest rate jump of the fourth quarter reflects the notion that President-elect Trump’s initiatives, if successful, could push annual GDP growth as high as 4% but at the expense of a wider budget deficit and higher interest rates. Such an environment would necessitate a fed funds rate of as high as 2%-3%, much higher than the current level of 50- 75 basis points. The Fed would have to quickly ramp up the fed funds rate should economic growth explode. These concerns moved the yield on the 10-year Treasury from 1.70% on the day before the election to as high as 2.60% before year end.
The yield on the 10-year Treasury began the year at 2.24%. The low was 1.37% reached in July following the U.K.’s vote to leave the Eurozone. After Brexit, yields rose to 1.70% immediately before the presidential election. After the November 8 election, the yield on the 10-year Treasury moved 75 basis points higher, ending the year at 2.44%. While a 75 basis point jump may not seem like much, it was a significant drop in terms of dollar price – i.e., the price on the 10-year Treasury dropped from $99.50 to $96.09, a decline of 3.43%.
Although the Fed has begun slowly tightening U.S. monetary policy, there is still a great deal of quantitative easing taking place around the world, particularly in Japan and the Eurozone. As a result, the yield on international bonds will continue to limit the increase in U.S. rates in 2017. Yields in the U.S. look attractive to foreign investors, compelling them to buy U.S. bonds. The 10-year German bund currently yields approximately 0.27% and the Japanese 10-year yields 0.05%. While these yields have finally pushed into positive territory, the yield differential with the U.S., which is usually around 1.50%, is now over 2.00%, making U.S. Treasuries quite compelling for foreign investors.
Corporate bond performance was strong on a relative basis in 2016. Even though benchmark interest rates (i.e., Treasury yields) increase in an environment where stronger economic growth and rising inflation are anticipated, such an environment also increases a corporation’s ability to repay its debt based on stronger earnings, allowing credit spreads to tighten.
When optimism about economic growth suddenly surges, low quality investments typically rally the most. Bonds with the lowest credit rating enjoy the most spread compression and the highest total return. Credit spreads ended 2016 near the tightest level in approximately two years. In contrast, when the year began, spreads were at their widest level since 2012 on the investment-grade side and at their widest since 2008-2009 on the high yield side. Thanks mostly to their rally in November and December, high yield bonds actually outperformed stocks in 2016. The Barclays High Yield Bond Index returned 17.18% while the S&P 500 Index returned “only” 11.93%. Single B-rated bonds returned 15.81% and triple C-rated bonds returned 31.50%!
Corporate issuance was $1.6 trillion in 2016, another record level, and much of the same is anticipated in 2017. January is typically the heaviest month of the year for new issuance, so it will give us an idea of how the remainder of the year might go.
The yield on the 10-year AAA general obligation bond started the fourth quarter at 1.51% and ended the year at 2.31%, up 80 basis points. While municipals sold off in line with the Treasury market, the selloff accelerated after the election as investors rotated out of municipal bond funds and into the equity market. By the end of November, the municipal market was oversold and municipal ratios were well north of 100% of Treasuries. Once investors realized the extent of the rotation, they bought back municipal bonds and municipal yields ended the year at 97% of Treasuries.
Tax-exempt bonds had a rough fourth quarter versus Treasury bonds because President-elect Trump is expected to propose cuts to the top marginal income tax rates. Individuals are the largest buyers of municipals bonds so, all things equal, a decrease in the highest marginal personal tax rate leads to a decrease in demand for municipal bonds and an increase in yields. On a more positive note, Trump’s intent to increase infrastructure spending could help the performance of tax-free municipal bonds to the extent federal spending on infrastructure projects reduces spending that might otherwise be required at the local level.
The Bank of America Merrill Lynch 10- year AAA-A Municipal Bond Index ended the year with a total return of negative five basis points, the only negative return since the index’s inception in 1997. The next worse year was a 12-basis point return in 1999. BBVA Compass Global Wealth has always benchmarked its tax-exempt bond portfolios off of an index that is shorter in duration than the benchmarks used by most other municipal bond funds/managers. The current environment is a good example of those times when a short duration benchmark is most helpful. The longer end of the muni yield curve had a very difficult fourth quarter, and, therefore, a rough year.
We anticipate that the path to higher interest rates could be more linear in 2017 given the expected stream of Fed rate hikes and fiscal stimulus initiatives.
We anticipate that the yield on the 10-year Treasury will approach 3.00% by the end of 2017. The yield on the bellwether bond closed at 3.03% in 2013, so the bond market may simply retrace its steps. However, we anticipate that the path to higher rates could be more linear in 2017 given the expected stream of Fed rate hikes and fiscal stimulus. For the last two years, rates have risen in the fourth quarter, only to go right back down in the first quarter. That pattern could repeat again in 2017. However, given the stimulative vibe from the new administration and Congress, it seems a little less likely. Certainly, the anticipation of stimulus measures should limit the amount by which interest rates can drop. Should we get some weaker data in the first quarter, the bond market may very well sit flat as opposed to rallying like it has done in the last two years.
The Treasury yield curve steepened during the fourth quarter in what can be described as a “bear steepener” – i.e., a bond market marked by higher overall interest rates and an increased spread between long-term and short- term interest rates. Long rates are more influenced by inflation than short rates which are influenced more by Fed policy. Inflation expectations increased in the fourth quarter based on prospects for accelerating growth under the Trump administration. Therefore, long-term yields moved higher at a faster rate than short-term yields, causing the yield curve to steepen.
If investor thinking is “off sides” at the moment, it is likely on the short end of the yield curve where the market has not fully priced-in the number of rate hikes that the Fed is projecting. While the yield curve has steepened since the election, we do not expect the steepening to continue. Investors will eventually “ catch up” with the Fed and inflation expectations will likely recede a bit as stimulative initiatives fail to live up to the hype.
That said, curve flattening could accelerate if the Fed begins hiking rates without inflation moving much above current levels. If the curve unexpectedly steepens, it could be because investors choose to reallocate into equities and do so by selling 10-year bonds. The long end of the yield curve (10-year) is considered a parking place for global wealth and a source of funds when tactical asset allocation changes are implemented. Given that prospects for the bond market in 2017 are not great while stronger economic growth might improve corporate earnings, it is possible that pension plans and other global institutional investment pools rebalance in favor of equities to start off the year. If so, the curve could steepen by way of long-term yields rising.
Similarly, technical cash flows in the retail sector began to affect other parts of the bond market a few weeks ago. Cash flows out of bond funds turned negative for the first time in years as retail investors began to shift assets from the bond market to the equity market. As retail investors sell shares of bond mutual funds, fund managers must sell bonds in order to provide liquidity for redemptions, causing forced selling. In a forced selling environment, the first bonds sold are often the most liquid (high credit quality, large issue size) while the last bonds sold are often the most illiquid bonds (low credit quality, small issue size). This imbalance works itself out over time as the pace of bond mutual fund redemptions slows, but it can take weeks or even months to resolve itself, leading to a period of underperformance for high quality bond portfolios. Regardless, high quality bonds remain an important risk mitigator for equity holdings and other higher volatility investments.
Economic growth (GDP) should continue to improve in 2017, perhaps even reaching an annualized rate of 3.0%, although BBVA Research is currently projecting a rate of 2.30%. Monthly payroll gains could surge to as high as 200,000. The pace of acceleration will ultimately depend on which stimulative measures get past the deficit hawks in Congress. Terrorism will also play a role in 2017 – more terrorism means lower interest rates and subdued growth, all other things equal. The Fed has said that a 3.0% Fed funds rate is “neutral” such that a rate below that threshold is stimulative and a rate above that threshold is restrictive. If Trump’s initiatives are successful (i.e., growth accelerates to 3.0%), then the bond market could prove to be self-correcting in that higher interest rates would lead to reduced borrowing that would ultimately slow GDP growth and lower interest rates.
Assuming growth accelerates above its current pace in 2017, it is difficult to see how corporate bonds underperform Treasuries. There is plenty of room for credit spreads to tighten even more, especially in the finance sector. Issuance should remain steady and even rise if capital spending increases. Historically, increased supply has widened spreads, but that has not been the case in this cycle. The market has more than digested the bonds that come to market because the demand for yield is so great. However, as yields rise and investors are able to attain a comfortable level of yield on high quality bonds, look for a rotation from lower quality bonds to higher quality bonds to ensue.
In addition to the threat of lower marginal tax rates, one headwind for the municipal market in 2017 is headline risk due to state pensions being underfunded. Otherwise, demand should remain very steady. Every time there is a selloff, buyers emerge to gobble up available bonds and that trend is expected to continue.
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This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.
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Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes:
S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), BofA Merrill Lynch U.S. Treasuries 1-10 years, BofA Merrill Lynch U.S. Agencies 1-10 years, BofA Merrill Lynch U.S. Corporates 1-10 years A-AAA, BofA Merrill Lynch U.S. Municipals 1-10 years A-AAA, Russell Top 200 Index, Russell 1000 Index, Russell Midcap Index, Russell 2500 Index, Russell 2000 Index, Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).