Bond Market Commentary
Bond Market Commentary
Brexit - A shock but not a crisis
By Douglas Drabik
June 24, 2016
There are plenty of perspectives on the Brexit vote as media outlets bombard the airwaves and internet with how this all will play out. Seeing so many perspectives speaks loudly as to why we are seeing an immediate surge in volatility. Uncertainty creates volatility and opposing viewpoints adds to the unpredictability. Clearly the markets had an immediate reaction but this short-term affect is still largely based on speculation of how this will play out. The long-term consequences are unknown for now and will likely be quite different depending on which perspective you’re considering.
The short-term reaction of uncertainty is a flight to quality, in this case, U.S. Treasuries and gold. This is a continuation of what we were experiencing before the announcement but with a whole lot more momentum. The volatility has been amplified but is nothing new. Treasury prices rallied on the news (yields down). Product spreads have widened, reflecting a broad “risk off” trade. The probability of a rate move by the U.S. central bank (Fed) has actually shifted from a hike to perhaps a more accommodative stance, although the probability of any move is very low all the way through February, 2017. The U.S. markets are tied to the global markets and therefore we may continue to see volatility based on the collective flight to quality; however, the markets are clearly watching and digesting what the next steps may be.
Equity markets took hits across the globe. Europe was down >10% in a single day. The DOW opened down 200 points and continues its anticipated day weakness. From a fixed income perspective, momentous events such as Brexit emphasize the importance of “Knowing What You Own”. With interest rates continuing to fall, investors, more than ever, need to allocate assets appropriately and not find unsuited replacements that don’t substitute for the known cash flow and income taken with fixed income holdings. Substantial pullbacks of 5% or 10% of wealth could take long periods to recover. From a relative basis, U.S. Treasury yields are much higher than global rates and typically investment-grade assets provide much desired credit protection in volatile times.
Many of the global central banks have expressed their willingness to level off market reactions if need be. The Fed is monitoring the markets and will provide liquidity if necessary. U.K. officials will likely enact measures to ease any market turmoil. Bank of England Governor Mark Carney has stated that policy makers are ready to pump 250 billion pounds ($345 billion) into the system, although he believes the U.K. banks will withstand the disorder.
From Britain’s perspective, things will clearly change, but wasn’t that the point? Giving credit to their awareness, the British people were certainly mindful of the potential consequences of their vote. Perhaps the British vote to exit reflects a belief that the benefits of independence from the EU will offset any risks of financial consequences? As Americans, we should be aware that freedom of choice may outweigh financial concerns. Even so, there may be positive financial fallout as well. Certainly, direct taxation via European Union membership will go away. There will be certain trade-offs between negotiating as a combined state to negotiating on their own. It can be argued that it will be more costly to negotiate alone but the counter is that they will be negotiating for the sole benefit of their people, not other nations that happen to be part of the EU.
What we can conclude now is that the short-term affect is a flight to quality. Volatility is likely to remain for the short-term as long as uncertainty prevails. And now, more than perhaps any period in recent history, it is important to know what you own and why you own it. Appropriate asset allocation is essential.
Brexit > Fed (for now)
By Benjamin Streed, CFA
June 20, 2016
Last week’s market movement was a combination of the Fed and recent Brexit (Britain leaving the European Union) polling, both advocating a broad “risk off” trade for world markets. A summary of the Fed’s meeting minutes: the committee skipped raising rates in June as the markets anticipated, but the details surprised the markets as six officials now anticipate one additional hike this year (up from only a single member in March). The group gave a mixed picture of the US economy with such conflicting statements as “the pace of improvement in the labor market has slowed while growth in economic activity appears to have picked up”. They also noted an expectation that labor markets will continue to strengthen and although the housing market has improved business investment remains “soft”. The central bank reaffirmed that interest rates are likely to rise at a “gradual” pace, which now sounds questionable as the major dissenter, Kansas City Fed President Esther George, voting in favor of a pause after advocating for a hike in both March and April. According to the Fed itself, the median projection for the federal funds rate at the end of 2016 remained at 0.875%, implying two quarter-point increases sometime this year (there are four more meetings). Meanwhile, the median long-run projection for the federal funds rate fell to 3.00% from 3.3% in March. The chart below details committee member expectations for the central bank rate. This is colloquially referred to as “the dot plot”. Notice any major change? Hint, it’s in red in the right-hand chart. The dramatic change in expectations from March to June is something to keep an eye on.
Moving across the pond, this week marks one of the first times in recent memory that the markets will not focus their attention on the Fed, but will instead scrutinize every single Brexit poll taken and whether that figure is leaning towards “remain” or “leave”. Generally speaking, the markets over the last few weeks have seen a general “risk off” trend as people across the globe worry over the implications for a Britain-less European Union (EU) and whether it would spell the beginning of the end for the regional economic system. There are varying estimates regarding the severity of a Brexit vote, but the consensus agrees that GDP in the area will likely fall across the board while other fringe states (Spain, Greece and Italy) may then be inclined to follow Britain out the door and be the second, third or even fourth dominos to fall.
Monday morning action has turned positive for risk assets (equities higher, bond yields up) as polls have shifted back down toward 50/50 after having been slightly in favor of a “leave” vote. Estimates from Bloomberg currently show 42% in favor of leaving, 45% “remain” and still 13% undecided. Of course, there’s a pretty wide margin of error in these polls so no real clarity will come until the final count on Thursday. Since the beginning of 2016, as the percentage of “leave” votes have trended upwards US Treasury yields have seen a trend lower with the 10-year note starting at 2.26% and falling as low as 1.57% last week. Has the Treasury market already priced in a Brexit? Any indication that the country will stay in the EU could produce volatility in the Treasury market. We probably should expect a wild week, but at the same time don’t be surprised if it gets choppy as markets continue to sort this out.
Fairytale endings – Central Bank intervention
By Doug Drabik
June 13, 2016
Round and round we go, where we stop nobody knows. Are we riding a children’s carousel but only for real this time? The world economies need a spark. The central banks come to the rescue implementing easing programs, buying securities by the billions and thus pushing money into the markets. This allows banks to loan money out, individuals to borrow and spend on new businesses, services and goods. People fill newly created jobs and employment increases. Existing and new employees make money and feel and/or realize new wealth. They spend money. Companies continue to hire to keep up with the new demand and consumer spending continues to thrive. Corporations profit while banks’ margins improve through money lending and stronger balance sheets. Prices gradually rise, inflation seeks a healthy level, and the nations’ GDPs improve… or not. Somehow the fairytale ending has been rewritten.
Quantitative easing has taken security assets out of the market and put cash back into it; however, after the 2008 financial crisis, depository institutions have implemented higher underwriting standards and changed lending practices. Individuals are not qualified or interested in taking new loans, building businesses or purchasing stuff. Where does all this money go? With interest rates low, taking a chance at appreciation seems a better alternative for many investors versus earning dismal yields. Equity markets provide this alternative despite companies suffering from declining earnings and falling profits. Global interest rates are being forced to low and negative levels. Demand gets pushed to U.S. markets, thus helping to snuff domestic interest rate increases. Many corporations and individuals just sit on cash.
One thing seems clear in these muddied financial waters. It’s not working. The U.S. appeared to be the only economic power showing signs of, albeit slow, steady growth. What should be asked is whether continued central bank manipulation is hampering the free market effect? Low interest rates are designed to spur borrowing and jump start the economy but have zero and negative interest rates spurred nothing more than fear and saving, the opposite of the desired affect?
Like it or not, interest rates have no legs to foster a run in the near future. In addition, continued global central bank manipulation appears to be promoting more fear than stimulation. It may be that interest rates continue to fall and the yield curve continues to flatten. Now, more than ever, may be a dangerous time to reach for yield and/or substitute asset classes for alternative purposes. Although it is changing rapidly, right now we still have slope in the curve and interest rates are relatively attractive versus all global comparisons. Stay the course with core assets in fixed income and total return assets in investor appropriate asset classes. Don’t let life investments have a bad fairytale ending.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.