Asset Management: Fixed Income Insights

April 2017 Fixed Income Market Update

april-2017-tch-fixed-income-insights

The bill to repeal and replace Obamacare was pulled from the House floor on March 24th when it became clear it would not pass due to dissent within the Republican party. As the first major legislative initiative for Republicans since their sweeping victory in last year’s elections, its failure called into question the ability to pass other significant legislation. While health care reform did not secure sufficient votes, other agenda points such as personal and corporate tax reform are likely to draw greater party-line support and a fiscal stimulus package could potentially appeal to Democrats as well.

Effective March 29, United Kingdom Prime Minister Theresa May officially triggered Article 50 of the Lisbon Treaty. This action began the formal two year negotiation process for the U.K. to leave the European Union, almost nine months after the “Brexit” vote at the end of June 2016. The U.K. is the first member of the union to depart. The E.U. is balancing the desire for a productive trade agreement with the world’s sixth largest economy with the goal of disincentivizing other member nations from departing the union. Part of a recent broader global trend, in February, inflation in the U.K. rose 2.3% for the trailing twelve months. The increase was the highest level since 2013 and core inflation hit 2.0% for the first time since 2014. The Bank of England’s target for inflation is 2.0%.

Dutch elections were closely watched for signs of populism’s strength in Europe. Instead of continuing the wave of global populism, incumbent Prime Minister Mark Rutte’s Party for Freedom and Democracy defeated Geert Wilders’ Freedom Party, winning 33 seats to 20. Wilders was unlikely to be able to form a government even had he won more seats than Rutte, but the defeat was more pronounced than most had expected.

North Korea test fired multiple missiles into the Sea of Japan in the beginning of March. Three of the missiles landed in Japan’s exclusive economic zone, prompting Japan to move to its highest military alert. Prime Minister Shinzo Abe said that the missile launches “demonstrate evidence of a new threat from North Korea.”

The Fed raised the Federal Funds rate range by 25 basis points at their March 14-15 meeting to a range of 0.75% to 1.00%. The move came as no surprise with Fed Funds Futures pricing in above a 90% likelihood of a rate hike after Chair Yellen delivered a speech to the Executives’ Club of Chicago in early March. In that speech she stated that if economic indicators continued to meet expectations a “further adjustment of the federal funds rate would likely be appropriate.”

The Fed released its newest ‘dot plot,’ summarizing the expectations of Fed Governors for the Fed Funds rate at future dates. There was no change in the projection, which called for two additional hikes this year, three in 2018 and a longrun level of 3.0%. Federal Reserve Vice Chairman Stanley Fischer reinforced the call for two additional rate hikes in a March 28 interview, saying it “seems about right.” At the end of the month, Boston Fed President Eric Rosengren and San Francisco Fed President John Williams hinted that a fourth hike in 2017 was a possibility.

Federal Reserve Bank of Cleveland President Loretta Mester, in a speech on March 23, indicated that “if economic conditions evolve as I anticipate, I would be comfortable changing our reinvestment policy this year.” Her views on the reinvestment of maturing principal from the Fed’s $4.5 trillion balance sheet follows on the FOMC’s statement from this month’s meeting when they began discussing the eventual wind-down of the balance sheet, though offering no concrete details.

In our view, the Fed capitalized on market confidence and excitement surrounding increased growth expectation to deliver a rate hike they wish they could have delivered sooner. After two years of one hike each, the Fed appears to be testing market sentiment on how to further extricate themselves from an exceptionally accommodative policy. Reaction to date suggests fixed income markets were comfortable with the move and may allow the Fed a further window to act, though the Fed’s projected terminal point remains unchanged. A high level of positive economic news appears priced into U.S. markets, heightening the possibility of disappointment. The Republican setback on healthcare reform demonstrates the difficulty in treating recent policy proposals as a fait accompli and a reminder that legislative and fiscal policy are unlikely to be a panacea. Nonetheless, U.S. consumer confidence and global inflation have rebounded sharply, maintaining the positive backdrop for non-governmental sectors of U.S. fixed income.

 

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