For the first quarter, the Barclays Aggregate Bond Index had a higher return (3.03%) than it did in two of the three previous years. Considering the index’s yield entering the year of 2.59%, the first quarter delivered a rather large return and yet another setback for the chorus of bond bears.
A new year begins
A summary of the first quarter suggests a sleepy quarter, yet, it was anything but. Option adjusted spreads on the corporate debt moved tighter by a single basis point to 164, the S&P 500 rose less than a percent and oil rose about $1 a barrel. These metrics, however, mask the nasty start to the year for everything but Treasuries. Setting new lows daily, oil fell to $26/ barrel (-37%), equities entered correction territory briefly with the S&P falling greater than 10%, and corporate spreads widened to 215 mid-February. During this period, combining the market fear with uncertainty and discomfort regarding negative interest rates, speculation began around the European banking system’s ability to generate profits in a negative interest rate environment, markets seemed on the precipice of a downward spiral.
And yet, in a matter a days and without a concrete catalyst, investors’ concerns faded and equities and oil rose sharply, fears of financial contagion was nearly forgotten and credit spreads tightened quickly. In April, corporate spreads tightened to 146 basis points and oil rose nearly 20%.
But not the rates
As expected, with market sentiment plummeting, interest rates in the U.S. fell sharply in the early part of the quarter. However, as markets broadly recovered from mid-February through the end of the quarter, U.S. interest rates rose only modestly from their intraperiod lows, uncharacteristic of such a period. One of the factors that needs to be examined to understand this phenomenon is cumulative impacts of global central bank policy and changes set forth in the first quarter.
In terms of U.S. monetary policy, only the aggregate projections of Fed governors, i.e. the ‘dot plot’ changed during the period. The dot plot had called for four rate hikes in 2016, a number we referred to as ‘aspirational’ in our prior quarterly piece, which was lowered at the March meeting to only two for this year. Subsequently, individual Fed members voiced their opinions seeming to hint at a more hawkish bent, before ultimately being trumped by Chair Yellen who said during a speech that it was “appropriate for the Committee to proceed cautiously in adjusting policy.” At the April meeting, the Fed was modestly more hawkish, softening some of the language about global concerns and highlighting strengthening labor market conditions.
For all the aims of transparency, the openness of the Fed and the statements of various individual members has at times sent mixed messages. Given the significant role of monetary policy in financial markets since 2008, it makes sense that greater transparency has been sought from central banks, but whether delivering that transparency is beneficial to markets is another question.
A recent anecdote, a routine flight on an airplane highlighted that other side of transparency. Presumably, after years of hearing passengers complaining of being left on the runway with no information, our captain opted for more transparency. He informed the passengers over the public announcement system that the wing is missing a part and that we would need to locate a replacement before taking off. Upon locating the part, he then announced that the appropriate mechanic needed to be found. This much lionized transparency led to wild passenger speculation and loud gasps at every hint of turbulence during the flight. Perhaps all the repairs were completed expertly, but it felt like the most turbulent flight in years.
For all the pleas for information, the passengers did not seem to really want all the details. At the end of the day, most of them seemed to want to trust the pilot to fly them safely. While the analogy to the Fed is imprecise, the attempts to divine the Fed’s intentions from each Fed governor’s unofficial remarks feels as if it is adding to, as opposed to diminishing, volatility. With the significance of the Fed’s role in today’s investment environment, the appeal of transparency is understandable, but perhaps a translucent Fed would make for a smoother flight.
The limits of ‘no limits’
Calming markets has been the objective of Mario Draghi, president of the European Central Bank (ECB), as well. In December, he successfully, if temporarily, assuaged markets with the promise of ‘no limits’ to ECB action after markets failed to respond as hoped to a December ECB meeting. Markets had been disappointed at that meeting, despite that the central bank delivered an expansion of quantitative easing (QE) and a cut in the deposit rate further into negative territory. Seemingly unwilling to disappoint markets again, the ECB delivered a massive easing package in March. Draghi announced a further lowering of the deposit rate, further expanding QE in terms of total Euros, and expanding the eligible assets to include corporate debt. This package, significantly in excess of expectations in depth and breadth, led first to a strong rally, but then reversed when Draghi announced that the ECB was approaching the limits of its negative interest rate policy (NIRP). While seemingly certain that there were, in fact, limits, the announcement was disappointing to markets growing accustomed to the dissolving boundaries of monetary policy.
Whatever the immediate market reaction, in our view this package was of immense significance. Importantly, for U.S. investors, it furthers the substitution effect, whereby non-U.S. investors buy substantially similar risk-free assets for the significantly higher yields offered in the U.S. That process has been ongoing and this most recent package enhances the appeal of U.S. debt. But perhaps more importantly, the new ECB package expands the concept of substitution more directly to the corporate credit universe.
Interestingly, corporate debt is, in a way, more fungible than rates since multi-national corporations are more likely to shop for locations to issue debt between jurisdictions, while major developed market sovereigns are more likely to issue in their local currency. The ECB action then does not only increase the global appetite for corporate debt, but is also likely to attract multi-national corporations to issue debt into their region. One of the factors we have viewed as a headwind to credit spread tightening has been the record issuance, which has been keeping supply high, but if corporations do, in a serious way, begin to location shop to benefit from ECB-supported lower rates and spreads, this may increase issuance in lower yielding areas, alleviating issuance pressure in the US.
Whither go negative rates
In the first quarter, an astounding $7 trillion worth of debt was trading with negative yields and nearly 40% of sovereign debt issued by G7 countries carried a negative yield. Berlin Hyp, a German bank, issued the first covered bond at a negative yield in March, joining troves of already issued covered bonds in negative interest territory. Royal Dutch Shell Plc, Siemens AG and Sanofi were among the first European corporates to see their bonds trade with yields below zero.
While the ECB has not been timid in regularly reminding anyone who will listen that they believe countries should use the cover of monetary policy to enact the structural reforms needed, it will be interesting to observe if the most recent round of ECB actions creates its own structural reform of sorts in the European financial system. Historically, the European corporate debt market has not been as robust as the U.S. system and it is worth considering the impact of a massive new buyer in the space. Will it enhance a corporate debt system as corporations utilize the capital markets to a greater degree or will the ability to absorb issuance with little discrimination by the central bank withdraw liquidity from the system?
Even in comparison to the magnitude of the Fed and the ECB, the Bank of Japan’s (BOJ) monetary policy is sui generis. Due to a massive quantitative easing program, the BOJ owns roughly one third of all Japanese government debt. Despite being the most indebted nation in the world, the program has driven 70% of Japanese government debt into negative territory. In March, the government issued 10 year bonds with negative yields. For a country spending 10.5% of its budget on debt service (the U.S. is 6% by comparison) and suffering from low growth and worse demographic trends, perhaps being paid to borrow money is the only solution to managing debt service costs. If negative rates were to be adopted as a means to finance deficits, it would bode poorly for an exit from NIRP.
Any desire for a diminished role of monetary policy in world economies continues to be wishful thinking. The economic morass in Europe and Japan have led to a magnitude and trajectory of policy for the ECB and BOJ that have made the Fed’s task of normalizing policy more difficult. The first hints of inflation appearing in the U.S. are yet unlikely to force the Fed’s hand on speeding rate hikes as the Fed considers the other potential consequences, such as currency strength and the fear that the weight of global slow growth will pull the U.S. economy down as well.
These economic and monetary policy considerations lead to our view remaining that the Fed, by desire or not, remains more patient than had long been assumed. After the combination of flight-to-quality and global monetary policy drove Treasury yields significantly lower in in the first quarter, the likely drivers of fixed income returns looking forward reside in the non-governmental sectors. While the credit cycle is no doubt maturing, relative to the initiation of past Fed tightening cycles, investment grade credit spreads were both wider and presenting steeper credit curves. This situation suggests a positive backdrop for the credit space. The significant volatility in credit spreads and interest rates during the first quarter highlighted how quickly markets can turn and further highlights the difficulty in timing markets. In the wake of the turmoil of 2015 and the January/ February period of 2016, opportunity exists in capturing those sectors and securities that were most mispriced, while we expect the global situation and relative U.S. economic leadership to support high quality U.S. fixed income more broadly, including mortgage backed securities (MBS) and credit.
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