Asset Management: Fixed Income Insights

May 2017 Fixed Income Market Update

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The United States launched airstrikes against Syrian air bases following the Syrian government’s use of chemical weapons against civilians. Also in April, tensions with North Korea rose following several additional missile tests and the annual military parade. President Trump invited the full senate for a classified briefing regarding the threat from North Korea. North Korea launched additional missile tests on April 28th, which have been judged as failures.

The Trump administration announced its plan for one of the president’s key campaign initiatives: tax reform. The proposal includes lowering corporate taxes to 15% from 35% and shifting to a territorial tax system from the current citizenship based system. Changes to personal income taxes include reducing the number of brackets and lowering marginal rates, while eliminating many tax breaks and increasing the standard deduction. The announcement is generally viewed as the framework for negotiations rather than a formal proposal.

The first round of French presidential elections was held on April 23rd. Markets responded positively to the first place finish of independent Emmanuel Macron and the inclusion of only one of the two non-mainstream candidates. Marine Le Pen from the National Front received the second highest number of votes and will advance to the second round on May 7th as well. Ms. Le Pen has advocated a referendum on E.U. membership, immigration restrictions and a broadly “France First” agenda. Left wing Jean-Luc Melenchon, the other non-mainstream candidate seeking to capitalize on the global populist trend, narrowly missed the final round of elections. Centrist Mr. Macron is a significant favorite to beat Le Pen, with current polling showing him having a nearly 20 point advantage.

European inflation rose to a 1.9% annualized rate in April. Core inflation rose 1.2%, the largest increase in nearly four years. The European Central Bank (ECB) met in April, but announced no policy changes while acknowledging progress on inflation and other economic measures in Eurozone. Eurozone Purchasing Managers’ Index (PMI) for manufacturing and services increased to 56.7 in April, which is the highest level in six years. Given the improving inflation and other data, speculation has increased that the ECB will announce a further reduction in its quantitative easing program at its next meeting.

On April 5, the Fed released minutes from its March 14-15 meeting, when it raised the Fed Funds by 25 basis points. Of note, the Fed appeared to begin conversations around the eventual wind down of its $4.5 trillion balance sheet. Though multiple scenarios were discussed, “participants agreed that reductions in the Federal Reserve’s securities holdings should be gradual and predictable, and accomplished primarily by phasing out reinvestments of principal received from those holdings.” Further, “participants generally preferred to phase out or cease reinvestments of both Treasury securities and agency MBS,” as opposed to only one of the two sectors.

In response to a question as to whether two additional rate hikes in 2017 were still warranted, Federal Reserve Vice Chairman Stanley Fischer said, “we’re feeling that way and so far haven’t seen anything to change that.” The Fed’s next meeting runs from May 2 – 3 with limited expectations of any additional increase in rates (5% implied probability as of April month end Fed Fund futures.) The following meeting is June 13-14 and the market is currently projecting approximately a 60% chance of a rate hike for that meeting.

In our view, the slowing of the reflation trade in March and April has been a natural calming of the early market excitement surrounding the new president’s policy proposals. Waning exuberance has coincided with an uptick in foreign policy tensions, moderating short term U.S. economic data and increasing expectations of policy adjustments from major central banks. While all these factors bear monitoring, U.S. fixed income markets have absorbed these developments relatively well to date and they do not yet suggest a meaningful change in outlook. While first quarter GDP is most likely an outlier, we expect caution from the Fed should weaker data persist. The stimulative impact of tax reform to the real economy is likely months away, but progress on the initiative could improve sentiment further. Should either foreign policy tensions rise or French election results surprise, U.S. fixed income would be the likely beneficiary. Absent either, the asset class is still well positioned for the current environment with yields near recent highs.

 

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