Asset Class: U.S. Fixed Income

January 2019 Fixed Income Market Update

The United States Capitol building

Economic and market perspective

The decline in U.S. stocks reflected fading risk sentiment broadly. While magnified by fundamental factors, oil captured the same trend, falling to $45 a barrel from $51 at the end of November and $73 at the start of the quarter. Declining energy prices, which impacted November’s inflation readings, are likely to continue impacting headline inflation in the coming months.

The arrest of Huawei Technologies Co. Chief Financial Officer Meng Wanzhou contributed to market fears in the month. Huawei is a significant Chinese company and the arrest raised concerns that trade relations between the U.S. and China were worsening rather than improving after the temporary arrangement reached at the G20 in late November. Against the backdrop of trade tensions, economic data in China continued to weaken. Chinese retail sales in November grew at the slowest pace since 2003 and failed to meet expectations. The Chinese government has indicated it will increase ‘countercyclical’ measures, including fiscal and monetary policy to support their economy.

Adding to tensions, the U.S. government partially shut down on December 23 as Congress and President Trump did not agree on terms to pass the next budget. The House (under Republican control at the time) passed a budget in line with the President’s request for funds to build a border wall; however, Senate Democrats have indicated they would not support this version of the budget. Though the shutdown is only partial and already the third government shutdown of 2018, given the entrenched positions on funding for the border wall, there is concern this shutdown could last longer than previous ones.

As expected, at its early December meeting, the European Central Bank (ECB) announced it would officially end its purchase of new assets at the end of December 2018. The ECB will continue to reinvest the principal of maturing assets, which will maintain its roughly €4.7 trillion in assets, at least until it begins raising interest rates. The ECB balance sheet is equivalent to approximately 40% of Eurozone GDP, approximately double the Fed’s balance sheet size relative to the U.S. economy. At the same time as ending active buying, Draghi indicated that while risk were roughly balanced, “the balance of risk is moving to the downside owing to the persistence of uncertainties related to geopolitical factors, the threat of protectionism, vulnerabilities in emerging markets and financial market volatility.” Political uncertainty has increased in Europe with the ‘yellow vests movement’ and riots in France and the lack of progress on Brexit.

The Federal Open Market Committee met on December 18-19th and announced a 25 basis point increase in the Fed Funds Rate, in line with expectations. The rate hike was the fourth hike of the year and ninth of the current cycle. The new range for the Fed Funds Rate to a range is 2.25% – 2.50%. The Fed referred to strong economic fundamentals, lowered inflation expectations for the upcoming year, but decreased their expectation of rate hikes in 2019 to two from three. The Fed’s ‘dot plot’, which shares the anonymous expectations of individual Fed members, revealed a lower median level for long term neutral rates at 2.8% versus 3.0% in the last dot plot. However, Chairman Powell seemed to downplay the chances of slowing or altering the pace of the wind-down of the balance sheet and did affirm that additional rate hikes could be warranted. Despite the adjustments, the market was expecting more dovish language than the Fed delivered.

Subsequent to the meeting, rumors emerged that President Trump intended to fire Chairman Powell. The president has frequently criticized the Fed Chair, who he had nominated just over a year ago. The rumor and recent market volatility prompted Treasury Secretary Mnuchin to call the heads of the six largest U.S. banks to assess the state of the financial system. Mnuchin also denied President Trump would fire the Fed Chairman, including questioning his legal ability to do so.

Outlook and conclusions

In our view, the fading of risk sentiment was already disproportionate to economic fundamentals coming into December before market fear accelerated in the month. U.S. economic data has remained robust though consensus expectations are for slowing, but positive growth. Factors that in a vacuum might have been interpreted more neutrally, such as the Fed’s language surrounding the rate hike, have been viewed more negatively given the number of factors causing market concerns. With an already shaky equity market, trade tensions, political concerns overseas, deteriorating international growth, and a partial U.S. government shutdown, each marginal factors has increasingly impacted investor behavior. Recent market volatility and positive fixed income returns during the month demonstrate the defensiveness of the fixed income, while widening spreads have enhanced total return opportunities within the asset class. As markets sort through numerous geopolitical, monetary policy and fundamental economic developments, the likelihood of additional volatility remains elevated and further deterioration of risk sentiment is possible before markets calm. Nonetheless, the opportunity set in non governmental fixed income is robust and overall yields for broad U.S. fixed income at 3.3% are at the highest levels to begin a year in almost a decade.

 

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