Asset Class: U.S. Fixed Income

July 2018 Fixed Income Market Update

Economic and market perspective

Tariffs and fears of protectionism reappeared at the end of May as the Trump administration let waivers on steel and aluminum tariffs lapse for U.S. allies. This theme continued in June as the U.S. and China resumed their earlier escalation of tariffs with the U.S. imposing tariffs on $50 billion worth of Chinese goods beginning in July. China threatened tariffs on a similar amount of U.S. goods, prompting the Trump administration to announce tariffs on another $200 billion of Chinese products with an additional $200 billion to follow if China retaliated. The expected impact to U.S. GDP if tariffs are fully implement is expected to be modest, with some estimates as low as 0.1%, but meaningfully higher to Chinese GDP. Though the direct impacts to the U.S. economy may be modest, market concerns center on the escalation of tensions, the broader impacts of protectionism and the volatility associated with policy uncertainty.

The Organization of the Petroleum Exporting Countries (OPEC) met during June and announced an agreement to increase production in response to concerns surrounding rising oil prices this year. Countries reduced production more than expected after the 2016 deal; this reduction was largely due to turmoil in Venezuela, where production has shrunk meaningfully. This new arrangement is expected to add 600,000 to 800,000 barrels a day of production, less than the one million barrels a day that had been rumored. Also in the month, the U.S. State Department indicated that Iranian oil purchases must end by early November, reducing a potential source of production. Oil prices rose over 10% during the month, closing at $74 per barrel.

In mid-June, the European Central Bank (ECB) announced that it would reduce its purchases of new securities beginning in September 2018 contingent on data affirming its medium term inflation outlook. The plan calls for monthly purchases to decline from the current level of €30 billion a month to €15 billion in September and cease completely at the end of the year. Since the quantitative easing program began in 2015, the ECB has amassed over €2.4 trillion on its balance sheet. As part of the announcement, the ECB indicated that it does not expect to increase rates in the region until mid-2019.

At the June 12-13 meeting of Federal Open Market Committee, the FOMC raised the Fed Funds rate by 25 basis points to a new range of 1.75-2.00%, in line with market expectations. The hike was the second of the year and the seventh in the current cycle. Of note, several changes were made in FOMC language, including upgrading economic growth to “solid” from “moderate” and removing the long-held statement that “the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.” The aggregation of views of the individual members (including seven not voting on the FOMC this year) captured in the ‘dot plot’ show a narrow majority of eight Fed members believing the Fed will hike two or more times this year (with one projection for three times) and seven believing the Fed will hike one additional time (five members) or no additional times (two members.) The combination of the language changes and updated dot plot have been interpreted as a marginally more hawkish stance from the Fed. The market is not projecting a hike for the July 31/August 1 meeting, but projecting approximately a 75% chance of an additional hike at the September 25-26 meeting.

 

Outlook and conclusions

In our view, the second quarter continued many of the key themes seen in the first quarter: improving economic fundamentals against a turbulent policy backdrop, with increasing interest rates having multiple secondary effects. Economic data in the U.S. remained robust, even strengthening in areas such as unemployment, which tied the lowest levels since 1969. Stronger data contributed to rates moving higher, though in both the first and second quarters, rates rose before varying degrees of volatility and risk-off sentiment brought yields off their peak levels. Whether policy induced, such as fears surrounding tariffs and their potentially far-reaching effects, or from direct fears around the higher rates, market volatility has risen, contributing to generally wider spreads for risk assets. While these reactions contributed to interest rates on longer maturity Treasuries declining from intra-quarter peaks, the Fed has continued to raise the Fed Funds Rate, leading to continued flattening of the yield curve. This flattening and the increase in volatility are worth monitoring; at the same time, economic fundamentals remain strong and the combination of higher Treasury rates and wider spreads has led to the most attractive yields on broad bond benchmarks since 2010.

 

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