Various members of the U.S. Federal Reserve and the European Central Bank (ECB) are probably hoarse from all the “jawboning” they’ve been doing. Each group has been busy managing interest rates in their respective domains by talking a good game, rather than actually playing a good game (i.e.; changing policy). Remarkably, the leaders of each group are telling different stories, but the effects on interest rates have been the same. ECB President Mario Draghi says he will do whatever it takes to stave off economic decline, even though the policy measures he’s suggesting aren’t even a viable option at this point. He contemplates buying securitized assets in a fashion similar to the U.S. Fed, but such assets don’t exist yet in the European Union. Still, his insistence that he will take action has reduced interest rates throughout Europe. Fed Chair Janet Yellen, on the other hand, has been doing a lot of talking in an effort to lay the groundwork for higher interest rates in the U.S.
Despite conflicting longer term goals, the short term result of all this talk has been universally lower interest rates. Yields on German, French, Italian and Spanish 10-year bonds were all at multi-year lows at quarter end. Ongoing economic weakness in Europe and geopolitical problems elsewhere also caused excess cash to flow into U.S. Treasuries. This helped the Fed keep rates at low levels even as Quantitative Easing tapered toward zero. Despite dramatically reduced Fed bond buying, the yield on the benchmark 10-year Treasury ended the third quarter 6 basis points lower than where it started, at 2.5 percent. This small decline hid a lot of volatility along the way, however, as yields bounced from 2.33 percent to 2.64 percent at various points during the quarter.*
As with Treasuries, investment grade corporate and municipal bonds continued to perform well. With many investors nervous about buying longer term bonds ahead of a possible interest rate reversal that could trap them with a capital loss, most managers focused on corporate bonds with maturities under 5 years. High quality municipal bonds that might be less vulnerable to a Fed rate hike in 2015 were also popular during the quarter.
At the other end of the quality spectrum, high yield bonds didn’t perform as well. Large outflows of retail money resulted in forced selling by fund managers into a market already short on liquidity. During the first week of August, for example, high yield funds saw over $7 billion of outflows, the largest weekly exodus from the category since 1992. Clearly there’s some nervousness in the credit markets, as investors still have vivid memories of the large losses in subprime credit in 2009.*
Looking toward year end, we expect more of the same from both the ECB and the Fed. Europe remains moribund, so Draghi will continue to promise massive accommodation in hopes that he can buy enough time to convince Germany that real action is warranted. With growth in the U.S. continuing to improve, the last thing Janet Yellen wants is to upset the continuity of bullish thought with a carelessly placed comment or two. Interest rates in the U.S. will likely remain low until the Fed is certain any rate rise will not reverse ongoing positive trends.
*Data from Bloomberg LLC