Reflationary forces dominated the fixed income market as the second quarter ended. A June rate increase (to a range of 1.00% to 1.25% on Fed Funds) by the Federal Reserve, and a rise to the 2.84% level on the 30-year U.S. Treasury led some market participants to believe the long deflationary spell in the U.S. economy was ending. That said, the rate hike combined with dovish language from Fed Chair Yellen kept bond markets guessing. Many analysts interpreted her comments as a “heads up” for a less aggressive Fed stance going forward.
As the graph above shows, the election of President Trump prompted a jump in inflation and growth expectations in the U.S. bond market. Long term interest rates increased nearly 40% during the fourth quarter of 2016. Broad deregulation, a better health system and tax cuts were going to push growth dramatically higher, or so we were told. Washington D.C. remains the capital of dysfunction, however. Under no scenario will one side work with the other, out of fear of a backlash from their base. Nothing gets done, and the economy suffers. Wash, rinse, repeat. So far, 2017 has been no different.
Meanwhile, economies in the Eurozone are finally showing signs of life after a decade of malaise following the financial crisis. This has prompted the European Central Bank (ECB) to consider a halt to its bond buying program, which had driven interest rates below zero in several member nations. The German 10-year bond, for example, which was in negative territory last year, started June at 0.25% but ended at 0.47%. This increase doesn’t look like much, but it equates to a 2% decline in the bond price, which wipes out 8 years of yield at the old rate! As we’ve noted in the past, aggressive easing by the ECB has acted to suppress U.S. interest rates as well. If the interest rate ceiling in the Eurozone continues to rise, we would expect U.S. rates to follow along.
Going forward, we will continue to invest as we have since the financial crisis—with one eye on the economy and one eye on the “leadership” in Washington, including the Federal Reserve. Politics (rather than basic economics) have played a central role in fixed income markets for over a decade. The Fed in particular continues to talk about normalizing rates and reducing their balance sheet. Their actions don’t quite align with their talk, however. So, it looks like the new boss is the same as the old boss. Same as it ever was.