2016 has been a year of surprises. Following the Fed’s long awaited interest rate increase last December, many presumed that it would be the first of several over the coming year in a return to “normalcy”. However, the New Year was ushered in by an unanticipated currency decline in the Chinese renminbi and yet another downdraft in energy prices, the two of which were not completely unrelated. These developments spooked the Fed. In turn the market’s hope for prospective rate hikes, faster growth, a needed whiff of inflation and renewed animal spirits began to wither. Equities suffered a rough first quarter while bonds did well.
Fascination with negative interest rates became heightened during the first half of the year as interest rates on many sovereign bonds approached or pierced the 0% boundary. With central banks buying bonds hand-over-fist, many became resigned to rates being “lower for longer”. In turn, investors moved into riskier assets as they have from time to time during the “risk-on/risk-off” environment that has prevailed throughout this zero rate regime. Stocks had a nice run during the 2nd quarter and bonds tread water right up until the shocking Brexit vote in the UK. The resulting decline in stocks was deep and quick, as was the uptick in bonds. Post Brexit the 10 Year US Treasury bond traded as low as 1.36%, representing a decline of 91 basis points (.91%) from the yield at 2015 year end.
Markets were reasonably calm during Q3, although much deliberation was directed towards monetary policy in both Japan and the US. The Japanese central bank decided that negative interest rates on longer term bonds could be counterproductive and moved to target the yield on their 10 Year bond at 0%. This potentially represented a change in thinking regarding the global wave of central bank-induced bond buying and yields shifted higher before settling back a bit at quarter’s end due to the Fed’s continued hesitance to raise benchmark rates in the US. But there was a sense that the tide may have turned in that, in addition to Japan’s monetary pivot, evidence on wages and productivity hinted ever-so-slightly at a mild and welcome increase in inflation.
In perhaps the biggest surprise of the year, the Republican Party swept to power by holding the House and Senate and winning the White House. Many had expected the unlikely prospect of a Trump victory to roil the markets…and it did for several hours during futures trading late that evening and continuing into the wee hours as Dow futures plunged roughly 900 points or over 4% in value. But by the opening bell on Wednesday stocks were up and climbing, as were bond yields.
Investors quickly focused on campaign promises such as lower taxes, less regulation and higher infrastructure spending, driving stocks higher and bond prices lower. Since the election, the S&P 500 is up about 5% and the 10 Year Treasury bond is up 53 basis points to 2.38% as we write.
So where does all of this leave interest rates? Amazingly, about where we finished 2015! With the Chinese currency shock, a downdraft in oil and Brexit driving rates far below expectation, were the events of 2016 simply an interruption of the path to more normal interest rates? This appears to be a big part of the story. However, the prospect of renewed animal spirits, driven by the potential brew of lower taxes, less regulation and higher infrastructure spending is also a big part of the story.
Markets quickly discount new information and today’s markets reflect optimism that the new administration’s policies will soon become reality with one party in charge of the legislative and executive branches of government. While Republicans may appear to be in the catbird’s seat, we have to remind ourselves that it was only weeks and months ago that the GOP was seen as hopelessly split into factions representing a variety of viewpoints. One faction will resist infrastructure spending as they did in 2009. Another will look to “pay” for some of the tax cuts with entitlement benefit changes which will surely meet resistance. And let’s not forget that the unexpected nature of our election results will have its own ramifications as both the administration and its critics adjust to the new reality.
The slow and gradual path to higher rates is back on track, with the Fed expected to raise rates 2 or 3 times in 2017 (three 25 bps moves would bring the overnight rate to a whopping 1.125%). For bond investors, this may require some adjustments, perhaps a bit less duration, some exposure to TIPS and some diversification into fixed income and global macro alternatives. Over the long haul, we think that moderately higher rates will be good for bond investors, believe it or not, as reinvestment rates increase and the yield curve remains steep.