PMC Weekly Review - December 16, 2016
There was very little suspense going into this week’s Federal Open Market Committee (FOMC) meeting, much the same as a year ago when the Fed made the first interest rate hike since the financial crisis. Global financial markets had priced in a 100% chance of a rate hike this week, and Chair Yellen did not disappoint. However, the announcement of the expectation for three further hikes in 2017, rather than two, did surprise most market observers, and global markets reacted sharply. U.S. Treasury rates jumped, the dollar strengthened (particularly against emerging market (EM) currencies), and oil prices fell (a stronger dollar makes oil more expensive). US equity markets had a temporary setback in their seven-week run since the election, but rebounded on Thursday to pre-announcement levels.
A number of similarities exist between the Fed hikes last year and this year. The market had widely anticipated the Fed to move earlier in both years, only to be told the data didn’t support an increase until the final meeting of the year. In 2015, the ratesensitive 2-year note hovered between 50 and 75 basis points (bps) in yield until November, when it began a steady climb to a high of 109 just before year-end.1 This year, the 2-year bounced back and forth between 50 and 90 basis points until early November, when it began a steady climb from 80 basis points to 1.27% by mid-December. In both years, gross domestic product (GDP) growth was miserable in the first six months before rebounding in the second half of the year, leading to the Fed’s comfort with raising rates. However, valuations and the underlying credit conditions are substantially different today than a year ago, which likely will lead to a dramatically different investor experience in 2017 compared to this year.
In the fourth quarter of 2015, the price of oil was in the process of falling from just over $50 a barrel to an eventual low of $36.70. Other commodity prices, such as coal and copper, also were falling on lower estimates of global demand. This created a “risk-off” environment in the credit markets, and single-A corporate spreads widened from less than 100bps in early 2015 to 121 at the end of the year, 2 while high yield spreads ended the year at 660 basis points, more than 200 basis points higher than the tightest levels of the year. Not surprisingly, both the investment grade credit and the high yield credit indices turned in sharply negative returns for the year.3 The Fed hike was just icing on the cake for 2015. However, this set the credit markets up for what would turn out to be a well-above-average year in 2016. After some initial weakness in the first quarter, both indices rebounded nicely. As of December 14, the high yield index is up 16.9% for the year, as spreads have fallen to just 401 basis points, a level not seen since September of 2014. The A-rated corporate index is up 3.5%, as spreads have settled back to just 101 basis points. Although these returns were welcomed by investors after a difficult 2015, they set the market up for a bleak outlook for 2017. Even though spreads could tighten over the course of 2017 from these levels, any tightening is likely to be modest, and widening is more likely.
The new Administration, bolstered by control of both houses of Congress, aims to deliver significant personal and corporate tax reform (including a tax holiday on the repatriation of corporate profits held overseas), an infrastructure spending bill, loosening of the regulatory environment, and changes in US trade policy. All of these could help stimulate growth or inflation (or both) in the short term. Investors are already pricing in higher inflation expectations into the market in both Treasury Inflation-Protected Securities (TIPS) and the five-year/five-year forward market. GDP growth expectations for 2017 have been raised, but so has the forecasted range for 10-year Treasury yields. How much or how little of its agenda the Administration can actually get passed through Congress, and when, will of course change these expectations. Higher GDP growth and inflation would give the Fed the ammunition to continue to raise short-term rates, and higher inflation expectations would typically drive long-term rates higher as well. With even modestly higher rates across the yield curve and little room for spreads to tighten, investor expectations across the fixed income spectrum should be modest at best.
1 U.S. Department of the Treasury, Daily Yield Curve Rates
2 Per Barclays Live: Option Adjusted Spread (OAS) of Bloomberg Barclays A-rated Corporate Bond Index
3 Per Barclays Live: OAS of the Bloomberg Barclays U.S. Corporate High Yield Index
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