Looking back at the 4th quarter of 2013, the actions of the Federal Reserve continued to be front and center, as market participants were focused on how future Fed policy is going to be affected by a number of key events that took place during the quarter. These include the naming of a new Federal Reserve chairperson as well as a release of data pointing to a stronger U.S. economy.
Beginning to taper
The Fed announced at the end of the quarter that it plans on starting to taper its quantitative easing program, in which the Fed has been purchasing US Treasury and mortgage securities in an effort to stimulate the economy and support the financial markets. As a result, interest rates rose across most maturities for the quarter, as investors came to grips with the fact that at least some of the extraordinary measures that the Fed has had in place over the last few years will begin to be scaled back. Just as importantly, however, the Fed tried to make it clear that a tapering of its bond purchases should not be perceived the same as tightening its monetary policy.
The Fed acknowledged that the use of accommodative measures through its Fed Funds policy should continue for some time, due in part to unemployment levels and measures of inflation. Moving forward, I believe that the Fed’s ability to communicate the future direction of monetary policy through its forward guidance will be a key variable that will impact both the overall level of interest rates and the shape of the yield curve.
From a performance standpoint, returns for the bond market were down modestly for the quarter, with higher Treasury yields being largely offset by the strength of corporate bonds and other non-Treasury sectors. The improving economic backdrop led to demand for fixed income sectors with credit risk. In fact, those sectors with the greatest amounts of credit risk performed the best; the high yield corporate sector, for example, out-performed US Treasuries by over 400 basis points for the period, as we continue to see corporations in the US reap the benefits of having strong balance sheets and significant access to capital and liquidity.
So what does all this mean for investors?
As we look ahead to 2014, we believe there are three main questions facing the fixed income markets.
First, how will tapering expectations change if we receive economic data that points to continued strength?
While current expectations are for the Fed to modestly reduce the scale and scope of their bond purchases, more supportive economic data could materially change the speed in which the Fed executes its tapering and thus impact the yield curve and level of rates.
Second, if labor market conditions continue to improve, how long will the Fed remain committed to keeping short term rates low?
While they have gone to great lengths to establish a set target for unemployment before they plan on hiking short term interest rates, the markets could challenge this commitment and cause further increases in rate volatility.
And third, how long will the corporate credit market continue its strong performance?
Although corporations have a lot of things working in their favor, credit spreads are close to the tightest levels we have seen in the last 20 years.
Overall, 2014 will likely be a year of continued uncertainty in regards to economic and labor market conditions, the regulatory environment, and government policy. Whatever the outcome, however, I believe that bonds should continue to play a critical role in an investors’ overall asset allocation strategy. Bonds have many important features such as income generation, principal protection, diversification, and the ability to target specific liabilities. These characteristics can be beneficial to investors regardless of the market environment.
Diversification/asset allocation does not ensure a profit or guarantee against loss.
Any fixed income security sold or redeemed prior to maturity may be subject to loss.
Investments in mortgage securities are subject to the risk that principal will be repaid prior to maturity. As a result, when interest rates decline, gains may be reduced, and when interest rates rise, losses may be greater.
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