After hiking interest rates in December for the first time since 2008, the Fed decided to stand pat at its mid-March meeting. Viewpoints spoke with Tom DeMarco, CFA,® a market strategist in Fidelity Capital Markets’ bond division, about what the Fed’s decision says about the health of the U.S. and global economy, and how long it might take for the Fed to consider raising rates again. We also discussed how the bond markets are likely to perform in the coming months, and some of the potential tailwinds for corporate and high yield bonds.
|Q:||What did you think of the Federal Reserve’s decision to keep interest rates unchanged at its recent meeting?|
DEMARCO: I didn’t expect the Fed to raise rates at this meeting, but I have to admit I was caught off guard by the dovish tilt to the statement, the Fed's rate forecast survey known as its "dot plot," and their economic projections. I was expecting a more hawkish tilt, and the market reaction suggests other investors were as well.
Since the December meeting, we have had a string of better data. Break-even inflation rates had rebounded nicely, as did personal consumption expenditures, which are the Fed’s preferred gauge of inflation. At the same time, the China growth scare had become somewhat less urgent, energy and other commodity prices had a nice bounce, and overall financial conditions had moved from negative to positive (looking at the Bloomberg Financial Conditions Index). To me, all of this suggested Fed could get back on point with their prior message of rate normalization.
|Q:||Do you still expect the Fed to raise rates this year?|
DEMARCO: Given my expectations and looking at the calendar, I thought the Fed would lower the dot plot forecast to show that the central tendency was to raise rates three times in 2016, down from four at their December meeting. In fact, the change was even more dramatic, with the median forecast indicating only two rate hikes this year. This is in-line with my January forecast. I think the earliest the Fed may move is at their June meeting, but honestly with the tone of the statement and the fact that they omitted their assessment of risks statement for a second meeting, even two moves may be in doubt. Fed funds futures markets are pricing in the September meeting as the next (and only) move up in the Fed funds rate this year. There is plenty of data between now and June though, and Chair Yellen did say in her press conference that every meeting was a live meeting.
The economic picture is still a bit mixed. The global economy is slowing and the U.S. continues to muddle along. The industrial side of the economy is still struggling, and I expect it to remain challenged. But the consumer side of the economy is hanging in there and the housing market continues to improve. When we spoke last, various market indicators were flashing an elevated risk of recession. With the reversal in energy markets, credit spreads, and equity markets since the Fed’s December meeting, recession risk has receded considerably, but not gone away. I expect economic growth to remain sluggish, and given the Fed’s more dovish tilt, I think the U.S. dollar may remain under pressure a while longer—which may be part of the Fed’s intent.
|Q:||If the Fed raises rates in June, how might that affect the bond market?|
DEMARCO: I don’t think that a Fed rate hike would cause yields to run away from investors. There are headwinds to rising yields, including the relatively slow growth of global economies. What’s more, there are significant yield differentials between U.S. bonds and foreign bonds. Countries making up roughly one-quarter of the world’s gross domestic product (GDP) are in some kind of negative rate regime, which makes U.S. assets look fairly attractive.
|Q:||Is it strange to see so many negative yields?|
DEMARCO: Yes, it’s very strange to have negative yields past one-year maturities, and even in the front end of the curve it has been very rare. Taking official central bank rates negative is a new approach. The jury is out as to how effective it will be, and the impact it will have on banking and the economy in general. European Central Bank President Mario Draghi recently suggested that negative official benchmark rates probably would not go more negative, in Europe at least, hinting at a limit to this new policy approach.
|Q:||The ECB recently started buying European corporate bonds. What impact could that move have on the U.S. bond market?|
DEMARCO: I feel this move adds a positive technical factor to the momentum we’ve already been seeing in U.S. corporate bonds, and I think the potential for spread tightening looks favorable in the near term. I think the fundamentals in the high-yield sector remain questionable or even weak, but the technical backdrop also looks pretty favorable in that sector. In a broader sense, this too may prove to be beneficial for foreign buying of Treasury securities.
|Q:||What effect have rising commodity prices had on other financial markets?|
DEMARCO: Energy prices have had a nice bounce—around 50%—from their lows in February to mid-March. The equity and credit markets have benefited from this rebound. The high-yield sector, which has considerable exposure to energy and commodity firms, has been a major beneficiary of higher energy and metals prices (iron ore is up 58% from the lows in December and copper prices are up 17% as well).
|Q:||Can corporate bonds continue to perform well in the near term?|
DEMARCO: Yes, I think so. I tend to prefer investment-grade corporate bonds over high-yield bonds based on the fundamental picture of those markets. I’m emphasizing quality these days. I see opportunities in the home builders and building materials companies because of the strength in the housing market. And while the automotive sector has gotten more expensive, it should continue to perform well if consumer spending remains healthy. I also like bonds in the REIT and tobacco sectors. Meanwhile, there’s been a fair amount of M&A and spinoff-type activity in the food-and-beverage and medical device sectors. I expect the companies involved in these deals to deleverage their balance sheets after closing their deals, which may provide opportunities for investors from a relative value perspective.
|Q:||What’s your outlook for the Treasury market?|
DEMARCO: No appreciable change since we last spoke—while the yield on the 10-year Treasury could once again eclipse 2%, I also think the upside is fairly limited based on my outlook for GDP growth and Fed action. So it’s still a relatively sanguine outlook. Like Chair Yellen though, I remain data dependent.
|Q:||In January you noted that the municipal market looked relatively expensive. Is that still true?|
DEMARCO: Muni bonds have become less expensive as we’ve moved further into 2016 and the new issue calendar has sprung to life. On a relative value basis (the muni yield as a percentage of comparable Treasury yield is one measure), I still like longer-dated munis more than shorter-term munis. I expect munis may remain under pressure through April from a combination of supply and lower redemption money, and seasonal issues around tax time, when there can be some selling pressure.
The 10-year part of the municipal yield curve looks slightly cheap, and the yield curve gets cheaper as you move farther out. Spreads are clustered fairly tightly in the muni market, so I don’t believe it makes much sense for investors to wander too far down in quality—the increased risk may not justify the incremental yield on those issues. Taxable munis and Build America Bonds, however, look rich versus corporate bonds. This has more to do with sell-off in the corporate sector in the fall-winter. If the recent rally in the corporate sector continues at the current pace this relationship may reverse relatively soon.
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