2016 Midyear Fixed Income Market Outlook

July 7, 2016

Great Britain’s recent decision to leave the European Union – known colloquially as “Brexit” – sent shockwaves throughout the world. In this midyear commentary, we spoke with Craig Elder, Senior Fixed Income Analyst and author of Baird’s
Fixed Income Weekly, about the U.K.’s referendum vote, as well the Fed, the upcoming presidential election and what’s in store for the fixed income market the rest of the year.

Baird:

Before we get into the fallout from the Brexit referendum, let’s start with the first six months of 2016. How would you describe the first half of the year for the fixed income market?

Craig:  

Total returns were fabulous. There’s been a huge demand for fixed income, and not only from American investors. Foreign investors have been buying American debt – even municipals. They don't get to reap tax benefits, of course, but the yields are attractive when compared to the global bond market, and defaults are few and far between.

Of course, we’re still dealing with really low rates. Years ago, if you had an 8% Treasury coupon, you didn't care if interest rates went up – you’ve got an 8% coupon. Now you have a 1.5% coupon, and if rates were to go up, it would take a long time for that coupon to offset the principal loss. But that may be a 2017 worry – I don't know if that's a 2016 worry yet.

Baird:

The biggest news in fixed income recently is the U.K.’s decision to leave the European Union. How is Brexit impacting the U.S. bond market?

Craig:

We’ve seen a big rally on Treasury yields on the 10-year. It went to 1.45% the Monday after the announcement (down from 1.75% just the week before) and has subsequently fallen as low as 1.32% since. And that’s one of the highest quality government debt yields available: The 10-year yields on Japanese and German government bonds are negative, and those for Great Britain have gone under 1% for the first time ever.

Baird:

How far-reaching do you expect Brexit’s impact to be?

Craig:

I think it’s adding to an existing atmosphere of fear and uncertainty – and when it comes to investing, any time you get fear, people run to the safety and liquidity of U.S. Treasurys. They’re safe and liquid (easy to buy and sell).

Look at what happened once the Brexit results were announced. First, no one among the Brexit supporters was prepared to take charge after the vote. Prime Minister Cameron announced his resignation, and no one really knew who was running the show. Second, you have countries within the U.K. like Scotland and Northern Ireland that wanted to stay in the EU – they’re talking about seceding from the United Kingdom and potentially rejoining the European Union. Third, almost immediately after the referendum results were announced, people started questioning if other countries were going to follow suit. The Netherlands, Sweden, Austria, Italy, France Greece, Spain – all of them could have votes to leave. So Brexit raises the question, Is the European Union going to hold together?

Whenever you have uncertainty like this – questions with potentially a global economic impact and no easy answers – you’ll likely see an increased demand for the safety and liquidity of Treasury bonds, and consequently a rise in bond prices.

Baird:

Do you feel the potential for another interest rate hike later this year has been put on hold?

Craig:  

I would now be surprised if the Fed raised rates at all this year – and that could be a problem down the road. My biggest worry with the bond market is that at some point, inflation could start rising to the point where the Fed will be forced to raise rates despite the weak economy.

If the Fed had been raising rates gradually for a couple of years, I would not have as much concern about future inflation.

Baird:

And the uncertainty in Europe isn’t helping matters.

Craig:  

Exactly. Traditionally, short-term yields have been determined by the Fed, and long-term yields have been determined by expectations for inflation. However, at this time, long-term yield levels are being driven by global long-term yields, with stable, highly rated countries like Germany and Japan dealing with negative yields. More than 20% of global sovereign fixed income debt trades with negative yields.

Now, my best guess is that this is not a long-term problem – I’m optimistic the stimulus that the European Central Bank is putting into the system will eventually work. We should see a pickup in inflation and some improvement in the European economies. It'll probably be next year, but as the rates go up, our rates will go up along with it. If I had to guess, I'd say next year at this time we're at 2.4–2.5% on the ten-year, though that's an admittedly optimistic outlook at this point.

Baird:

When evaluating the health of the fixed income market, what factors are you looking at?

Craig:  

Two of the big ones are unemployment and economic growth. Right now the unemployment rate is at 4.7%, and I've seen predictions of it going down to 4.3%. The underemployment rate stayed steady at 9.7%, but I think that comes down to below 9% eventually. As for the GDP, I’ve seen growth for the second quarter range between 2.4 and 2.5%. There is growth there – not great growth, but growth. Housing, autos and retail sales are doing well.

There is also the 2016 presidential election to consider. In addition to the uncertainty surrounding the outcome, Fed Chairwoman Yellen doesn't want to be seen as influencing the election and is trying to run the Fed as apolitically as possible.

Baird:

What do you expect for the rest of 2016 and beyond?

Craig:  

Going forward, I think the Fed and the European Central Bank will do what they can to keep the global economic system stable. Given the uncertainty created by Britain leaving the European Union, the Fed and the ECB will continue to keep interest rates low, and the ECB will likely continue the asset purchase programs. We think global interest rates will remain low for the time being, and spread levels on fixed income sectors will remain tight.

Baird:

It sounds like we still may be on a bit of a wild ride.

Craig:  

The way I like to think of it, may we live in interesting times – pardon the pun.