Will the increased volatility and low bond yields from 2015 linger into 2016? How will the first interest rate hike since 2006 play out in the bond market? Baird sat down with Senior Fixed Income Analyst Craig Elder, author of Baird’s “Fixed Income Weekly,” for his perspective on what’s in store for the bond market in the coming year.
Baird: How would you characterize the 2015 bond market?
Craig: I would call it a year of volatility, but expected volatility. There simply aren’t as many dealers as there once were, and they provided market liquidity. Since the economic crisis of 2008 and the resulting Dodd-Frank legislation, the dealers are not as active. That creates volatility in the market, and that’s what we experienced in 2015.
It’s also interesting to look at the total returns for the year so far. Outside of preferred stock, which has a 7.11% return year-to-date, everything is bunched in a group: munis at around 2.67%, mortgages at 1.4%, Treasurys at about 1%. It’s been a year of weak returns.
Baird: Did anything from this past year surprise you?
Craig: If there’s been one surprise, it was the Federal Reserve not raising rates in September. It’s one of those things where economists have joked, “We weren’t wrong, the Fed was.” If they had raised the Fed funds rate by 25 basis points then, they could have remained on hold until next year. Now, they’re going to move rates higher in the face of slower economic growth and weakness in the industrial sector. However, the strong job market is forcing the Fed to take action this month.
Baird: So you think they’re going to have to raise rates, whether they want to or not?
Craig: I think they’re going to move 25 basis points at the December Fed meeting. However, that will not likely have a major impact on interest rates, as the movement in rates has already been baked in. The yield on the 2-year was 0.41% back in January, and now it’s over 0.90%. Everyone’s expecting the rate hike.
The key to moving forward in Fed Chair Janet Yellen’s terms is the pace of the rate increases. You can argue what they’re doing is not really raising rates so much as “normalizing” the Fed funds target rate, “normal” landing somewhere between 3 and 3.5%. However, I don’t think they are going to get there for quite some time.
Baird: Could the Fed raise rates less than 25 basis points in December?
Craig: They could do 12.5 basis points (12.5%), and there was some suggestion that that’s what they should have done last September. But traditionally, most of the moves have been 25 basis points (0.25%) or larger.
Baird: This pace of normalization – what do you think it’s going to look like? Are you envisioning a process that spans several years?
Craig: We noted we’re likely going to get the 25 basis-point hike at the December meeting, which will begin the normalization of the Fed funds rate. If the labor market is still fairly strong, they could move another 25 basis points in March. If for some reason economic growth is slowed or if the labor market has weakened, we think they will wait until the May meeting.
My best guess, it will be 2018, maybe 2019, before they get back to normal.
Baird: Other than raising the Fed funds rate, what else could the Fed do to pump up the economy?
Craig: They could do another quantitative easing program, but that strategy becomes less and less effective each time it’s repeated. Another quantitative easing program would be the fourth since the recession. Probably the best thing they could do to prop up the economy is to take a measured approach when increasing interest rates.
Baird: What effect will rising rates have on the bond market?
Craig: The best way to look at it is to picture a “normal” yield curve. Let’s say we have a 1% Fed funds target. We then add another 50 basis points to get to a 2-year yield of 1.5%, then add another 125 basis points out to a 10-year yield of 2.75%. Another 75 basis points will get to the 3.5% level for the 30-year bond.
The impact will be more on the short end of the curve and not so much on the long end of the curve. Yields on the long end of the curve generally are influenced by inflation expectations. Inflation expectations going forward remain below the Fed’s target on inflation of below 2%.
Baird: It sounds like you’re expecting continued volatility into 2016 as the market tries to figure out how to operate in a rising-rate environment.
Craig: I see next year as being very similar to this year, though with interest rates slightly higher. Bond prices will again be volatile this year, but in a fairly narrow range. I just don’t see drastically higher yields or a collapse in yields, either. 2017 may be a different story – I think inflation could return in the picture in 2017.
Baird: Are you expecting more refundings, like we saw this year?
Craig: Probably – there is a bigger universe of bonds that are eligible for refunding in 2016 than there was in 2015. Estimates are $250 billion eligible for possible refunding in 2016 compared to $220 billion in 2015. The caveat is that if rates spike higher, it could dampen the activity in refunding.
Baird: What kind of demand do you anticipate for bonds in the coming year?
Craig: The demand is still there – it’s just shifted slightly on the retail side. Traditionally the largest buyer of munis has been retail investors. However, over the past few years, retail investors have moved away from individual bonds and more toward managed bond funds. I think that’s to be expected in a low-yield environment.
Baird: Do you expect certain maturities to be more or less in demand in 2016?
Craig: I think people will still be skittish of going out long on the yield curve, so you’ll probably see more demand on the short to the medium part of the curve. Looking back to this year, investors probably wished they had extended investments out on the curve – better returns are with 20-year paper, as interest rates didn’t move as high as we thought.
Baird: What impact do you think the economic troubles of China and Europe will have on the bond market?
Craig: I don’t think what happens overseas affects the municipal bond market directly, but they can affect the dollar – something we watch very carefully. Thinking back to the Fed meeting this past September, if I can give the Fed an out for not raising rates, it wasn’t so much that they were worried about how raising rates would affect China or the emerging markets – I think it was more of a concern about the impact a stronger dollar could have on U.S. manufacturers, especially those with an overseas market.
For further insight into the bond market, check out Craig Elder’s “Fixed Income Weekly” at rwbaird.com/publicfinance.