PMC Weekly Review - September 18, 2015

A Macro View – Much Ado About Nothing

Thursday’s meeting of the Federal Open Market Committee (FOMC) was the focal point of nearly every market commentator, economist and money manager for the last four months. It was certainly the first meeting in several years where the outcome was in any sort of doubt. Yet, as it has for the last year since it ended new bond purchases under the quantitative easing process, the Fed again declined to raise the Fed Funds target rate from its current 0.0-0.25% range. The U.S. equity markets gyrated for the remainder of the afternoon, but the S&P 500 Index closed down less than 0.30% on the day. On the bond side, Treasury yields from 2 years to 10 years closed down 11-13 basis points, almost exactly where they ended up last Friday.

Even had the Fed raised its target rate by 25 basis points investors, professional and amateur alike, should have shrugged at the announcement and moved on with their day. The news might have created some short-term volatility in the markets (as though we haven’t seen rampant volatility over the last 90 days), but in the end, a modest increase in borrowing rates isn’t likely to have a significant impact on domestic economic growth. That won’t come until we see the cumulative effect of at least three or four quarter-point hikes. Chairwoman Yellen has stated clearly that when the Fed does move, it will be at a slow and gradual pace, far slower than any hiking cycle in the last 30 years, and we likely won’t see that third or fourth hike for at least nine months after the first one. Right now the bond market is pricing in roughly a 60 basis point increase in the 1-year Treasury, to 1%, over the next 12 months, meaning the Fed Funds rate won’t have hit its third hike by then.

Similarly, when a hike in rates does come, it won’t be the end of your fixed income portfolio, especially with the expected slow glide path. Since 1986, the smallest increase in the Fed Funds rate during a hiking cycle was a total of 1.75% over the course of 13 months, from mid-1999 through mid-2000. An even slower pace of rate increases will minimize the price loss on current bonds, and will allow the income component, as small as it is today, to overcome most, if not all, of it. In fact, during the 13 months of the 1999/2000 rate hike cycle, both the Barclays US Aggregate Bond Index and the Barclays Intermediate US Government Credit Bond Index rose by nearly 4.5% on an annualized basis. Of far greater impact on the fixed income markets than these marginal rate hikes over the next 12 to 24 months will be domestic and global macro events, similar to those that have driven returns since early 2009, when Fed Funds hit the zero-bound level. Global uncertainty in places like Greece, Ukraine and China will have both short-term and intermediate-term effects. General investor sentiment, particularly in the municipal bond market, will increase or decrease demand for fixed income securities, moving the prices and yields appropriately. And, as exemplified by the non-investment grade corporate and emerging markets, company- and country-specific events will have a significant bearing on excess returns.

In the end, professional fixed income investors are far less worried, at least at this point, about whether the Fed now will hike rates in October, December or in 2016. Rather, they are focused on managing their exposure to broad, global macro risks and company- or country-specific fundamentals to deliver their stated risk/return profile. Shouldn’t we retail investors follow their lead?

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