Fixed income markets: Closing out a second year of Fed tightening
January 21, 2016
As we leave behind a turbulent 2015, analysts are surprised at the challenges we have faced — and continue facing — in many markets. As we look to the balance of 2016, strategists are relying on analysis of prior Federal Reserve (Fed) hiking cycles as a guide for market behavior going forward. We think it makes sense to take such analysis with a substantial grain of salt. This is because we believe we are already two years into a monetary policy change, starting when the Fed began tapering its quantitative easing program in 2014.
Chart 1 helps explain what we mean, showing the two-year ascent of the Wu-Xia shadow federal funds rate. (The Wu-Xia rate is a depiction of short-term rates that is potentially more accurate than the traditional effective federal funds rate. It was developed by Jing Cynthia Wu, an economist at the University of Chicago Booth School of Business, and Fan Dora Xia, a Ph.D. working at Bank of America Merrill Lynch).
Additionally, we think enormous global debt levels will make raising policy rates in this environment very tricky. Capital markets have been buoyed by enormous liquidity injections from central banks. These markets now face a challenging episode as the Fed continues its tightening cycle.
Chart 1. Federal funds: Appearance versus reality
Sources: Board of Governors of the Federal Reserve System and Wu and Xia(2015).
Chart is for illustrative purposes only.
Repercussions of bold monetary policy
The U.S. Federal Reserve ventured into unorthodox monetary policy when it implemented emergency liquidity injections and quantitative easing measures starting in 2009. In the following years, the central bank continued these actions with additional programs of quantitative easing and an attempt to influence longer-maturity yields with a so-called operation twist. Former Fed Chairman Ben Bernanke will tell you that the main effect on markets and economies comes from the changes in the Fed’s balance sheet. If the Fed maintains the current heft of its balance sheet (see Chart 2), it will not force a new tightening measure on the economy.
I believe that the main effect of the quantitative easing exercises could be characterized as a “portfolio balance effect,” whereby the central bank bought high quality fixed income assets and forced investors into cheaper, riskier investments. As the Fed has tapered, and significantly curtailed its purchases, financial asset prices have been pressured from a reduction of this effect. In short, the Fed’s purchases led to a distortion of asset prices (pushing them higher, well beyond fundamentals), and that support is now unwinding.
Chart 2. A swollen Federal Reserve balance sheet
Data: Bloomberg Financial Markets.
Chart is for illustrative purposes only.
The significance of the new tighter monetary regime cannot be underestimated. For instance, our research has identified a second-order effect that tighter money has had: a reversal of the foreign reserve and sovereign wealth accumulation that we have witnessed during the past few years of easy global money (Chart 3). The world reserve decline is now running counter to the easy-money policies of major central banks like the European Central Bank and the Bank of Japan. This development sends a powerful message: The Fed’s tightening — and its second-order effect on reserve managers and sovereign wealth funds — has stalled other attempts at providing liquidity.
Chart 3. World currency reserves versus central bank balance sheets
Data: Bloomberg Analytics.
Chart is for illustrative purposes only.
The onset of pressure
Back in late 2014, we highlighted several conditions that were beginning to challenge markets (see Grillo’s corner: The four horsemen). Most — if not all — of those conditions stayed in place during 2015. To begin with, divergent central bank policies presented enormous challenges for U.S. dollar-based portfolios. As the Fed gradually intimated forthcoming increases in short-term rates, the dollar rose in value against many other currencies. With markets shutting off the liquidity spigot, asset prices began to reverse their multi-year bullish run. Many foreign bourses ended the year with price declines, and for all but a few of them, the translation of returns back into dollars was brutal (see Table 1).
Table 1. World equity indices, year-to-date performance (as of Dec. 28, 2015)
|Equity index (country)
(in local currency)
(in U.S. dollars)
|Mexican IPC Index (Mexico)
|Ibovespa Index (Brazil)
|Euro Stoxx Index (euro zone)
|FTSE 100 Index (United Kingdom)
|CAC 40 Index (France)
|IBEX 35 Index (Spain)
|S&P / ASX 200 (Australia)
Data: Bloomberg Analytics. Data accessed on or about Dec. 29, 2015.
The liquidity reversal hit the high yield bond market particularly hard. For 2015, the sector declined by 3.5% on a total return basis. Risk premiums widened by 185 basis points. (Today, defaults are starting to rise after a notable period of low levels.) The high yield troubles were centered in the energy and metals-and-mining sectors. However, other commodity-related companies saw their bond prices decline as well. We also witnessed an increase in idiosyncratic credit events outside of these sectors.
Fittingly, individual investors and their advisors are concerned about the events outlined above. The second half of 2015 was marked by outflows from bond and equity mutual funds. Outflows were very likely driven by investors who were concerned about liquidity as well as the outlook for returns in a rising rate environment. Funds that had significant exposure to less-liquid investments are now starting to either gate withdrawals or shut down altogether in order to prevent a disorderly wind-down.
Markets are beginning to see the ramifications of this new environment, as the pressures have trickled down to asset managers. The squeeze has applied particularly to portfolios that contain illiquid investments, which can be problematic in an environment of heavy investor withdrawals. All in all, we believe episodes like these should be taken as wake-up calls to fiduciaries, reminding them about the daily liquidity challenges.
We think it bears repeating that all of this market turbulence and volatility comes in the midst of a pernicious environment of low liquidity, the contours of which we highlighted in Grillo’s corner: The four horsemen. Macro-prudential rules and regulations that were designed to make deposit-taking institutions safer have thinned out their trading portfolios. Most of the marginal risk has now been shifted to mutual funds, exchange-traded funds, and sovereign wealth funds, as well as currency reserve entities. The reduction in liquidity, together with the higher-rate regime, is forcing significant selling pressure onto these entities.
Currency reserve managers have been forced to sell U.S. Treasury investments so that they can defend their currencies against further declines or a disorderly sell-off. The reduction in oil and other commodity revenue for many developing nations has forced them to sell sovereign wealth fund assets. These pressures may intensify in 2016 if the Fed continues its interest rate hiking cycle. That would put billions of dollars of fixed income investments at risk for further selling pressure.
A hangover into 2016
We believe we could be heading into another challenging year if the Fed continues the tightening regime it has pursued for the past two years. In our opinion, the central bank has made a policy mistake by employing unorthodox liquidity policies for many years now. That activity has contaminated the normal fundamental pricing mechanisms of many financial assets (and many hard assets as well).
As a result, we are living in the shadow of a correction as prices go back to levels that are consistent with significant global economic headwinds. With all of this in mind, we believe investors would be well served by carrying a higher level of quality assets, and we think it makes sense to build in some liquidity buffers as well.
The views expressed represent the Manager's assessment of the market environment as of January 2016 and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
The Mexican IPC Index is a capitalization-weighted index that represents stocks traded on the Mexican Stock Exchange.
The Ibovespa Index measures the performance of the most liquid stocks traded on the Sao Paulo Stock Exchange.
The Euro Stoxx Index is a market capitalization-weighted index of 50 large, blue-chip European companies operating within euro zone nations.
The FTSE 100 Index tracks the returns of the 100 most highly capitalized companies traded on the London Stock Exchange.
The CAC 40 Index reflects the returns of the 40 largest equities listed in France (based on market capitalization).
The DAX index measures the total return of 30 large German companies that are listed on the Frankfurt Stock Exchange.
The IBEX 35 index is based on the 35 most liquid stocks traded on the Madrid Stock Exchange.
The S&P/ASX 200 index represents approximately 80% of equity-market capitalization in Australia. Companies reflected in the index are listed on the Australian Securities Exchange.
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