Brexit concerns build
Some volatility returned to financial markets this week, as residual global growth concerns and risks surrounding the June 23 British referendum on whether to leave the European Union weighed on market sentiment.1 While equities and oil prices saw week-over-week declines, global government bond yields continued their steady march downward.2 With risk appetite largely sidelined, both high yield bond prices and senior secured loan prices trended lower this week. Of the two, high yield bonds saw the largest declines, returning approximately -1.28% in the week ended June 16.3 Following two straight weeks of inflows, high yield bond mutual funds saw outflows of more than $1.8 billion in the week ended June 15, the majority of which came from exchange-traded funds.4 Senior secured loans drifted lower in sympathy with high yield bonds and equities, posting a slight decline of -0.08% in the week ended June 16.5 Currently yielding approximately 6.44%, senior secured loans have benefited from solid supply and demand dynamics in recent months as investors have continued to seek out higher yielding assets.6 On the demand side, outflows from bank loan mutual funds of approximately $500 million in April turned to approximately $300 million in net inflows in May and June.4 That, in combination with more than $24 billion in new collateralized loan obligation formation, has helped senior secured loans return approximately 4.40% year to date.5 By comparison, high yield bonds and the S&P 500 have returned approximately 8.02% and 2.42%, respectively, over the same period.3,2
Lower for (even) longer
As expected, the U.S. Federal Reserve left interest rates unchanged at its June 14–15 meeting, citing mixed economic indicators and the recent slowdown in the pace of improvement in the labor market.7 Ahead of the meeting, a June rate hike had effectively been taken off the table by May’s disappointing nonfarm payrolls report and the upcoming “Brexit” vote. This, coupled with the notably more dovish tone struck by Fed Chair Yellen in recent comments, had already lowered investor expectations around the number of rate hikes for the rest of 2016. While the Fed minimized recent weakness in labor markets, saying it expects the labor market to strengthen further, officials lowered their projection for how many times they expect to raise rates in the coming years. This new, flatter “dot plot” still shows that the median FOMC member expects two rate hikes in 2016.8 However, a greater number of Fed officials now project only one increase this year than when the Fed last released projections in March. Perhaps more importantly, the Fed also lowered its expectations for where short-term interest rates will be at the end of 2018 and lowered the pace of expected moves in both 2017 and 2018 from four to three.8
This shift in the Fed’s longer-term interest rate expectations is notable, as Yellen has typically ascribed low interest rates mainly to lingering headwinds from the financial crisis. In her June 6 speech in Philadelphia, for example, Yellen said she expected the “neutral rate of interest itself will move up” as the “headwinds that have lingered since the crisis slowly abate.”9 In her press conference Wednesday, however, Yellen pointed to more structural, persistent forces that could keep interest rates lower for longer. While reiterating expectations that the effects from the financial crisis will diminish, she also pointed to the effects of slow productivity growth and aging societies around the world as factors that could depress interest rates over the long run.10
Despite Yellen’s insistence that every meeting is “live” and that “it’s not impossible” that the Fed will raise rates in July, market expectations tell a far different story. Fed funds futures currently place only a 2% likelihood of a rate hike in July and around a 50% likelihood of a single rate hike in 2016.11
Meanwhile, global government bonds continued to trend lower, with the 10-year yields in Germany, Japan, the UK and Switzerland all hitting fresh lows this week.12Notably, almost the entire length of Switzerland’s yield curve is now trading in negative territory, with its benchmark 30-year bond dipping below zero for the first time ever.
Chart of the week: Retail investors miss out
Source: Thomson Reuters Lipper, Bloomberg, Franklin Square Capital Partners.
- The S&P 500 fell 10% in just three weeks during the first quarter of 2016.13Investors responded by selling equities in size. Outflows continued into the second quarter even as markets recovered. Despite the early weeks of negative performance, the S&P 500 returned 1.3% during the first quarter and 2.8% year to date.13
- Looking more broadly, household wealth in the U.S. rose $837.4 billion during the first quarter, which was less than many analysts expected given quarter-over-quarter equity market performance.14 Holdings of equities fell $143.3 billion, despite the fact that the S&P 500 ended the quarter with positive performance.14
- While allocations to equities declined in the first quarter, household allocations to some of the lowest yielding assets—including savings deposits, agency securities and money market accounts—rose to $127 billion.14 According to the Federal Deposit Insurance Corporation, these assets earn approximately 0.06% annually, compared to senior secured loans and high yield bonds, which returned 1.3% and 3.2%, respectively, in the first quarter.3,5
1 Federal Reserve Bank of St. Louis, http://bit.ly/28K5oKU.
2 Federal Reserve Bank of St. Louis, http://bit.ly/1nUCIvg.
3 Bank of America Merrill Lynch High Yield Master II Index.
4 Thomson Reuters Lipper.
5 Credit Suisse Leveraged Loan Index.
6 Credit Suisse Leveraged Loan Index (based on a three-year maturity).
7 The U.S. Federal Reserve, http://1.usa.gov/1UXznVu.
8 The U.S. Federal Reserve, http://1.usa.gov/1UPqboZ.
9 The U.S. Federal Reserve, http://1.usa.gov/1OaNlXm.
10 The U.S. Federal Reserve, minute 17:00, http://bit.ly/1tyCrlm.
11 Bloomberg based on CME data.
12 The Wall Street Journal, http://on.wsj.com/1Uy7XcQ.
13 Bloomberg, as of June 16, 2016.
14 Board of Governors of the Federal Reserve System, Financial Accounts of the United States, First Quarter 2016
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