Monthly Markets Memo - June 2017
by Dan Zalipski & Scott Rosenquist, CFA
Through much of the year the international equity markets have easily outpaced the domestic U.S. equity markets. This past month, however, saw a break in that trend with the U.S. outperforming international equities as both groups moved higher. Despite this, both developed and emerging international equity markets are well ahead of their U.S. counterparts on a year-to-date basis.
The bond market also moved higher as yields experienced some downward pressure (bond prices and yields move in opposite directions). The 10-year treasury’s yield slipped further, touching an intra-day low of 2.11%, down from 2.285% in late May, and well off their year-to-date highs of 2.60% last seen in March. This mini-rally was also seen within high yield and investment grade corporate bonds. Inflation linked bonds were alone in their recent sell-off as the latest inflation report fell short of expectations. Finally, the commodity markets experienced the most volatility over the past month, with the Bloomberg Commodity index down over 5%, driven by the latest slide in oil prices.
The Fed’s Plan
The Fed increased interest rates for the third time in six months at their June meeting. Market participants largely expected this move, but were more interested in details surrounding the Fed’s plan to reduce the size of its balance sheet. For the better part of the last decade, the Federal Reserve (Fed) along with other central banks in Europe and Japan were engaged in an unconventional monetary policy known as Quantitative Easing (QE). QE’s goal was to kick-start economic growth by injecting liquidity and pulling down interest rates, which in theory, stimulates borrowing and spending, contributing to economic growth. The banks did this by buying bonds in the open market, but in doing so, the Fed’s balance sheet grew from ~$900 billion in 2008 to a staggering $4.5 trillion today.
Taking note of lessons learned when it came time to taper and end QE, the Fed is looking to shrink the size of the balance sheet in an orderly and predictable manner as to avoid an unexpected negative impact on the markets. Their current balance sheet is composed of primarily U.S. Treasuries and mortgage backed securities, and has been reinvesting the proceeds of these holdings as they mature. To reduce the size of their balance sheet, the Fed is planning on discontinuing the reinvestment of maturing assets. The plan is to do this in phases over time, starting with $10 billion per month, with the expectation of increasing the divested assets every 3 months. The amount rolling off their balance sheet will be capped at $50 billion per month, and will continue until the balance sheet is "appreciably below that seen in recent years but larger than before the financial crisis." The timing as to when they will begin has not been announced, but many analysts believe it will commence prior to year-end.
With some of these details now revealed, investors are working to determine what the potential impacts will be on the market. The Fed has expressed that the balance sheet reduction should occur in a behind-the-scenes manner while affirming that the federal funds rate remains their primary means of adjusting monetary policy. This is an important distinction, because there is a consensus that the balance sheet reduction program will contribute to increasing interest rates. In reducing their reinvestments, the Fed is removing themselves as a buyer from those respective markets. With such a large participant moving to the sidelines, issuers will find themselves needing to raise yields to entice the remaining buyers. It is for these reasons, that many market participants expect the Fed to pause their rate increases when it comes time to begin the balance sheet reduction. In so doing, they will be able to monitor and assess the market impacts from their balance sheet reduction steps independent of a federal funds rate increase, enabling the Fed to balance monetary policy as they navigate these uncharted waters.
Fed Officials have signaled for one additional rate hike this year as the unemployment rate is approaching what may be considered full employment. One metric that continues to come in below Fed expectations is inflation. Typically, a tighter labor market will lead to higher wages and put upward pressure on inflation. This relationship will be closely monitored by the Fed as Janet Yellen believes the low inflation numbers to be transitory.
As the first half of 2017 comes to a close, the global economy is experiencing synchronized expansion for the first time in years as Europe and emerging markets show signs of growth. The international equity market has outperformed the U.S. year to date and is an area we continue to monitor for additional opportunities. Valuations across most markets appear full with relatively low volatility. While this can persist for some time, we will look for any opportunities as this dynamic changes.
“I felt that the Fed had always been the agency that picked up the pieces when there was a financial crisis, and it was invented to do exactly that.” – Janet Yellen, Chair of the Board of Governors of the Federal Reserve System
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendation for any individual. Although general strategies and / or opinions are revealed, this post is not intended to nor does it represent or reflect transactions or activity specific to any one account. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All data and information is gathered from sources believed to be reliable and is not warranted to be correct, complete or accurate. Investments carry risk of loss including loss of principal. Past performance is never a guarantee of future results.