Fixed Income: From Summer Wind to Autumn Leaves

fixed-income
kevin-temp2
Head of Fixed Income Strategy
10/05/2016

With the calendar turning to October, investors are entering the final lap of 2016. Certainly, there was a lot to digest in the third quarter, as the money and bond markets were faced with the potential fallout of the Brexit vote to begin the three-month period and concluded it with a heavy dose of central bank policy decisions. Before embarking on the homestretch, let’s take one last look at how Q3 panned out in the fixed income arena. While we are going to focus our comparison on a quarter-versus-quarter perspective, it should be noted that there was definitely volatility squeezed in between the end of June and the end of September that did not necessarily get captured in the final quarter-end results.   Key Fixed Income Gauges Key Fixed Income Gauges Overseas in the sovereign debt market, 10-Year German and Japanese yields remained in negative territory, although for a brief post-European Central Bank meeting trade in September, bunds did cross over the zero threshold back to the positive side of the ledger. As the data in the table clearly reveals, the 10-Year bund yield ultimately ended up little changed. In Japan, the 10-Year Japanese government bond yield also moved closer to zero in September before finishing the quarter back in the negative area, registering a quarter-on-quarter increase of 13 basis points (bps). The action in Japan’s sovereign debt market reflected the Bank of Japan’s decision to try to steepen the yield curve by shortening the duration of its quantitative easing (QE) program. In the U.S. Treasury (UST) market, the post-Brexit flight to quality trade was of paramount importance to begin Q3 as the 2-Year yield dropped to a low of 0.55% in early July and the 10-Year yield posted a new all-time low of 1.36%. As domestic economic data continued to come in, revealing visible improvement from earlier in the year, and the worst-case scenarios post-Brexit failed to materialize, safe-haven demand gave way to the fundamentals. In the process, Federal Reserve (Fed) policy expectations were recalibrated (i.e., a rate hike is back on the table). As a result, the UST 2- and 10-Year yields reversed course and rose roughly 30 bps and 40 bps, respectively, from their aforementioned lows. Ultimately, the quarter-on-quarter changes amounted to +18 bps and +12 bps, respectively. In the credit-sensitive sector, both investment-grade (IG) and high yield (HY) spreads flattened to their lowest readings since mid-2015. The most notable narrowing occurred in HY, where spreads contracted by 114 bps. It is interesting to note that despite the increase in UST yields in Q3, IG corporate yields actually fell 4 bps due to the narrowing in spreads being more than the increase in Treasury yields.   Conclusion Here in Q4, besides the usual economic forces, investors will once again be confronted with potential monetary policy actions, and throw in a U.S. presidential election for good measure. As we saw in the waning days of September, the risk-off trade can come back at any unannounced moment, as concerns about Europe’s banks once again came to the fore. Barring any further negative headlines on this front, economic data looks to be moving to the front of the line for the fixed income arena. However, it would be prudent for investors to expect the potential for a near-term reaction to the outcome of the U.S. presidential election as well. With the Fed putting the markets on notice that the case for a rate hike has strengthened, we would expect to see volatility return to the UST market, as investors respond to incoming data with a “will they or won’t they?” mindset.
About the Contributor
kevin-temp2
Head of Fixed Income Strategy
As part of WisdomTree’s Investment Strategy group, Kevin serves as Head of Fixed Income Strategy. In this role, he contributes to the asset allocation team, writes fixed income-related content and travels with the sales team, conducting client-facing meetings and providing expertise on WisdomTree’s existing and future bond ETFs. In addition, Kevin works closely with the fixed income team. Prior to joining WisdomTree, Kevin spent 30 years at Morgan Stanley, where he was most recently a Managing Director. He was responsible for tactical and strategic recommendations and created asset allocation models for fixed income securities. He was a contributor to the Morgan Stanley Wealth Management Global Investment Committee, primary author of Morgan Stanley Wealth Management’s monthly and weekly fixed income publications, and collaborated with the firm’s Research and Consulting Group Divisions to build ETF and fund manager asset allocation models. Kevin has an MBA from Pace University’s Lubin Graduate School of Business, and a B.S in Finance from Fairfield University.