Well, we’ll give the Fed this, they do keep it interesting! They could have made what would have essentially been a symbolic hike of 25 basis points to the funds rate, issued a dovish statement for the future and closed a fun filled six-year chapter in their history. But they didn’t.
If you thought things were confusing before last Thursday, wait until something good happens, like China announcing a massive stimulus plan, or oil stabilizes and starts rising on a production accord.
Based on last Thursday’s FOMC, could anyone blame you if you ran around with your hair on fire worrying about a real Fed tightening cycle? Or what if things get worse in China or oil plunges to $30? Quantitative Easing IV? Based on yesterday, that is no longer laughable either!
From the FED Chairwoman’s opening statement:
“Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” Also, "Heightened concerns about growth in China and other emerging market economies have led to volatility in financial markets."
The Fed, in our opinion has essentially changed the dynamic. In their statement and Chairwoman
Yellen’s press conference, the Fed has seemingly tied themselves to the state of foreign financial markets, most notably China. The fact that four voting FOMC members, who had, as recently as July 29th estimated a first rate hike to occur in 2015, changed their estimate of a first rate hike to sometime in 2016 is very telling. As we know, August was a month dominated by concerns over a meltdown in China’s equity markets. Meanwhile, economic data in the U.S. for August was encouraging. Therefore, the change in sentiment was most caused by global financial market concerns. This latest development in the Fed’s thinking is a game changer, and not a good one in our opinion.
The Fed had the opportunity to remove a huge level of uncertainty for the financial markets and by punting, missed its chance. We believe that as we move through the coming days and weeks, this will actually do more harm to risk markets (investment grade and high yield corporate bonds,commodities, emerging markets and global equities) than good. Large scale uncertainty is almost never a good thing. As yesterday’s events are fully digested, market volatility could likely increase noticeably.
The U.S. Treasury curve reacted as we would expect given the “Dovish Hold” action steepening sharply instead of what we expected, a “Dovish Hike”. The 2 and 3-year Treasury notes rallied, declining in yield 13 and 15 basis points respectively, post FOMC. The belly of the curve as well as the long end lagged with the long bond declining only 7 basis points in yield. It is likely we might see the yield curve continue to steepen with 2-year and 3-year notes outperforming 10s and 30s. However, given the big move yesterday, we could get a little pull back before we continue to steepen. Even with this rather big move, we like the 3-year part of the curve best in Treasuries and Agencies based on roll down opportunities.
Equities and high yield corporate bonds did what they should have done after the FOMC’s announcements. They ran in circles for a bit in complete confusion and then ended up down or wider from pre-FOMC levels. Given our view on increased volatility and potential poor liquidity, we like staying inside of the 5 year point on the curve on investment grade corporates and put a premium on names that carry liquidity.
Municipals, on the other hand, tightened. We like the Municipal sector quite a bit and we think the 3-year point for municipals looks very attractive compared to corporate and agency debt (bullets and callables) alternatives on a tax equivalent basis. Heck, even on an outright yield basis, they look good.
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