The second quarter of 2015 can be characterized as very volatile, highly eventful and extremely interesting. The Greeks and the Troika (made up of the European Commission, the European Central Bank and the International Monetary Fund) sparred back and forth over a bailout agreement. China’s stock market fell 17%, Puerto Rico acknowledged that their debt is too high and the Fed prepped the markets for an interest rate liftoff. Although the ebb and flow of daily events made for some drastic price moves both up and down in the quarter, bond prices finished only moderately below where they started. According to Morningstar, the Barclay’s Credit index of corporate bonds with maturities between 1 and 5 years was down .11% and the Barclay’s Municipal Intermediate index was down .79% from March to June.
Even though most second-quarter U.S. economic data have surprised to the upside, the Federal Reserve decided in June to maintain overnight interest rates in range of 0 to .25%. The Fed, headed by Janet Yellen, reiterated its desire to keep the status quo and vowed to be “data dependent” with regard to future increases. Yellen basically said that if the economy continues to improve at the current pace, interest rates will eventually rise. These comments were viewed by market observers as a “shot across the bow” of the doves on the Federal Open Market Committee (FOMC), who appear to want to keep rates low forever. General wisdom is now pointing towards September as the earliest month for liftoff. Fed funds futures are pricing in a greater than 50% probability of an initial September interest rate hike, according to Bloomberg.
Before the Fed commits to a rate rise, not only will the U.S. economy have to be on steady ground, but Europe and China will need to be relatively stable as well. Given that currency and financial markets are so intertwined around the world, many economists believe it would be a mistake for the Fed to tighten domestic policy at the same time other countries are loosening theirs. Under this scenario, the U.S. dollar would continue to strengthen, making U.S. goods more expensive for overseas buyers. This would put U.S. firms at a competitive disadvantage, perhaps leading to an American economic contraction. The Fed is carefully weighing all these factors in determining when, and how much, to push up domestic interest rates.
Following the theme of negative return for the quarter, longer-dated municipal bonds fared worse than shorter-dated maturities. Credit problems also rattled the muni market in late June, when the Governor of Puerto Rico stated flatly that the island’s $72 billion in debt (more per capita than any U.S. state), is simply “not payable.” Those comments, although not a surprise, caused credit spreads (an indication of credit risk) to increase to levels not seen since 2013.
During the second half of 2015, we will continue to operate with one eye on the Fed and the other on news internationally. Although a rate rise seems the most likely outcome, we’ve been down this road before. Foreign economic events continue to exert a heavy pull on U.S. interest rate policy, and random credit issues seem to pop up at least once a quarter in a world swimming in debt and deficits. Our fixed income portfolios remain in a defensive posture, ready for whatever combination of forces comes our way.