Will the Calm Continue for the U.S. Bond Market?

It wasn’t just the kids who enjoyed a summer break this year, as global financial markets seemed to take some time off in the third quarter as well.

While at times 2016 has been akin to a rollercoaster (think oil dropping into the $20s only to double off the lows, or of the Brexit vote back in June), the summer months proved to be a pocket of calm.

The U.S. bond market certainly enjoyed this stability, as yields in most investment grade sectors ended September just slightly above their levels on June 30th. For example, the 10-year U.S. Treasury Note started the quarter at 1.47% and ended at 1.60%. While a modest change in quarterly yield isn’t unheard of, what is unique is the fact that the yields closed within 10 basis points of 1.60% on 83% of all trading sessions.

The quiet wasn’t solely limited to U.S. Treasuries – corporate bonds, municipal bonds and mortgage-backed securities also witnessed range bound interest rates, and hence, more or less flat performance during Q3.

So why the calm?

We think it has a lot to do with the complacency that investors are feeling as a result of central bank intervention. It is no secret that monetary policymakers are doing whatever they can to support growth and inflation. The Federal Reserve, and even more so the European Central Bank and Bank of Japan, have extremely easy policies in place. Financial markets have taken comfort in this support, which is likely the reason for market stability.

This calm has the potential to end in the coming months, however, as two major domestic events take place: the U.S. election and two Federal Reserve meetings. This election season is clearly unique and, depending on which presidential candidate emerges victorious, has the potential to stoke volatility. At the same time, the Federal Reserve has indicated it would like to raise the Federal Funds Rate before the end of the year. While the Fed has been hoping to raise rates for most of 2016 without any success, the data stars seem to be aligning for them to give it a go.

Paradoxically, we think a rate hike by the Fed will have the greatest volatility impact not in the bond market, but in other parts of the financial markets. Currencies, commodities and equities are a few places that come to mind. This is because the level of longer-term bond yields is dictated mainly by economic growth, inflation and other factors such as global yields, not necessarily the Fed Funds Rate. These metrics remain subdued: 2016 U.S. GDP will likely come in around 2%, inflation is running below 2% and many global sovereign bonds are trading at negative yields, which provides support for U.S. bonds.

So while summer break is likely over, we don’t see many reasons to expect that the stability high quality bonds have enjoyed will go away any time soon.

The water is still fine.

Source: Bloomberg