2014 – A Review
At the beginning of calendar year 2014, expectations by many pundits were for U.S. Treasury yields to end the calendar year at higher levels due to projections of an improving domestic economy and the possible end to the Federal Reserve’s quantitative easing program. As is normally the case, what actually happened during 2014 was much different than what was originally projected.
The U.S. yield curve flattened during 2014 as short-term yields, which are more sensitive to projected Federal Reserve actions, increased with expectations the central bank would begin modestly reducing stimulus policies. In contrast, the mid- and longer-term yields fell in response to economic pressures from moderate global growth, lower inflation (including declining oil prices), fiscal austerity, struggling emerging market economies (including China) and strong foreign demand. As evidence, the two-year U.S. Treasury yield increased from 0.38% to 0.67% during the year while the 30-year U.S. Treasury yield fell from 3.97% to 2.75% for the same period. In general, the declining interest rate environment provided some tailwind to the overall bond market given bond prices move inversely with yields. The broad U.S. bond market, as measured by the Barclays Aggregate Bond Index, posted quarterly and annual returns of 1.79% and 5.97%, respectively.
Another economic theme during the year was the divergence in monetary policy of the major central banks across the globe. Over recent years, the major central banks, including the Federal Reserve in the U.S., have been implementing aggressive monetary policies from the same “playbook” in a somewhat coordinated manner. However, the U.S. economy has emerged as a leader in economic growth compared to other major economies, posting a third quarter Gross Domestic Product (“GDP”) of 5.0%. The Federal Reserve appeared to be further along in their process compared to many others, with expectations for it to possibly make their first rate hike during 2015, while weak economic environments in continental Europe and Japan are forcing those central banks to accelerate their efforts to boost economic activity and thwart deflationary pressures. The U.S. dollar appreciated meaningfully in this environment, up almost 12% during the year, as yield-hungry global investors were attracted to the higher relative yields in the U.S. and the “safe-haven” characteristic of the currency in the midst of economic uncertainty and heightened geopolitical risks.
When reviewing the fixed income markets during the year, returns generally differed by sector, quality and duration with almost all areas posting positive absolute returns for the year. In general, bonds with longer durations outpaced bonds with shorter durations given their prices are more sensitive to movements in interest rates. The best area of the bond market during 2014 was the 30-year U.S. Treasury. This long-duration security was up an astonishing 29.38% for the year. Related to quality, investment grade corporate bonds were up 7.46% during 2014, outpacing high yield (or below investment grade) corporate bonds that posted an annual return of 2.46%, as measured by the Barclay’s U.S. High Yield Corporate Index. Emerging market debt, as measured by the J.P. Morgan EMBI+ (a U.S. dollar denominated index), generated an annual return of 6.15%. A difficult area of the bond market for U.S. based investors (that were not hedged back to the U.S. dollar) was non-U.S. bonds that were denominated in currencies that depreciated versus the U.S. dollar.
2015 — A Preview
Looking forward in 2015, all eyes will be on the Federal Reserve’s Federal Open Market Committee (“FOMC”) with speculation abounding as to when it will begin to raise interest rates. The Federal Reserve’s two primary purposes are employment and price stability. Employment measures, including the unemployment rate, improved during the year, while inflation has remained below the Federal Reserves’ long-term target of 2%. At year-end, consensus appeared to be that the Federal Reserve will first raise rates in mid-2015 with possible future rate hikes in the latter half of the year. The Federal Reserve remains data-dependent, so a change in the direction or the magnitude of economic data could change the central bank’s course. As stated last quarter, the Federal Reserve remains in the difficult and unenviable position of removing accommodative policy without thwarting domestic economic growth.
Expectations are for volatility in returns to increase, especially if global monetary policies continue to diverge and/or the Federal Reserve begins raising rates. U.S. Treasury yields will continue to have conflicting pressures — upward pressure from the projected Federal Reserve rate increases and a strengthening U.S. economy offset by downward pressure from sluggish global economic growth, strong demand and a low inflationary environment. The year 2014 surprised many on the upside, but the return expectations for fixed income securities during 2015 should be somewhat muted compared to long-term averages.
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