Monetary policy divergence gained momentum in the first quarter. Key central banks continued extraordinarily accommodative monetary policy measures during the quarter — most noteworthy being the European Central Bank’s (ECB) launch into sovereign quantitative easing (QE) — in sharp contrast to the U.S., where the Federal Reserve ( Fed) prepared markets for a rate liftoff from zero later this year. Market participants remained fixated on predicting the actions of key central banks such as the Fed, ECB and People’s Bank of China (PBOC) at the expense of market fundamentals.
While the Fed hinted at rate rises later this year, the markets grappled with the timing and pace, trying to anticipate how the Fed would balance its dual mandate of full employment and price stability amid conflicting economic indicators. While the labor markets showed continued strength pushing ever closer to full employment, global disinflation and falling commodity prices pushed the Fed’s 2% inflation target even further into the distance. Furthermore, a strengthening U.S. dollar began to increase pressure on the U.S. economy — hurting exports, dampening corporate earnings and importing disinflationary pressures via cheaper import prices.
Amid this backdrop, shifting views on the course of Fed action led to a continuation of heightened volatility in interest rates, and broad U.S. fixed income indices ebbed and flowed with U.S. Treasuries throughout the first quarter. January was marked by two central macro events: the ECB’s QE announcement and a nearly 10% decline in the price of West Texas Intermediate crude oil (WTI). Plunging oil prices put additional downward pressure on an already weak inflation outlook, while the ECB’s renewed commitment to easing via bond purchases sparked a global rally in developed market sovereign bonds. International investors further supported the U.S. Treasury market, seeking exposure to the strengthening U.S. dollar, which rose 5% in January and over 9% in the first quarter. U.S. Treasuries rallied in January and then reversed course in February on concerns of an earlier-than-expected Fed tightening. However, as the March FOMC meeting approached, U.S. Treasuries began to recover as fear abated amidst signs of a moderation in economic growth in the first quarter. By quarter-end, expectations for imminent Fed policy tightening diminished, solidifying the U.S. Treasury rally.
The Barclays U.S. Aggregate Bond Index (“Barclays Aggregate”), the proxy for the broad U.S. fixed income market, was up 1.61% for the quarter, led by an over 2% gain in January on falling yields. Comparatively, the S&P 500® Index, the proxy for the broad domestic equity market, edged up only 0.95% for the quarterly period.
U.S. Treasuries rallied most significantly on the long-end of the yield curve, leading long duration U.S. Treasuries to continue their surprisingly strong rally as yields pushed still lower. The 10- and 30-year U.S. Treasury yields began the quarter at 2.17% and 2.75% and ended at 1.92% and 2.54%, respectively. Long-duration government bonds were the highest performing sub-asset class, with the 30-year U.S. Treasury up 5.05% for the quarter.
In addition to U.S. Treasuries, all sectors of the Barclays Aggregate generated positive returns in the first quarter. The corporate sector was the strongest performing sector, led by the utility bond segment as the standout performer, posting a quarterly return of 2.50%. The worst performing sector was asset-backed securities, which still rose 0.90% for the quarter. From a credit perspective within the investment grade universe, performance was led by the A and BBB credit quality segments, which are the primary corporate components of the Barclays Aggregate.
The insatiable thirst for yield continued in the first quarter, and there was a strong bid for high yield fixed income securities (that is fixed income bonds rated below investment grade). The outlook for an improving economy and low default rate expectations, boosted investor appetite and high yield corporate bonds were up a robust 2.52% for the quarter as measured by the Barclays U.S. Corporate High Yield Index.
Looking abroad, developed country government bonds performed well in local currency terms, but when converted to U.S. dollars, returns were negatively impacted. Easy monetary policy and persistently low inflation remained key catalysts for government bonds. The ECB announcement of its sovereign QE program in January fueled a rally in European country bonds, with yields on over a quarter of Europe’s outstanding government debt now with negative nominal interest rates. Similarly, U.S. denominated emerging market bond indices also took part in the global bond rally, and similar to the U.S., corporate bonds followed government bonds higher. The J .P. Morgan Emerging Markets Bond Index Plus (EMBI+), a dollar-denominated index of emerging market bonds, returned 1.87% for the quarter.
In summary, the rallying global fixed income markets provide investors a lot to contemplate. The impact of central bank policy easing on interest rates has been profound, and the ramifications of global QE experiments are yet to be known. The prior notion of a zero-bound to interest rates has been shattered in Europe, and investor projections for higher interest rates have been met year after year with the exact opposite — lower and lower yields.
It appears the Fed, after more than six long years, will finally lift its policy rate off of zero sometime this year, but it is unclear how the global fixed income markets will react to such an event. The pace and magnitude of rate increases going forward will depend on economic developments. Furthermore, lifting rates from zero is just the first step in policy normalization — no one yet is talking about how the Federal Reserve will approach reducing its bloated $4 trillion balance sheet.
Amidst these uncertainties, we believe proper strategic diversification is critical and that actively managed investment solutions can add real economic value to investors’ portfolios.
You should carefully consider the investment objectives, risks, charges and expenses of GuideStone Funds before investing. For a copy of the prospectus with this and other information about the funds, please call 1-888-98-GUIDE (1-888-984-8433) or download a prospectus. You should read the prospectus carefully before investing.
S&P 500® is a trademark of The McGraw-Hill Companies and has been licensed for use by GuideStone Funds. The Equity Index Fund is not sponsored, endorsed, sold or promoted by Standard & Poor’s and Standard & Poor’s makes no representation regarding the advisability of purchasing the Equity Index Fund.
All indices are unmanaged and not available for direct investment. Index performance assumes no taxes, transaction costs, fees or expenses. This update is prepared for general information only and it is not to be reproduced.
GuideStone Capital Management, a controlled affiliate of GuideStone Financial Resources, serves as the investment adviser to GuideStone Funds.