Federal Reserve Hikes Rates at June Meeting
At their mid-June Federal Open Market Committee, the Federal Reserve moved forward with a 25 basis point increase
This “wall of maturities” has the potential to materially alter the Fed’s influence on broader financial conditions. Previously, the Fed replaced maturing bonds with newly-issued securities at auction, serving as a key support mechanism for financial conditions by creating demand for Treasuries and maintaining a large amount of the banking system reserves. In other words, despite a lack of direct asset purchases since the conclusion of the Fed’s third quantitative easing program in October 2014, the Fed has remained stimulative through the reinvestment of maturing securities.
Although the Fed provided some insight into their plans for shrinking the size of their balance sheet, any long-term implications for financial conditions, asset prices, and economic fundamentals remain difficult to discern. Declining demand for Treasury securities on behalf of the Fed may lead to rising Treasury rates, as previous Fed Treasury reinvestments helped apply upward pressure to Treasury prices through the stripping of supply from the market; however, the combination of interest rate hikes and a shrinking balance sheet could conversely serve as a headwind to already elevated valuations across many “risky” areas of the market, potentially supporting safe-haven assets that typically benefit in a risk-off environment. To summarize, the ramifications of the Fed’s next chapter in their tightening playbook remain unclear, necessitating vigilance on the behalf of investors seeking to navigate the shifting winds of today’s central bank-dominated capital markets successfully.
- Corporate earnings improved and the U.S. labor market showed continued strength in the second quarter, supporting equity returns in all market caps.
Earnings remained particularly strong in the information technology sector, and news of Amazon’s $14 billion acquisition of Whole Foods created headlines about the evolving business of the Internet retailer.1
Stocks in the energy sector were hit particularly hard, with ongoing supply concerns weighing on oil prices as U.S. production increases garnered attention despite the continuation of OPEC’s production cuts.
Optimism abounded in Europe when Emmanuel Macron was elected president of France—just 14 months after founding a new political party—eliminating Marine Le Pen’s presidential hopes and reassuring European investors while spurring a 7% gain in the euro against the U.S. dollar.2
MSCI announced plans in June to add China A shares to the emerging markets index in a scaled fashion over the next year, contributing to double-digit returns in the Chinese market.
As anticipated, the Fed increased its target rate 25 bps during the quarter, and the market is implying a 57% probability of a third rate hike by year-end.3
Mario Draghi, Head of the ECB, showed confidence in improving economic conditions and shifted to a hawkish tone as he announced that the ECB may begin to curtail current stimulus efforts.
Inflation expectations continued to decline following the increase at the beginning of the year, decreasing the 10-year breakeven rate by 23 bps.4
The yield curve flattened as the 2-year Treasury increased 15 bps against a flat 10-year Treasury. The 10-year yield dropped to a low of 2.1% during the
quarter,but ended the quarter unchanged at 2.3% after Draghi’s announcement.5
Risk-on sentiment continued to rally, with no major changes to the stability of corporate credit fundamentals.
International real estate securities were positively affected by a growth in overall construction throughout the international market during the second quarter, due in part to
accessiblecapital markets and the beginning of the summer season in the northern hemisphere. In the U.S., REIT performance was more tepid, which may be a consequence of the rising rate environment.
Oil prices decreased during the second quarter due to rising fears of increasing production, while demand remained relatively flat for the quarter.
Livestock was the only portion of the commodity complex to provide positive returns, with reduced Brazilian exports and increased demand in China partially offsetting declines that led to a 3% loss in commodities for the quarter.6
MASTER LIMITED PARTNERSHIPS
A drop in the price of crude oil in the quarter led to a decline in MLPs. MLP performance had become less correlated with the price of crude oil as stability began to return to the oil markets; however, consistently high oil inventories weighed on commodity markets, creating a resurgence of apprehension in the MLP space despite the need for continued investment in U.S. energy infrastructure, even at current prices.
The risk asset rally supported by Macron’s election victory was beneficial for global macro managers with long positions in the euro and European equities, as well as for event-driven managers that tend to be more highly correlated to equity markets.
In late May, corruption allegations against Brazilian President Michel Temer shocked markets and led to a sell-off in the Brazilian real and equities. Emerging markets managers were generally positioned long risk assets in Brazil, as many were bullish on the reform agenda put in place by President Temer.
Major central banks such as the Fed, ECB, Bank of England, and Bank of Canada took a more hawkish stance toward the end of June, sending global bond yields soaring and the U.S. dollar plummeting. These large trend reversals hurt momentum-driven strategies such as Commodity Trading Advisors.
1 Turner, Wang, and Soper, Amazon to Acquire Whole Foods for $13.7 Billion, Bloomberg LP, June 16, 2017
2-5 Data from Bloomberg, L.P.
6 Data from Lipper
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