February 9, 2017. By John Wolfsberg:
After bottoming in the first half of 2016, interest rates rose sharply in the fourth quarter following the surprise victory of Donald Trump in the U. S. presidential election. Rates had entered the quarter on a slow upward trajectory as improving economic data suggested that a rate increase would be more likely during the December FOMC meeting. However, following Donald Trump’s victory the market immediately began to price in the anticipated impact of his policy proposals on economic growth and inflation, sending Treasury yields significantly higher in just a few trading sessions. Exacerbating this upward move in yields was continued Republican control of Congress, which suggested that many of the pro-growth policies articulated by Trump during his campaign (fiscal stimulus and tax cuts, in particular) would have a strong chance of being implemented.
As a result of the move in rates, fixed income returns for the quarter were negative for virtually every sector. Treasuries were impacted the most, with the 10yr Treasury losing 6.93% during the quarter (its worst quarterly return since Q3 1980) as its yield rose 85 bps, from 1.60% to 2.45%. Municipal bonds were also impacted as campaign proposals to reduce tax rates caused investor concern that tax-exempt income would lose its value. Corporate credit, while still experiencing negative returns, was helped by spread tightening caused primarily by the post-election risk-on trade. In general, lower rated credits (high yield) performed the best as investors pursued riskier assets in the expectation of a pro-growth environment.
The market’s initial reaction suggested investors believed all of Trump’s campaign proposals would be enacted as articulated resulting in strong growth and increased inflation. As we enter 2017 the market appears to have settled into a trading range with more of a “show me” attitude towards what campaign proposals may or may not become policy. The market now has to decide if the change from monetary stimulus to fiscal stimulus will result in growth signaling the beginning of a secular trend to higher rates.
Please take a moment to read our complete commentary here: Fixed Income Letter, Fourth Quarter 2016