The Great Bond Sell-Off of 2015: Repeating in 2016?
by Anthony Valeri, Fixed Income and Investment Strategist, LPL Financial
· Improving economic growth and rising Fed rate hike risks make the current bond market environment similar to 2015.
· Pressure may remain on high-quality bond prices, but we do not envision a repeat of the second quarter 2015 bond sell-off as Europe remains a key differentiator.
The trajectory of high-quality bond yields so far in 2016 is looking eerily similar to 2015, when a second quarter bond sell-off caught investors by surprise. Differences are present but a simple chart (lagging the 2016 data by just 10 days) illustrates how Treasury yields may be taking the same course in 2016 as in 2015 [Figure 1].
Treasury yields in both 2015 and 2016 fell sharply to start the year before rising late in the first quarter. The bounce higher in bond yields was, however, much stronger in 2015 compared to the narrower trading range that has characterized the bond market since early February 2016.
Last week’s Treasury sell-off raises the question of whether a 2015-like bond market sell-off, which occurred around the same time of year, may be repeating in 2016. In 2015, Treasury yields began to move higher in late April as economic growth expectations began to improve and Federal Reserve (Fed) rate hike expectations also increased. First quarter economic growth in both 2015 and 2016 was weak but improvement followed. Consensus forecasts for the second quarter of 2016 call for a 2–2.5% growth rate at this early stage—a notable advancement. .
Similarly, both rising Fed rate hike expectations and better growth expectations were responsible for last week’s jump in Treasury yields. Fed rate hike fears were by far the dominant driver, so it’s not surprising that Fed rate hike expectations also increased in the second quarter of 2015 [Figure 2]. The magnitude of the move was much greater in 2015, but 2016 is starting from a higher base given the December 2015 rate increase.
Even after last week’s sell-off, a June rate hike is only priced in at a 33% probability, and high-quality bond prices may still be vulnerable to further weakness if the pattern of 2015 is ultimately repeated. After scrutinizing the release of the April 26–27, 2016 Federal Open Market Committee (FOMC) meeting minutes last week, most investors still doubt the Fed will move in June, leaving expectations relatively modest. A rate hike in June is still not anticipated but remains a potential risk.
A DIFFERENT PATH IN EUROPE
Europe is a differentiating factor in 2016 compared to 2015. The path of the 10-year German government bond yield also showed a similar pattern in both early 2015 and 2016. In 2015, expectations of additional European Central Bank (ECB) rate cuts and bond purchases boosted growth expectations during the second quarter. However, the path of the 10-year German bond yield has taken an almost opposite trajectory since the start of the second quarter of 2016 [Figure 3].
German government bond yields jumped higher in late March following bold policy action from the ECB. With the market growing skeptical of the effectiveness of such policy, and Europe still showing sluggish economic growth, a meaningful turn higher in German bond yields has yet to materialize.
In 2015, Europe was the epicenter of the global bond sell-off during the second quarter. So far in 2016, a similar pattern is not developing and suggests extrapolating a similar sell-off is premature.