Insights

What a difference a new year makes! Having been lulled into complacency with respect to volatility, financial markets – particularly the domestic equity markets – got a rude awakening in early February. Suddenly, the “short vol” trade came to a screeching halt, and equities entered a period of heightened volatility with a distinctly downward trend. Exacerbated by political developments (principally, fears of a trade war), revaluation of tech stocks, and the challenge of rising interest rates, equities finished the period in a downward swoon.

Interest rate worries and oversized bets on continued market stability led to severe gyrations in the stock market in February. The Treasury market followed suit, with significant intra-day price fluctuations. The yield of the 10-year note finished the month 16 basis points (bps) higher. The yield curve steepened by approximately 8 bps from 2 to 30 years.

Bond markets sold off in dramatic fashion in January. The 10-year Treasury note yield rose 32 basis points (bps). The yield curve steepened modestly through 10 years, but flattened from 10 to 30 years. Equities posted large gains. The financial markets responded to more positive global economic news, strong earnings domestically, and momentum from the recently enacted Tax Cuts and Jobs Act of 2017.

The Tax Cuts and Jobs Act of 2017 (TCJA) was signed into law on December 22, 2017. Most provisions of the new law affecting individuals and businesses went into effect on January 1, 2018, including new tax brackets and new standard deductions. One of the most dramatic changes is the approach to corporate taxes. TCJA lowers the corporate income tax rate to 21% and moves the United States from a worldwide to a territorial system of taxation.

The volatility in weather conditions stands in stark contrast to the level of volatility in financial markets. During 2017, the yield on the 10-year maturity U.S. Treasury note rarely ventured out of a 25 basis point band, and ended the year only 8 basis points higher than where it began. Even more notable was the lack of volatility in domestic equity markets, where the VIX inched lower as stock prices surged. 

Against a backdrop of generally positive economic news, enthusiasm over potential tax cuts, a roaring equity market, and an upward move in oil and commodity prices, the Treasury market had yet another month of limited volatility. Ten-year yields fell six basis points (bps) before rising to a 2.43% yield at month-end, just a few bps higher than the October close.

It was another month of low volatility despite a considerable amount of news. The outlook for global growth has improved, as demonstrated in recent PMI releases, which included a surprisingly strong US ISM manufacturing number. Payroll data early in the month reflected the consequences of the summer’s hurricanes, but by mid-month, jobless claims suggested that this was a short-term phenomenon. Durable goods orders were up as well. The equity market continued its march forward. The Fed’s balance sheet normalization process began with (ultimately) little fanfare.

Tax rates are an important consideration in fixed income asset allocations. Many investors in high tax brackets assume they should be invested entirely in tax-free municipal bonds, while tax-exempt investors (e.g. foundations, pensions funds) ignore tax-free bonds altogether. In both cases, investors would be better served to consider a more balanced approach, focusing on the potential after-tax return and risk of all fixed income sectors.

After four rate hikes, beginning in December 2015, the federal funds rate stands at a range of 1.00% to 1.25%. The September FOMC meetings concluded with no change to rates. However, the hawkish tone delivered by the Fed through its “dot plots” showed continued support for a third rate hike in 2017 by 12 of the 16 FOMC members. This sent the implied probability of another rate hike this year up to 70%, from a low of 30% at the end of August. 

Although the economic data were mixed, the theme for the month was ultimately stable growth but weak inflation. Retail sales, consumer confidence, and GDP all were positive; housing releases disappointed. Corporate earnings topped 10% for the second consecutive quarter. Most importantly, inflation has clearly remained below market expectations as well as the Federal Reserve’s 2% target.