Market observers continue to tout the “divergence” narrative – that the U.S. zigged when Europe zagged – but I find this perception to be increasingly out of synch with what actually happened. In fact, the divergences in global economic performance – one of those being that U.S. monetary policy would tighten while European monetary policy would loosen – actually look very much like an explanation for what already happened last year.
U.S., Europe economic performance converges
For the first quarter of 2015, as the chart below highlights, economic performance converged, with the U.S. slowing and Europe surprising to the upside. The upshot? U.S. interest rates fell in March as the Federal Reserve acknowledged the weakness in growth and inflation and pushed expectations back for “liftoff”. Meanwhile, much of the impact of the European Central Bank’s (ECB) highly anticipated quantitative easing (QE) program appears to have been realized, as interest rates in periphery bonds reached their lows in March around the time of program implementation and more recently core rates (French and German) appear to have bounced significantly off of their lows.
Investors may have also noticed the underperformance of municipal bonds in April. We have used the theme “Where you hold your duration matters as much as how much duration you hold,” or its pop-culture version—“Dude, Where’s My Duration”?—to highlight that when the Fed is about to change policy, movements in the yield curve will greatly impact fixed-income outcomes. In April, the long end of the yield curve underperformed, and as municipal bonds have more of their interest rate exposure coming from the long end, this contributed to their underperformance.
The inflation factor
What accounts for the underperformance of longer maturity bonds in April? One reason is a recovery in inflation expectations. “Breakeven” inflation expectations refer to the market-based measures of inflation extracted from the prices of Treasury Inflation-Protected Securities (TIPS). These expectations have closely followed the price of oil as the latter contributes to the headline inflation that determines the inflation compensation in TIPS. As oil prices bottomed in March and moved higher in April, these inflation expectations correspondingly moved higher.
Another factor contributing to the rise in inflation expectations is the Fed’s more dovish monetary policy stance. To the extent that the Fed continues to postpone policy normalization, one potential consequence could be higher inflation in the future. And higher expectations for future inflation should exert a greater upward pressure on longer maturity interest rates than on shorter maturities.
Taking a closer look at interest rates
The second explanation for the recent long end underperformance lies in the global “divergences” theme. For long-end interest rates, recall this meant that low global interest rates would keep long-term interest rates in the U.S. low. Even as the Fed was looking to raise rates, the relative attractiveness of longer maturity U.S. interest rates would keep global investors moving into U.S. Treasuries and out of global alternatives. This was called the “conundrum 2.0″ as it referred to an earlier period (2004) where Fed tightening was met with huge global demand for Treasury debt that led to smaller increases in longer maturity yields than expected. Our “Conundrum in the Conundrum” theme questioned this outlook, viewing it better as an explanation for what had already happened rather than an outlook.
Jeffrey Rosenberg, Managing Director, is BlackRock’s Chief Investment Strategist for Fixed Income, and a regular contributor to The Blog.