The threat of a slowing China and its surprise currency devaluation drove stocks down and caused global policy makers to adjust policy direction and emphasis. Commodity prices and inflation expectations fell to levels last seen in 2009. U.S. economic data were similarly weak in the first half of the quarter evidenced mostly by weak industrial activity and slumping business sentiment.
It was central bankers to the rescue in the second half of the quarter. Japan’s central bank surprised investors with a negative interest rate policy. The European Central Bank (ECB) deepened its policy of negative rates and added corporate bond buying, along with an additional package of long-term lending programs for banks. Initially, the negative rate policy was a blow to European and U.S. financial institution stocks and bonds as it could severely threaten banks’ interest margins. And finally, the Federal Reserve (Fed) signaled a policy pause at its March meeting, lowering its forecast from four to two rate increases this year. These actions, along with improving economic data in the U.S. and around the globe, gave markets a boost.
The S&P 500 Index rose 13 percent from its mid-February low. Oil prices rose to near $40 a barrel by the end of the quarter, boosting energy and MLP stocks and bonds. High-yield bond spreads snapped back by 183 basis points and investment-grade corporate bond spreads narrowed 52 basis points from their widest levels. Interest rates, however, reversed their slide only slightly. The 10 year U.S. Treasury yield remains 50 basis points below where it started the year. Negative interest rate policies in Japan and Europe, where two-year government bond yields range from -0.25 percent to -0.5 percent, will likely keep U.S. rates low.
Interest rates fell, credit spreads were very volatile and weak fixed income liquidity clearly accentuated the market’s wild moves in the quarter. Treasury yields fell across the curve with the two-year falling about 30 basis points and the
10-year ending the quarter at 1.77 percent. Credit spreads moved wider during the quarter and were highly sensitive to oil prices. Spreads peaked in mid-February with the bottom in oil and then narrowed quickly with oil’s rebound. As a result, spreads made a complete round trip to close almost exactly where they started. The catalyst for the rebound was the ECB’s new program and the Fed’s patience in normalizing interest rates. Despite the rebound in credit spreads, bond market liquidity remains weak. New issue and benchmark bonds trade sometimes points above the same credit issued just last year. Dodd-Frank’s limits on market making and trading for banks continue to be a headwind against investors liquidity needs.