KEY TAKEAWAYS

· Mixed messages from the Fed and middle of the road economic data kept Treasury yields in a very tight trading range throughout August.

· Economically sensitive sectors continued to rally in August, while high-quality bonds lagged as Treasury yields moved toward the upper end of their recent range.

· The employment report from September 2, 2016, may not have been strong enough to force a Fed rate hike in September, but was solid enough to bolster the case for a December hike.

August proved to be a challenging month for high-quality fixed income [Figure 1]. Treasury yields rose across the maturity spectrum, with the benchmark 10-year yield ending the month at 1.58%, toward the high end of its recent range. The rising rate backdrop was a headwind for high-quality bonds, with both Treasuries (-0.6% as measured by the Barclays U.S. Treasury Index), and the Barclays Aggregate (-0.1%) seeing negative returns for the month. Municipals bucked the high-quality performance trend, but managed a positive return of just 0.1%.

Economically sensitive, lower credit-quality bonds continued the rally begun in mid-February 2016, as global investors continued to search for yield in a low-yielding environment. The rebound in the price of oil, up 7.5% during August, was an additional tailwind for high-yield and emerging markets debt (EMD), which were notably strong during the month. High-yield returned 2.1% during August, bringing its year-to-date return to 14.4%. High-yield’s performance since mid-February continues to be extreme, with a rolling six-month outperformance relative to the Barclays Aggregate at an impressive 12%, the highest over any such rolling six-month period in the last 10 years, outside of the recovery from the Great Recession.

The rise in yields was also a tailwind for preferreds, as financial stocks were beneficiaries of higher interest rates.  The rise in Libor (London interbank offered rate), covered in last week’s Bond Market Perspectives, was a benefit for bank loans, which returned 0.8% during August.

Rate Hike Timetable

A look at the market-implied chances of another rate hike occurring by September 2016, which have oscillated between 0% and over 60% in recent months, shows just how volatile short-term rate hike expectations can be [Figure 2].  The opinions of market participants fluctuate with Federal Reserve (Fed) statements, global events, and economic data points.

Fed Chair Janet Yellen’s August speech in Jackson Hole, where she indicated that the case for a rate hike had improved, served to push Treasury yields higher. Fed Vice Chair Fischer piled on soon thereafter, saying that Yellen’s speech could be consistent with two rate hikes in 2016. Yields rose in response to these hawkish comments, but have since receded. The middle of the road employment report for August (released on September 2) may have been weak enough to prevent the Fed from moving in September, while being solid enough to bolster the case for a December 2016 hike.

Regardless of whether the next rate hike occurs in September or December, the market and the Fed agree that the increase in the Fed’s policy rate will be slow and steady. Looking beyond 2016, however, is where markets are still drastically underpricing the Fed’s stated course. The Fed’s median projection for the long-term (approximately five years) fed funds rate is 3%, but the market is currently pricing in a mere 1.65%.

Value Remains Elusive

Another strong rally in lower-quality bonds has resulted in richer valuations across the fixed income market, making value difficult to find [Figure 3].

We still believe in fixed income for its diversification benefits as a risk mitigation tool, but no fixed income sector stands out as overly attractive.  We continue to view investment-grade corporates as potentially delivering incremental value over Treasuries, and think mortgage-backed securities (MBS) may add value as a high-quality option against a backdrop of range-bound yields. Although we believe high-yield may be slightly overvalued at this point, given its tremendous strength year to date, we still think a small allocation can add value for suitable investors, given its substantial yield. We prefer municipals over Treasuries, as a favorable supply/demand imbalance should remain a tailwind, with state and municipal spending still restrained, and the market’s appetite for yield remaining insatiable.

Anthony Valeri is fixed-income and investment strategist for LPL Financial.