U.S. Fixed Income: What's 'Nexit' For The Bond Market?

by: WisdomTree

By Kevin Flanagan

Well, here we are. The "leave" Brexit vote has become a reality and the global markets essentially responded as expected. While the catalyst this time around is perhaps different, it does seem as if we have been down this road before. Thus, it is important to not get caught up in the headlines of the day but, rather, focus on what comes next once emotions have cooled.

The U.S. Treasury (UST) market certainly delivered in terms of its response. As we discussed in our June 22 blog post "U.S. Treasuries: Brexit Meets Grexit," the 10-year yield dropped through some prior technical low points and made a run at the all-time nadir of 1.39% that occurred post-Grexit in July 2012. For the record, the intraday level got down to 1.40% before reversing course at one point by nearly 20 basis points (bps). This knee-jerk response was no doubt a result of heightened fears and anxieties as to what a "leave" vote could ultimately entail, reflecting uncertainties regarding the global economy, potential political fallout (which nation may be the next to leave?) and the health of the banking sector in the event of increased stress in the funding markets. It came as no surprise to see spreads increase in the U.S. corporate bond market, and we could see additional widening as the Brexit saga plays out in the near term. However, early on, yield levels for both the investment grade and high yield sectors have remained anchored by the visible drop in UST rates.

If anything good came from the financial and prior eurozone crises, they gave global central banks a playbook or blueprint as to what policies to implement to counteract potential disruptions in the financial markets, specifically the funding markets. Once again, we turn our attention to the arena where banks are funding themselves on a more short-term basis to see if there were any indications of stresses emerging. As of this writing, the early signs revealed only modest widening in LIBOR-OIS spreads (USD, EUR, GBP), but nothing that came even remotely close to the levels that existed during the eurozone crisis in 2011-2012. Along these lines, in its initial response to the result of the vote, the Bank of England pledged $345 billion for the financial system while the Federal Reserve (Fed) put out a press release stating that it was "prepared to provide dollar liquidity through its existing swap lines with central banks, as necessary, to address pressures in global funding markets."1

Obviously, potential rate cuts, especially from the Bank of England, have entered into the discussion as well, but the Fed also was brought into the mix. Indeed, Federal Funds futures posted anywhere from a 10% to almost 25% implied probability that the FOMC would also go down this road. At this point, our base case does not envision the Fed reversing last December's rate hike.

Conclusion

There's little doubt the Brexit headlines, and the potential fallout, will affect the U.S. fixed income arena in the near future. However, as we saw with Grexit, the UST market doesn't stay constant. In fact, a year after hitting its all-time low in 2012, the 10-Year yield had risen 120 bps to 2.59% as the bond market was in the throes of the "taper tantrum." A year from now, the U.S. will have a new president and fiscal stimulus/tax reform could be on the radar screen (just a thought), and don't count out future jobs reports if they show a rebound from last month's data. We're already seeing ramifications for the U.S. economy being put into perspective, with economists projecting little impact on real GDP this year, followed by a modest reduction, of a couple of percentage points, in 2017. The Brexit process itself will take time to play out because, based upon Article 50 of the Treaty on European Union, the U.K. has two years to negotiate its secession. A core strategy for fixed income investors' portfolio is of paramount importance.

Unless otherwise noted, data source is Bloomberg as of 6/27/2016.

1Federal Reserve press release, 6/24/16.

Important Risks Related to this Article

Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty.

Investments focused in Europe increase the impact of events and developments associated with the region, which can adversely affect performance.

There are risks associated with investing, including possible loss of principal. Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline. Investing in mortgage- and asset-backed securities involves interest rate, credit, valuation, extension and liquidity risks and the risk that payments on the underlying assets are delayed, prepaid, subordinated or defaulted on. Due to the investment strategy of the Fund, it may make higher capital gain distributions than other ETFs. Please read the Fund's prospectus for specific details regarding the Fund's risk profile. Kevin Flanagan

Kevin Flanagan, Senior Fixed Income Strategist

As part of WisdomTree’s Investment Strategy group, Kevin serves as Senior Fixed Income Strategist. In this role, he contributes to the asset allocation team, writes fixed income-related content and travels with the sales team, conducting client-facing meetings and providing expertise on WisdomTree’s existing and future bond ETFs. In addition, Kevin works closely with the fixed income team. Prior to joining WisdomTree, Kevin spent 30 years at Morgan Stanley, where he was most recently a Managing Director. He was responsible for tactical and strategic recommendations and created asset allocation models for fixed income securities. He was a contributor to the Morgan Stanley Wealth Management Global Investment Committee, primary author of Morgan Stanley Wealth Management’s monthly and weekly fixed income publications, and collaborated with the firm’s Research and Consulting Group Divisions to build ETF and fund manager asset allocation models. Kevin has an MBA from Pace University’s Lubin Graduate School of Business, and a B.S in Finance from Fairfield University.