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The case for the first great divergence in global monetary policy since the financial crisis of 2008 was officially inaugurated in the final quarter of 2015. Long-anticipated macro narratives, expressing monetary policy variance, were finally validated. There were many economic developments this past reporting period that facilitated the corridor for the U.S. Federal Reserve (Fed) to raise key interest rates. Central to this change, U.S. economic data remained upbeat and concerns over a hard economic landing in China moderated. In November, U.S. non-farm employment registered a resounding 271,000 gain; estimates had been anticipating an increase of just two hundred thousand. This robust employment data armored the Fed and paved the way for a rate hike. On December 16th, the Fed raised interest rates by 0.25%; the first of its kind in nearly 10 years.
Contrasting the U.S., the People’s Bank of China (PBOC) reduced both key interest rates and reserve requirements, which proved pivotal in alleviating the apprehension over a precipitous fall in Chinese growth. Similarly, the European Central Bank (ECB) eased monetary policy further by augmenting its pre-existing economic stimulus program.
These global policy disparities generated a lot of price volatility throughout the reporting period, but generally speaking, total returns were fairly muted. From peak to trough, the euro/U.S. dollar (USD) trading range was nearly 8.5%, but the euro itself only surrendered 2.68% to the dollar. Developed global government bond markets echoed similar price behavior. As the fourth quarter wound to a close, the developed global Government Bond Index (GBI) was down a mere 0.10%.
Japanese economic affairs kicked off the period in muddled form. Initially, a string of downbeat data releases, including weaker-than-expected industrial production, increased the risks that Japan would slip into yet another technical recession. Export growth also slowed; a symptom of waning overseas demand. Specifically, exports to China, Japan’s biggest trading partner, fell 4.6% in October. In November, Japanese gross domestic product (GDP) data officially qualified the economy as recessionary and further buttressed the viewpoints for more quantitative easing. No sooner had the “recession” proclamation been made, the December revisions to GDP painted an entirely different outlook. The revised report reflected more buoyant data on business investment and a rosier view of consumer spending. As it turned out, Japan’s latest recession was not a recession at all!
The abrupt revisions to GDP and the increase in global market volatility worked in tandem to support the Japanese yen in the past three months. As prospects for additional stimulus from the Bank of Japan diminished, so did the probability for additional yen weakness. Additionally, the harbor characteristics of Japanese Government Bonds (JGB) incited more demand for the currency as global risk premiums began to rise by the end of the fourth quarter. The yen outperformed most other G-20 economies, while benchmark JGB’s procured a 1.17% return at the end of the reporting period.
Commodity Linked Countries:
It was a mixed period for the commodity complex, both in performance and market drivers. The New Zealand dollar (NZD) ranked as the best-performing G-10 currency, but the appreciation was largely technical in nature. The Central Bank of New Zealand (RBNZ) actually cut by 0.25%, bringing the cash rate to 2.5%. However, the RBNZ was faintly more hawkish than the market expected by conveying its intention to remain on hold from further monetary easing. Sound domestic data in Australia helped to turn the tide for that country’s currency, the Aud. The unemployment rate in Australia fell to 5.9% versus estimates that were hovering around 6.2%. The labor data also dovetailed, strengthening consumer confidence and strong housing construction. In the fourth quarter of 2015, the NZD was up 6.75% and benchmark government bonds were down 0.38%. Mirroring its neighbor, the Australian dollar gained 3.82%, and local government bonds declined by 0.53%.
In sharp contrast, the odds that the Bank of Canada would cut rates further increased as the deepening oil rout weighed heavily on the country’s economic outlook. The Canadian dollar ranked at the opposing end of NZD, coming in last at -3.80% on the quarter. Similarly, the Norwegian krone continued to suffer from the incessant drop in West Texas Intermediate crude prices. Manufacturing and mining weakness continued to be the Achilles heel behind the economy, and will likely prove to be the main motive for a future rate cut by the Norges Bank. The krone lost 3.70% in the fourth quarter of 2015.
Until recently, economic progress in the U.K. was very promising, and like the U.S., poised for a rate hike. Unfortunately, the latest batch of macro data suggested that the U.K. recovery may be losing some steam. Leading surveys for U.K. manufacturers have been tarnished for some time, but other aspects of the economy began to exhibit some troubling signs as well. the U.K. Consumer Price Index began to disappoint, revealing a 0.1% decrease year-over-year where no change had been expected. Quarterly GDP figures revealed meager growth of just 0.5%; lower than the 0.6% anticipated.
This past reporting period could very well prove to have been an important inflection point for both U.K. bonds and the British pound. Until recently, the British pound was a constant relative outperformer and a good alternative to the U.S. dollar. Notably, the most recent remarks from the Monetary Pricing Committee (MPC) sealed the fate for the British pound. Growing doubts over the recovery have pared back the hawkish sentiment from the MPC. The committee highlighted that eight of its nine members continue to favor leaving the benchmark rate at 0.5%. The once resilient British pound as a consequence lost 2.59% in the past reporting period.
Sadly, the single biggest event in Europe had nothing to do with economics or markets, but with the heartrending terror attacks that struck the streets of Paris. The human tragedy was immeasurable, but the impact on financial markets was surprisingly short lived. Eurozone aggregate economic data continued to muddle along, either meeting expectations or beating them slightly. European manufacturing continued to show promise, edging up slightly from the prior month, while inflation figures remained constant, be it at extremely low levels. However, unemployment remained stubbornly anchored around 11% and continued to meddle with consumer confidence levels. Month-over-month retail sales disappointed forecasters, while eurozone expectations for growth dropped to their lowest levels since 2014.
In the last month of the reporting period, the ECB cut the deposit rate by 10 basis points to -0.3%. The Asset Purchase Program was also extended to March 2017 (from September 2016) but the size was unchanged at €60 billion. However, the combined package was far less aggressive than investors had expected. First, it fell short in providing stronger forward guidance; extending quantitative indefinitely until inflation reached 2%. Second, it did not remove the yield floor for government bond purchases or increase the pool of eligible assets. More importantly, the announcement also fell short of what the market had been expecting: a larger cut to the deposit facility. The underwhelming announcement incited the single largest intraday rally in the euro since 2009. However, the euro still finished the reporting period underperforming the USD by 2.82%.
During the reporting period, Federated Prudent Dollar Bear Fund had a total return of -1.74% (Class A Shares at NAV). The return for the inverse of the USD Index (DXY) was -2.37% for the same period. The fund’s absolute return was largely the effect of U.S. dollar strength against most of the fund’s currency holdings.
Performance data quoted represents past performance, which is no guarantee of future results. Investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than what is stated. Other share classes may have experienced different returns than the share class presented. To view performance current to the most recent month-end and for after tax returns, click on the Performance tab. Performance does not reflect the maximum 4.5% sales charge for Class A Shares. If included, it would reduce the performance quoted.
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A legacy underweight exposure to the euro bolstered return relative to the benchmark, JPMGXUS. Additionally, active duration management bettered fund performance relative to JPMGXUS. Lastly, the Fund’s continued abstention from overweight allocation to commodity linked investments and higher beta holdings benefitted overall performance, and sheltered the Fund from excessive market volatility.
Generally speaking, two topics dominated financial markets last year: Chinese growth concerns, and whether the Fed would raise interest rates. It may be fair to say that one of those unknowns is now officially behind us. This is not to imply that Fed monetary policy will be eliminated as a risk factor, but it may very well take a back seat to the China narrative. Economic prospects in China could very well become the first derivative to any macro thesis. Mining Chinese economic data will prove essential in determining the outlook for a myriad of markets and asset classes. In past correspondence, fund management persistently highlighted the importance of this subject; we believe that the coming year is no exception. In fact, 2016 may very well prove to be a critical inflection point for China. The country is undergoing large structural changes that are seismic in scale. Reengineering a nation into a consumer-led economy is a massive undertaking that does not happen overnight. However, the transformation will invariably encounter peaks and troughs; this will prove vital in assessing second derivate global implications and investment opportunities.
With the “if” finally removed from “if the U.S. raises interest rates” conundrum, the focus will likely shift to “how much and how quickly?” The velocity of U.S. monetary tightening will not only determine the direction of the U.S. bond markets, but also the fate of the USD as well. Dollar strength is likely to continue, but the composition of that appreciation is poised to change. First, the magnitude of USD gains is likely to be more truncated than in prior reporting periods. Secondly, the breadth of USD appreciation may no longer be so one dimensional and monolithic in scope. Foreign exchange selection is likely to change from a top-down methodology to one that is very currency specific. In some commodity areas, currency valuations are growing exceedingly cheap, but overall fundamentals remain fairly weak. This delicate balance will require both micro- and macro-analysis to determine whether commodity currencies should be re-introduced into portfolio holdings. Risk-adjusted returns are a top priority for fund management.
Front-end German bonds should outperform their U.S. counterparts as they will remain anchored by ECB quantitative-easing forces (where the divergence is most concentrated).