Head - Fixed Income Strategy
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In the short term, yields may be weighed down around current levels
The summer months tend to exhibit a strong seasonal pattern of high quality asset outperformance. This summer has held true to form, with long-dated US Treasury (UST) yields declining 25-30 basis points, and various maturities generating total returns between 3.0% and 5.0%. This is compared to a more modest 1.5% gain on the S&P 500 over the last several months. Currently, 10-year benchmark yields are at their lowest levels this year (~2.0%) and below levels prior to the Federal Reserve’s first rate hike in December 2015.
Geo-political events are largely responsible for the recent drop in yields, as North Korea tops a long list of conflicts driving demand for UST. This has been further exacerbated by weak inflation trends, rising concerns over the US debt ceiling and a likely negative economic impact from the devastating hurricanes in southern Texas and Florida. Moreover, the ongoing bond purchase programs in Europe and Japan continue to keep the yield gap between US and non-US markets historically wide, and the relative value for US assets attractive. In the short-term, many of these issues are likely to continue to weigh on investors’ minds and keep UST yields contained near current levels.
One issue was partially resolved as US politicians came to an agreement on the US debt limit. With a “hard” debt ceiling deadline expected to be triggered near the end of September or beginning of October (according to US Treasury estimates), politicians uncomfortably agreed to a three-month extension through mid-December. While also including a short-term “continuing resolution” to fund the government, this removes some near-term uncertainty over a potential government shutdown. That said, the debt ceiling debate has only been pushed to year-end and markets will likely need to contend with rising political uncertainty once again.
To complicate matters, the US FOMC (Federal Open Market Committee) is set to convene on September 20. Though our expectations are for the central bank to keep policy rates unchanged, we anticipate the committee to announce their intention to begin balance sheet normalization in the fourth quarter. Moreover, the ECB is likely to announce a further tapering of their bond purchase program later this fall. Central banks are set to decrease bond purchases by nearly $1 trillion in 2018. This will require a greater flow of private investment in order to fund government borrowings. We think this is modestly bearish for long-term US rates, as private investors may require higher UST yields in order to garner meaningful interest.
The September FOMC meeting also coincides with updates to the committee’s economic projections. This includes the famous “dots”, or FOMC member’s expectations of the future path of policy rates. With less certainty over core inflation meeting the committee’s mandate, it’s possible we could see a shift lower in longer-term policy rate expectations. In our view, we still expect an additional 25bp rate hike this year, likely in December. This should keep short-rates and LIBOR rates elevated, while also adding further flattening pressure on the Treasury curve.
In a surprise to markets, the Bank of Canada tightened policy rates on September 6 (the 2nd hike in the last two months), raising their benchmark rate an additional 25 basis points to 1.0%. According to the central bank, stronger economic data had allowed them to remove some of the “considerable” stimulus, while maintaining a cautious outlook. Indeed, the appreciation in the Canadian dollar was referenced in their statement, after gaining more than 8% over the last three months.
Short-dated Canadian sovereign yields spiked on the news, with 2-year benchmarks rising 10bp to 1.45%, the highest levels since 2011. Though 10-year yields moved a more modest 7bp (before settling in around 1.95%), long-dated bonds still underperformed, losing nearly 1.0% versus a 0.25% decline in short-term bond prices. At this stage, risks for additional rate hikes are building. If growth continues to improve and core inflation stabilizes, we would expect the yield differential between CAD and US rates to narrow further, with long-dated bonds underperforming.
We remain neutral US Treasuries.
Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuer’s credit rating, or creditworthiness, causes a bond’s price to decline. High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues. Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made.