Global Head of Fixed Income Strategy
June 20, 2016
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We expect today’s low-yield environment to persist. Here’s how we’re positioning for it.
US rates have been engaged in a tug-of-war over the first half of 2016.
Expectations of policy tightening in the US have ebbed and flowed, as sharp differences in Fed rhetoric has left investors confused over the timing of future rate hikes. As if this wasn’t confusing enough for investors, a sharp recovery in oil prices have fed into higher inflation expectations, though economic data has been broadly uninspiring. So, what might we see next for rates in the US and worldwide?
Put simply, we expect the current environment of low global yields to persist. For US rates, one of the more meaningful influences keeping them low is the growing universe of investment grade bonds around the world with negative yields. The European Central Bank (ECB), Bank of Japan (BoJ) and others have cut their policy rates to below zero. This has pushed investors in these regions to seek out positive yields in longer-duration bonds or in foreign markets, including the US.
Still, we do think US Treasury yields will go up this year. While the Fed has held off from raising policy rates at its June meeting, a July or September hike seems likely to us. Any tightening after that will probably depend on the health of economic data going forward. And, if the Fed does hike as we expect, this will likely push up the short-end of the US yield curve.
On the other hand, yields on longer-term US government debt are likely to remain well-anchored.
Negative interest rate policies and quantitative easing (QE) by the ECB and BOJ will likely keep the relative yield premium in US Treasury debt attractive, further supporting foreign demand. Moreover, at this late stage in the recovery, tighter US policy could have a destabilizing effect on global volatility, further enhancing the demand for long term Treasury debt. Rising oil prices could provoke short-term periods of rising long-term yields, but $60-65 will not likely change the structural anchor behind today’s low global rate environment. Therefore, any spike in long-term rates would be considered a buying opportunity, in our view.
In light of all this, we continue to favour extending duration in fixed-income portfolios, in both the US and European rate markets. However, with 10-year German Bunds turning negative for the first time ever last week, we find very little value in core Eurozone (EZ) rates. EZ periphery countries – such as Spain and Italy – offer better value, though spreads are likely to be dominated by political event risk.
In the US, we recommend investment-grade corporate bonds and tactically adding – or switching into – US TIPS (Treasury Inflation Protected Securities). In our view, higher oil prices are likely to mean short spells of higher headline consumer price inflation, which will enhance the carry on TIPS. This is expected to support TIPS’ relative outperformance versus nominal Treasury debt.
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.