Head - Fixed Income Strategy
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The future for long-term rates is under heavy geopolitical influence
When sitting down for a formal meal, reaching across the table (or across others) has always been considered impolite. Dining etiquette suggests that asking for items to be passed to you is more appropriate. In some ways, global fixed income markets are teaching us the rules of table manners.
Tighter Federal Reserve policy has lifted short-term rates, while flattening the Treasury yield curve. This makes reaching for yield in longer-durations less attractive. At the same time, historically low bond yields in non-US markets makes reaching for yield an arduous proposition. Subtle moves higher in rates can have significant impacts on performance. Similar to getting your hand smacked when reaching for the salt.
Despite 2Q US growth accelerating and inflation meeting the Federal Reserve’s mandate, 10-year Treasury yields are still well below its 3.1% peak back in May. We now see less predictable and possibly more negative economic impact from US trade actions across the world. In our view, if trade tensions escalate further, long-term UST yields could face further downward pressure.
However, the binary outlook for long-term rates is under heavy geopolitical influence. Excluding trade issues, we believe 10yr UST yields could easily be back over 3.0%. US macro fundamentals remain strong, with 2Q GDP growth accelerating near 4.0% amid strong earnings growth supported by US tax cuts. Moreover, wage pressures are building and the Fed’s inflation mandate on core personal consumption reached 2.0% last month. That said, we’d be very cautious about long duration exposures for any investors taking a more optimistic view on trade. Indeed, constructive rhetoric over NAFTA and the recently announced trade agreement between the US and European Union has moved long-term yields back towards 2.95%.
Investors should also take notice about what’s happening in other regions. The ECB announced their intentions to end quantitative easing (QE) in January 2019, which could take some pressure off the historically wide yield differentials between the US and the Eurozone. While in Asia, speculation that the Bank of Japan may be considering to re-calibrate its yield curve control policy pushed long-term core rates higher. 10-year Japanese sovereign bond yields tripled on the news to 0.1% (a 12-month high).
While volatility in long rates is likely to continue, short US rates remains contained by the Federal Reserve. In June, the central bank raised policy rates for a 7th time since December 2015, bringing the upper bound of the Fed Funds rate to 2.0%. Along with the reduction of the Fed’s bond holdings, short-term US rates continue to reach higher post-crisis highs. In our view, this trend is likely to persist. Supported by a healthy US economic outlook, we expect the Fed to continue to raise policy rates through next year. Our base case remains for at least one more rate hike this year, followed by at least three more rate hikes in 2019.
However, markets have been implying a much more benign pace of tightening. To be sure, pricing on futures contracts suggests a pace which is 50% lower than Fed projections. As was the case last year, we believe the market will need to adjust and close the gap, pushing short-term US rates higher. This includes dollar funding rates, where we expect 3-month LIBOR to reach 3.5% by the end of 2019. For this reason, we continue to look for economical ways of hedging floating-rate liabilities, while taking advantage of assets that have floating-rate coupons.
Tighter Fed policy is also likely to pressure the yield curve flatter. This is similar to every Fed tightening cycle in our history. Today, the yield difference between 2-year and 10-year Treasury yields is 30bp, the flattest since 2007. Considering the strong US fundamental backdrop, if trade fears abate, some flatness could reverse. Nevertheless, subsequent policy tightening will eventually put the shape of the curve back on its journey towards inversion in 2019.
Realizing the uncertainty ahead, and the difficultly in timing a long-duration trade, we prefer the attractive yield proposition in shorter-dated US Treasury rates. Policy divergence between the Fed and the rest of the developed world has created historically wide yield differentials. 2-year UST yields are now 7x higher than 10-year German Bunds with 20% of the duration risk.