Bonds: So It Begins!
Much of the sell-off late in the month of January across global equity markets was generated by interest rates and the potential impact not just synchronized, but markedly faster global economic growth could have on inflation expectations and the path to monetary policy normalization/tightening by global central banks. Three hikes to the fed funds rate is the current “base case” for 2018 – barring unexpected positive or negative economic or macro events in the interim. More than one FOMC voter has of late championed their belief that four hikes may be more appropriate with economic growth/inflation expectations being ratcheted higher in the wake of the passage of the tax reform bill in December. As we’ve noted previously, the FOMC is preparing to undergo some personnel turnover within its ranks, so the current rate outlook should be considered just that, the current outlook. Heightened interest rate volatility with an upward bias should be expected.
Very little occurs in a vacuum, and interest rate movements/shifts in the yield curve are no different, with interconnected global relationships playing a crucial role. The recent upward trend in intermediate and long-term Treasury rates has to some degree been driven by rising inflationary expectations amid the promise of faster economic growth on the heels of tax reform, but sovereign bond yields abroad have pushed higher recently as well, effectively pulling our rates higher with them. The yield on 5 and 10-year German bunds have broken out over the past few weeks to levels not seen in a couple of years, with the former moving into positive territory for the first time since January of 2016. 10-year Japanese Government Bonds (JGBs) yield a whopping 0.08%, which may not seem like much, and it isn’t, but given that the Japanese government had successfully anchored the yield at 0.00% for the past couple of years and can no longer do so points toward inflationary pressures not seen in the country for years. It appears that, ultimately, rising inflation will call for a policy response from the Bank of Japan – the question, however, is how soon.
Spreads on investment-grade corporate and high yield bonds relative to Treasuries remain tight and have exhibited few signs of stress despite the upswing in Treasury yields and the pullback in equities experienced of late. The Bloomberg Barclays U.S. High Yield Index has held up relatively well, rising 0.60% through January, while Treasuries and investment-grade corporates have had a rough start to the year, with the Bloomberg Barclays U.S. Treasury Index declining 1.35% through January, and the U.S. Corporate Index falling 0.95%. We maintain a neutral stance in high yield bonds as the yield pickup, or carry, remains relatively attractive versus what can be found elsewhere. High yield default rates should remain low, but active management in the space is advisable given tight spreads and where we are in the economic cycle. There will be a time to reduce exposure to credit, but given our economic outlook and where we believe Treasury rates may be headed, it seems premature to do so today.
Source: Bloomberg, Factset
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