Capital Markets Outlook  |  Q2 2017

The Fed and the ECB may surprise markets this year

Fixed income and currency insights


Fixed income: Rising tide of economic growth creates numerous strategy choices

While the post-election rally appeared to exhaust itself late in the first quarter, the global economic reflation story seems to be very much alive. On the basis of broadly positive macroeconomic data in the United States, Europe, Japan, and a variety of other markets, we maintain an optimistic outlook for a number of fixed-income sectors in the quarter ahead, particularly those sectors that are not heavily exposed to interest-rate risk. That said, as market participants monitor the interest-rate backdrop, as well as the transition from high expectations for growth-friendly policy to actual policy implementation in Washington, we expect volatility and risk aversion are likely to return periodically.

With respect to interest rates, we think the Fed may act somewhat more quickly than the market currently expects. The Fed hiked the federal funds rate by a quarter point on March 15, and it has projected that two more hikes are likely this year. For the time being, we think the Fed's anticipated plan does not depend on anything the Trump administration may or may not do in terms of policy. Instead, we observe that today's sustained backdrop of stronger commodity prices is adding to inflation in other segments of the economy, and this may induce the Fed to remain more explicitly on a path toward interest-rate normalization.

We also think the market currently may be underappreciating the possibility of monetary policy changes at the European Central Bank (ECB). The ECB, unlike the Fed, takes its policy cue from headline rather than core inflation. Headline inflation has risen rather substantially in Europe on the back of higher prices across the global commodity complex. While the ECB has said it will continue its quantitative easing program through the end of 2017, that does not mean the bank cannot raise interest rates. Indeed, it is likely to face increased pressure from the financials sector to leave its negative-rate policies behind.

Turning to the corporate debt markets, we note that spreads — the yield advantage of corporate bonds over comparable maturity U.S. Treasuries — are tight to historical averages, particularly among investment-grade bonds. Demand in this area has been quite robust, particularly from large investors such as global government agencies, supranational entities, and sovereign funds. Thus, while spreads are tight, we think fundamentals and demand will continue to help bolster this segment. We also expect high-yield bonds to continue to generate attractive returns in an environment of constructive fundamentals and below-average defaults. Of course, high-yield spreads have compressed significantly in recent quarters, and the average bond price within the index has moved close to par. As a result, valuations at the end of the first quarter of 2017 were not as attractive as they were in 2016. Nevertheless, we continue to like the prospects of high-yield credit in an environment of rising rates and inflation, even if returns are subdued as higher rates encourage investors to shift to other areas of the market.

In securitized debt, we continue to like the prospects of commercial mortgage-backed securities (CMBS) and non-agency residential mortgage-backed securities (non-agency RMBS). We also continue to find attractive opportunities in a relatively new segment of the securitized debt market: agency credit risk transfer securities (CRTs). The CRT market has grown substantially since these securities were introduced in 2013. CRTs provide investors with credit exposure to the U.S. residential mortgage market, helping to fill a void that has emerged from a lack of new supply in the non-agency RMBS sector. Against the backdrop of improving U.S. housing fundamentals, declining homeowner delinquency rates, and more stringent underwriting standards in recent years, we believe this area of the securitized sector will continue to offer compelling opportunities for investors going forward.

Currency

Within currency, the U.S. dollar outlook has become more clouded given the uncertainty associated with President Trump's policies, in particular, the ability of Congress to repeal and replace the Affordable Care Act (ACA) and repercussions this has for tax reform. As such, the more relevant driver of the dollar has been and remains the Fed. After ramping up its rhetoric and encouraging the market to price in a rate hike in March, the Fed released very subtle changes in the Statement of Economic Projection (SEP) "dots," helping to subsequently weaken the U.S. dollar. The Fed will continue to hike rates, but economic data and financial conditions will play a larger role in determining the pace, leaving the dollar as neither the leader nor laggard among currencies.

The outlook for the euro is dominated by relative monetary policy and the issue of political risk. The ECB left policy unchanged at its March meeting but signs of dissent among the hawks and doves seem to be occurring earlier than the market had expected. It is highly likely that during 2017 the ECB will need to reduce the exceptional degree of policy accommodation in place, albeit at a cautious pace, and barring an exceptional outcome in the French elections that could add to instability. This should put a floor under the euro and ultimately help it rise.

The United Kingdom has invoked Article 50 of the EU treaty and initiated the long legal process of leaving the EU. In this negotiation, the EU has incentive to discourage other member countries from thinking that leaving the union is more attractive than staying in it. While some agreement will be reached that is not catastrophic, negotiations are likely to begin on a discouraging note and become more practical over time. Also, as U.K. inflation has climbed due to a weaker currency and higher energy and food prices, the Bank of England saw its first dissenter calling for a rate hike. However, growth data is once again rolling over as real incomes and real spending are getting hit, and this will likely keep the Bank of England on the sidelines. This should keep the pound weak.

The Bank of Japan (BOJ) kept its Yield Curve Control settings unchanged and Governor Haruhiko Kuroda gave no signal the bank would consider exiting its extremely loose monetary policy this year, which leaves the yen as the G4 funding currency of choice. Supporting this thesis are signs that a wage-price spiral remains absent. Without greater wage growth, Japan's national CPI is likely to keep undershooting the BOJ's target. In the short run, the dollar-yen rate has traded in a range, and it is likely to remain range-bound.


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