Fixed Income Outlook  |  Q3 2018

Interest rates and trade create headwinds

Fixed Income Team

Interest rates and trade create headwinds

  • The U.S. economy is poised to pick up some speed in the second half of 2018.
  • Escalating trade tensions between the United States and its major trading partners pose risks.
  • The European Central Bank is poised to wind down its bond-buying program by year's end.

The outlook for global growth is stable — albeit less synchronized — for the remainder of 2018, we believe. The U.S. economy is poised to expand at a stronger pace this year, buoyed by government spending and corporate investment. The likelihood of a recession remains relatively low. More strikingly, we are starting to see some convergence in global growth rates — especially between the United States and the eurozone — in the second half of this year. The growth gap had widened during the first half of 2018.

For fixed-income markets, this year is turning out to be more challenging than 2017. Higher interest rates, the long-feared trade war, rising inflation, higher oil prices, and political risks have weighed on the global bond market. The Federal Reserve raised rates twice this year — in March and in June 2018 — and signaled that it is on track to raise short-term rates at least once more this year. The yield on the benchmark 10-year Treasury crossed the 3% psychological barrier in April, setting a new five-year high, and the yield curve has flattened. Higher rates typically create some challenges for fixed-income assets.

Bond yields will continue to drift higher over the course of 2018, in our view, as rate normalization continues in the United States and globally. A more hawkish Fed also stepped up the pace of its balance sheet reductions in April, and this is expected to continue through October, when the pace will reach its highest level. Across the Atlantic, the European Central Bank plans to wind down its bond purchase program by the end of 2018. But, the ECB remained dovish and said it did not expect to raise interest rates, which are at historic lows, until the fall of 2019 at the earliest.

The risk that the trade conflict between the United States and its major trading partners will escalate continued to plague markets and investor sentiment. In July, the United States and China imposed punitive tariffs on each other's imports. The European Union, Mexico, and Canada have similarly retaliated against President Trump's steel and aluminum tariffs. While the volume of trade targeted is too small to influence the economic trajectory much, the possibility of an expanded and more damaging trade war looms.

U.S. economy a bright spot

The American economy headed into the second half of 2018 with strong momentum and the longest streak of job growth on record. The labor market remains robust as hiring improved and wage gains accelerated. Employers added 213,000 net new jobs in June as more people flocked to the job market, reflecting healthy gains in a broad range of industries such as manufacturing and construction. The unemployment rate rose slightly to 4% in June from an 18-year low of 3.8% in May.

The economy grew at an annual rate of 2.2% in the first quarter of 2018 due to lower consumer and business spending. Still, corporate investment picked up in the second quarter, although most of the increase has been in extractive industries where high prices and a relaxation of environmental regulations have boosted profit margins. We expect U.S. growth to be stronger in the second half than in the first six months of 2018, supported by the latest fiscal stimulus and corporate investment.

The risks to growth, however, seem asymmetric to the downside. The tariffs imposed by President Trump, along with the threats of more tariffs and trade restrictions, are unsettling financial markets. There is clear historical evidence that uncertainty is bad for investment. The administration's hard line on trade policies has prompted retaliatory measures by major trading partners, including China, the European Union, and Mexico. China, the world's second-biggest economy, has imposed $34 billion in retaliatory tariffs on American goods. Canada, a member of the North American Free Trade Agreement (NAFTA), which is still being renegotiated, announced retaliatory tariffs against almost $13 billion of U.S. products. The European Union has announced similar measures.

Fed and interest-rate hikes

The Federal Reserve raised rates in March and in June 2018, and signaled that two additional rate increases in 2018 are likely. U.S. government and global bond yields trended higher. The yield on the benchmark 10-year Treasury has continued to hover near the 3% psychological barrier, signaling that higher rates are ahead in the world's biggest bond market. The 2-year yield also hit its highest level since 2008, and the yield curve has been on a flattening trend. Debt yields also rose pretty much in lockstep with oil prices. That is not surprising because of the clear influence energy has on headline inflation.

The strong economic recovery in the United States and a more determined Fed means U.S. rates are likely to rise gradually. This upward drift, however, may continue to be interrupted by rallies when markets fear that higher rates may constrain growth. The Fed's June increase pushed the federal funds target to 1.75%–2.00%. These increases add to the costs of consumer debt, particularly credit cards, home equity lines of credit, and other adjustable-rate instruments. We believe there is increased risk of overtightening as the Fed steps up the pace of balance sheet reductions and interest-rate hikes in the second half of this year. Short-term rates have kept pace with balance sheet reductions. It's not at all clear to us that the Fed is paying enough attention to developments at the front end of the yield curve, which are certainly rippling through the economy and asset markets.

Meanwhile, U.S. inflation accelerated in May to the fastest pace in more than six years, reinforcing the Fed's outlook for interest-rate hikes. The consumer price index rose 0.2% from April and 2.8% from a year earlier, partly reflecting higher fuel prices. The Fed's preferred gauge of core prices was up 1.8% in April from a year earlier. While it is likely that core inflation will breach the Fed's 2% target later this year, policy makers seem quite comfortable with that outlook for 2018. Oil prices rose quite sharply this year, driven by a growing global economy, production cuts by OPEC, and increased geopolitical tensions.

The ECB's balancing act

Across the Atlantic, the European Central Bank (ECB) in June decided to end its €2.6 trillion bond purchase program by the end of 2018. The bank said it did not expect to raise interest rates, which are at historic lows, until the fall of 2019 at the earliest. The looming trade war, with the United States and Europe announcing tit-for-tat tariffs on products, have raised concerns about growth in the region. ECB President Mario Draghi and other policy makers have singled out protectionism as a threat to the eurozone's outlook.

One of the big stories in the first half was the deceleration in the eurozone. Economic growth slowed to 0.4% in the first quarter — the weakest in six quarters — after expanding 0.7% at the end of 2017. Manufacturing eased, and the euro strengthened. Fortunately, this material downshift appears to be coming to an end as growth indicators stabilize, domestic demand steadies, and consumer confidence rises. Inflation in Europe hit 2% in June for the first time in more than a year, supported by higher oil prices. The pickup in the inflation rate was just above the ECB's target.

Still, political turmoil in Italy — the eurozone's third-largest economy — is likely to complicate the ECB's policy decisions this year. Prime Minister Giuseppe Conte took power in early June to head a new populist government made up of the anti-establishment 5-Star Movement and the far-right League party. The populists have various economic proposals, and if enacted, they would raise Italy's fiscal deficit, lower potential growth, and worsen Italy's public debt. Italy needs growth driven by a better economic structure. Without that growth, it remains vulnerable to higher interest rates. Given the new coalition's program, we think the default risk on Italian government securities (BTPs) is materially higher than it is for Greece or the other bonds included in the JPMorgan High Yield Index.

Cross currents in emerging markets

The jump in global interest rates, a stronger dollar, rising oil prices, and trade jitters have caused havoc across emerging markets. We expect bond yields in emerging markets to continue rising over the coming months. The Fed will be a primary focus for the remainder of 2018 as rate increases and balance sheet reduction are widely expected to be implemented at a faster pace, and these will continue to have impact on emerging markets.

Political risks also weighed on some key emerging-market economies, including Mexico, Argentina, and Brazil. President Trump's protectionist trade policies targeting U.S. trading partners, including Mexico, continues to weigh on Mexican asset markets. Also, the leftist Andrés Manuel López Obrador was elected president in a landslide victory that swept aside the previous ruling party, which has governed the country for most of the past 70 years. In Argentina, the central bank raised rates to double digits to defend a battered peso, which had been weakened by capital flight. In Brazil, political uncertainty ahead of the October presidential elections weighed on bonds.

China, the world's second-biggest economy, is showing signs of slowing and is vulnerable to private capital outflows. The government has cracked down on borrowing to curb rising debt levels in the country. The knock-on effect of the trade dispute with the United States may heighten the downside risks for the Chinese economy.

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