Fixed Income Outlook  |  Q4 2021

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Putnam Investments

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The U.S. dollar is likely to appreciate as rates trend higher

Expectations about the U.S. and global recovery continue to be marked down as the impact of higher prices, concerns around the Delta variant, and slower consumption rein in excessive optimism on growth. The Fed has signaled its tapering of asset purchases is coming. Tapering likely will formally commence in November and is expected to take place over the following eight months. The latest median expectations from the FOMC highlight almost seven rate hikes through the end of 2024, a somewhat hawkish innovation and supportive of the U.S. dollar. But compared with prior cycles, this is a relatively moderate pace. As a result, labor market data and future job gains will be pivotal for the Fed. The path of rate hikes makes dollar appreciation against currencies backed by resolutely dovish central banks such as the Japanese yen, the Swiss franc, and, potentially, the euro, more likely.

Euro may weaken as ECB mulls policy

At its last meeting, the ECB recalibrated its pandemic emergency purchase program (PEPP) to a "moderately lower pace" of asset purchases and pushed other major decisions to December. European growth data remains solid but has likely peaked and is stabilizing at lower levels as inflation starts to move higher. This is likely to make other issues on the ECB's agenda — the future of the PEPP, which is currently set to last until March 2022, and whether to expand its asset purchase program (APP) — more contentious in December. Growth concerns are likely to dominate over the short term. The euro might continue to weaken under the current central bank policy. But the magnitude of the descent may be limited if there are hawkish signals from the ECB.

We are less bullish on the British pound

The United Kingdom remains positioned well for domestic and global recovery, fueled by one of the better-run vaccination campaigns. The BoE has moved to a more hawkish stance earlier than expected. The Coronavirus Job Retention Scheme (CJRS), due to end on September 30, will provide some insight into the tightness of the labor market and when the BoE may raise rates. The U.K. has also been affected by energy supply issues and a jump in inflation. Despite a more hawkish central bank, stagflation concerns have dominated and weighed on the pound. Until these concerns abate, we are less bullish on the pound.

Japan's yen could strengthen on risk appetite

The Bank of Japan (BoJ) remains largely sidelined, with limits on further monetary policy easing. As short-term rates make hedged international bonds highly attractive, this should represent the bulk of flows into global, especially U.S., bond markets. The yen had seen a large repricing due to the global recovery and has reached the upper end of the range since peaking in April. The ruling Liberal Democratic Party held party leader elections on September 29. Fumio Kishida was appointed as the next prime minister. This outcome is expected to have limited impact on the yen-dollar exchange rate. From here, the risk for the yen is more balanced than before and may be skewed to yen strength, depending on global risk appetite.

More from Fixed Income Outlook

Fixed-income markets faced multiple risks, including the Fed's plan to unwind debt purchases, the shifting growth outlook, and Covid-19. But, we believe the environment for bonds remains supportive.