Fixed Income Outlook  |  Q4 2016

The end of the era of unlimited central bank support

Fixed Income Team

Putnam fixed-income views chart

Key takeaways

  • We expect the next Fed rate hike will occur in December 2016, even as European and Japanese central bankers pursue new forms of policy easing.
  • Negative rates, which have helped sustain a broad-based bid for risky assets, are increasingly recognized for their negative economic and market effects.
  • We consider risk assets that do not carry an overabundance of interest-rate risk to have positive return prospects in the months ahead.

Risk assets outperformed safe havens during the quarter chart

The third quarter saw reasonably widespread improvement in the U.S. economy. With the labor market in decent shape, consumer confidence robust, and household income and spending both rising, we think the current environment is relatively benign for risky assets. This informs our near-term outlook across a broad swath of the fixed-income markets, but particularly in out-of-index opportunities ranging from high-yield bonds and bank loans to securitized debt and select emerging markets.

The Fed's voices of dissent

The policy backdrop to today's healthy risk appetite, as it happens, is showing a growing acceptance of the Fed's plan to raise rates. Notably, the Fed's September meeting produced three dissents. Subsequent speeches by various Fed officials revealed that the split on the Federal Open Market Committee is quite deep now. Although there has been a concerted effort by the Fed to stress that the November meeting is live — i.e., that it could come with a rate cut — we expect that a hike is most likely in December. This requires the economic data flow to continue in its recent, positive vein, and it also requires us to avoid a tail-risk scenario of a Trump presidency. If Trump were to somehow come out ahead of Clinton, that would be likely, in our view, to usher in a period of policy uncertainty with serious economic risks.

The end of the era of unquestioned central bank support?

The Fed's September meeting was one of the key events that occurred at the end of the third quarter. Two other key events — meetings by the Bank of Japan (BoJ) and the European Central Bank (ECB) — also brought policy outlooks into focus for the markets. Both the BoJ and the ECB were widely expected to announce new forms of policy easing, and markets were disappointed by the actions the banks took.

In the case of the BoJ, we believe the market may have misjudged. Indeed, we see the BoJ's engineering of "yield curve control," in which it will seek to maintain the 10-year Japanese government bond (JGB) yield at zero percent, as creating the possibility of substantial policy easing. This would include the BoJ's commitment to increase the monetary base, and a potential trend toward fiscal relaxation — allowing the government to expand spending with no impact on JGB markets.

In the case of the ECB, the bank's inaction was attended by rumors that the tapering of quantitative easing (QE) was under discussion. We take the view that the ECB will, in fact, extend its QE program beyond the current program's limits, which set an expiration for March 2017.

The combination of these actions by the U.S. Fed, the BoJ, and the ECB have led investors to wonder whether we have indeed reached the end of the era of unquestioned central bank support for asset markets. This lingering question has left interest rates somewhat higher than at the start of the third quarter.

Rates rose across the yield curve chart

Low and negative rates push up risk assets and appetite, to a point

Overall, the past several years of QE, which have focused on bond purchasing and the maintenance of yields in exceptionally low to negative territory, have poured immense liquidity into the markets. Risk assets have generally benefited from this policy backdrop. Some of the sectors of the bond market, including high-yield bonds, but particularly emerging markets, have performed marginally better in the past few years because they offer investors a yield advantage. With the governments holding government bond yields down, liquidity has flown into these other sectors.

However, as the world has gotten closer to the zero bound on rates, and even moved into negative territory, the marginal impact has not had as large an impact on global investors and risk-taking overall.

In addition, markets are now better aware of the way negative rates may have negative effects. The banking sector, for example, is penalized in a negative-rate environment, as its profit-generating potential becomes structurally limited. Individual savers are another case in point. When short-term rates are negative, it becomes very difficult for savers to feel good about their forward earning potential, which itself becomes a disincentive to save. Thus, while higher interest rates spark all manner of concerns for market observers, they could have a positive effect of increasing consumer confidence.

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