Markets & Economy

Bond Market Observations: The Wheel Goes Round and Round

Bond Market Observations: The Wheel Goes Round and Round

As any hamster knows, running in place takes a lot of effort. Despite prodding and poking our priors, our global economic outlook remains essentially unchanged from last month. Incoming data have modestly outpaced expectations across major advanced economies, consistent with an upturn in global activity that supports commodity prices that was already in the outlook. Anchored by stronger global demand and more favorable prices of important exports, growth in emerging market economies seems well maintained.

In the U.S., the advance of activity is supported by accommodative financial conditions made possible by the Federal Reserve’s (Fed) slow journey to policy normalcy and the expectation that the new administration will deliver at least a fillip to spending, both through regulatory relief and fiscal stimulus. The U.S. shares some of this demand momentum with its trading partners via dollar appreciation—although mostly in the past tense because we think the bulk of the gain in terms of foreign currencies will be seen in the rearview mirror. The net depreciation of the euro and the yen implies that Janet Yellen succeeded where her colleagues Mario Draghi and Haruhiko Kuroda failed—she eased financial conditions in those two economies stuck with negative policy interest rates. 

With commodity prices firmer and resource slack in the U.S. nonexistent, inflation overshoots the Fed’s two-percent goal. Indeed, a pop in the Consumer Price Index for January puts inflation measured in that more understandable but less Fed-favored index considerably north of the goal already. Looking more broadly, the generalized trend is toward higher inflation worldwide, modestly so but discernibly different from the past few years.

This global economic forecast differs from the last one only by rounding error (measurable in hamster sweat). Our sense is that this fits squarely in the consensus. That is among our palpable worries. The consensus is tightly clustered even though President Trump shows himself to be unpredictable and our reading of Washington politics more broadly (as seen in the recent commentary “Will Politics Trump Economics?”) serves as a reminder that the Founding Fathers located the Capitol on swampland.

Even so, at least as reflected in asset prices, market participants are similarly nonchalant about the outlook. Equity prices post new records daily, implied volatilities of those prices trend lower, and risk spread on debt instruments narrow. True, in almost everyone’s outlook, a rising boat of the U.S. economy lifts most asset boats, but we are talking about a gain of about one-quarter percentage point in real GDP growth to a level that would have been dismissed as anemic one decade ago. 

We think this synchronicity in opinions owes as much to monetary as fiscal and regulatory policies. As shown in the chart, market expectations and Fed guidance have moved into close alignment, almost exclusively as officials scaled back their firming intentions. Give credit where credit is due. Fed officials at the turn of last year did not stay to the script when they found it was from a horror movie.1 The median response in the latest Survey of Economic Projections of Federal Open Market Committee (FOMC) participants put the appropriate federal funds rate at year end at 1.4 percent, about one percentage point lower than one year ago and consistent with three quarter-point hikes in 2017. Market participants, ourselves included, waver between anticipating two or three moves, still harboring the suspicion that Janet Yellen has not completely molted her dovish feathers, but this is a far cry from the dislocation of early 2016.

The reassurance that the Fed is not planning to over-tighten helps to offset Trumpian tribulations, keeping forward-looking measures of volatility subdued. This suggests to us that a serious threat to our outlook is that the Fed shows itself as less willing to continue to foam the financial runway with a very low nominal federal funds rate. That is a risk, not our central tendency, in an outlook with already fat tails away from the central tendency because of the political environment, and is still another reason to remain nimble in positioning.

Along the baseline path, with the Fed more in sync with markets, the U.S. yield curve is fairly priced. The remaining opportunity in the Treasury space, therefore, is to buy the reason the Fed tightens—inflation will rise further and breakeven inflation benefits. This benefit is less attractive as returns have adjusted in recent months, but a modest amount remains given our assessment of fair value.

Otherwise, selectively seek out those fixed-income assets more highly loaded to economic expansion and firm commodity prices. In the U.S., some industries in the high-yield sector will enjoy lower expected default rates and improved recovery performance. Some emerging market sovereign securities also retain their allure. After all, the Fed may be ambling toward the exit, but the European Central Bank and the Bank of Japan will be sitting on global rates for some time. As a result, low rates are climate, not weather, and the attractiveness of acquiring securities with carry is considerable. 

We are not ready to raise our risk budget, although we keep looking for the window to do so. For now, make space for higher-carry opportunities at the expense of investment-grade corporates, which look expensive, and mortgage-backed securities (MBS) and commercial mortgage-backed securities (CMBS), which teeter in value in advance of Fed tightening, a potential pickup in volatility, and impaired fundamentals.

Reduction is discipline, and we try each month to reduce our economic, valuation, and portfolio assessments to a straightforward map from one to the other, as below. To repeat, the major news is that the Fed will not be news. Tightening, glacial albeit, is priced in, which limits rate opportunities to inflation break-evens and economy-sensitive high-yield and emergingmarket sovereign securities. The world is a changeable place with fat tails to the distribution of potential outcomes for asset prices. With so many opportunities for surprise littering the forward calendar of political events, we favor bulleted positions that allow the tracking performance dials to be turned down or up as events warrant. 

1Fernanda Nechio and Glenn Rudebusch, “Has the Fed Fallen Behind the Curve this Year?” FRBSF Economic Letter, November 7, 2016, explain that this revision was neither outsized nor inconsistent with incoming data. As for why to adjust, we still think our interpretation from last year (“Fed Thoughts: The House on the Hill”) still fits the bill.

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