US Fixed Income

Fixed Income | September 26, 2017

Howard Greene, Head of US Fixed Income

Global Intelligence Autumn 2017 - US Fixed Income: The Backdrop Icon

THE BACKDROP

Despite moving closer to what we regard as full employment,2 we are still unable to generate a corresponding healthy inflation rate.

The yield curve has been a little flatter over the last three months, but with something of a twist: the short end has continued to inch higher, but out beyond the two-year maturity, rates are actually a little bit lower.1 This is a scenario we don’t often see when short-term interest rates are on the rise.

Changes to the US Yield Curve

Changes to the US Yield Curve
Source: US Department of the Treasury, as of September 18, 2017

We believe this is due to the ongoing lack of inflation. The employment and inflation data shows us that despite moving closer to what we regard as full employment,2 we are still unable to generate a corresponding healthy inflation rate.

We remain in an approximate 1 - 3% growth environment domestically, and we don’t expect that to change. Interestingly, we are seeing global synchronized growth around 2%, with economies delivering a reasonably sustainable level of growth with no apparent inflation on the horizon.

With the way the yield curve is behaving, the market appears to be telling the Federal Reserve that there may be a potential issue on the horizon. The concern is that if the Fed continues to hike rates at the same pace in the absence of inflation, it runs the risk of flattening and/or inverting the curve and causing an instant recession. An inverted curve is extremely disruptive to the economy and is certainly something the Fed wishes to avoid. On the positive side, the Fed now has the data that tells them they don’t have to continue to hike rates at the pace originally expected, as current inflation expectations in the system are not enough to push yields higher at the long end of the curve.3 We’ve already seen the Treasury Inflation-Protected Securities (TIPS) market underperform.1 As a result, the Fed has now shifted its focus to balance sheet reduction, as the sale of longer maturity securities may be their only policy option that could influence longer-term rates.

Given the current lack of inflation, we don’t anticipate another increase in the Federal Funds rate until at least December, possibly later. Instead, the Fed will begin reducing their balance sheet in the fourth quarter. As this is something that has never been done before, we expect them to take a measured approach with their intentions well telegraphed ahead of any action.

Global Intelligence Autumn 2017 - US Fixed Income: Opportunities For Investor Icon

OPPORTUNITIES FOR INVESTORS

At this point in the cycle, returns are expected to come primarily from yield versus spread compression, as we find it hard to see a massive rally in credit taking place.

Credit markets remain very well supported. We have seen high levels of issuance and demand has been quite strong. New issue concessions are virtually non-existent, which speaks well to investor demand and the appetite for yield both domestically and globally. At the margin, some of that may be due to US corporate issuance on Taiwan’s Formosa bond market, which is taking some supply out of our market and satiating the Taiwanese demand for long duration assets, but demand domestically is also healthy.4

We have been moving some of our credit exposure down the yield curve into shorter maturities so we’re not as exposed on a duration Dollar basis. We have more Treasuries than previously in the long end, although we are still underweight and credit is positioned primarily in the intermediate to short end. At this point in the cycle, returns are expected to come primarily from yield versus spread compression, as we find it hard to see a massive rally in credit taking place. We may slowly inch a bit tighter on credit spreads, but we do not anticipate a material shift in either direction.

Global Intelligence Autumn 2017 - US Fixed Income: Risk Icon

RISKS

Our expectation is that the outcome of the NAFTA negotiations will have little impact on the market, with some potential headline volatility on the way.

Geopolitically the temperature is rising steadily, and the new administration here in the US is having difficulties getting its policy agenda in place. That being said, it is expected that tax reforms are on the horizon, which would be viewed favorably by the market. NAFTA negotiations are now underway and while speculation on a negative result is rampant, it is important to remember that NAFTA is a 25-year-old document that needs to be updated considering the advances in technology and global trade that have occurred since its inception. Our expectation is that the outcome of the NAFTA negotiations will have little impact on the market, with some potential headline volatility on the way.

Global Intelligence Autumn 2017 - US Fixed Income: On Our Radar Icon

ON OUR RADAR

The recently announced departure of Federal Reserve Vice Chair Stanley Fischer from the Fed Board came as a bit of a surprise, though he was expected to retire at the end of his term in 2018.5

The recently announced departure of Federal Reserve Vice Chair Stanley Fischer from the Fed Board came as a bit of a surprise, though he was expected to retire at the end of his term in 2018.5 A change at the top is also increasingly likely when Fed Chair Janet Yellen’s term expires in February. While the speculated list of potential replacements is fluid, we expect the current course of policy to remain on track regardless of the new Chair.

1 Bloomberg, as of August 31, 2017.
2 Bureau of Labor Statistics, Employment Up 156,000 in August, September 6, 2017.
3 Bloomberg: The Fed Has an Inflation Expectations Problem, July 18, 2017.
4 Reuters: US Issuers Rush to Sell Formosa Bonds Before Rule Change, February 13, 2017.
5 Federal Reserve: Stanley Fischer Submits Resignation as a Member of the Board of Governors, September 6, 2017.
Investment Considerations
Individual portfolio management teams may have different views and opinions that are subject to change without notice.
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About the Author

The opinions expressed are those of Manulife Asset Management™ at the time of publication, and are subject to change based on market and other conditions. The information in this article including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Asset Management disclaims any responsibility to update such information. All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife Financial, Manulife Asset Management, nor any of their affiliates or representatives is providing tax, investment or legal advice. Past performance does not guarantee future results. This material was prepared solely for informational purposes, does not constitute an offer or an invitation by or on behalf of Manulife Asset Management to any person to buy or sell any security and is no indication of trading intent in any fund or account managed by Manulife Asset Management.

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Fixed Income