Bonds (August 2017)
Markets Underestimating The Fed







“We think the markets are under-pricing rate hikes by the Fed and bond investors should stay protected by not extending duration beyond the benchmark fixed out to five years but not longer.”

Vasu Menon, Senior Investment Strategist, Wealth Management Singapore ; Member of OCBC Wealth Panel

 

Key Points:

  • The market seems comfortable with the idea that the Fed will start to shrink its balance sheet and raise interest rates again before the end of the year. However, it is doubtful that there will be more than one rate hike in both 2018 and 2019. We think the Fed will be more aggressive.
  • Even though the Fed has raised rates much faster than the market expected a year ago the basic approach still prevails where the Fed’s outlook is seen as overly hawkish. This view served the market well for many years, but has not adjusted to the reality of the policy tightening cycle. Interest rates are likely to rise faster than the market is projecting and this is set to put some upwards pressure on bond yields.
  • Considering overall financial conditions, rather than just the level of real interest rates, should add to our understanding of policy. One of the reasons the Fed was slow to hike in 2014-16 was that the strong U.S. dollar was acting as a drag on growth and so reducing the need for monetary policy tightening. In contrast, financial conditions have loosened over the past nine months, despite three rate hikes, as capital markets and the U.S. dollar have become more supportive of growth. This means that the Fed needs to keep pushing interest rates higher if it wants to slow down the economy.
  • We have been looking for four rate hikes in 2018, after the one in December. Admittedly, that looks dubious in the light of lower inflation readings, but not if you accept the view that much of the hit to prices is temporary, and especially if you look at the looser financial conditions.
  • The coming months will see the nomination of a new Fed Chair. It is hard to see a credible candidate who is more dovish than Janet Yellen. A low-credibility nomination would have limited ability to influence the rest of the committee. Any candidate who favours a more “rule-based” approach would be more hawkish than the current stance. Assuming that the pro-growth administration favours low interest rates, reappointing Yellen looks like the line of least resistance.
  • We continue to favour a carry strategy. We think that the outlook for corporate bonds remains positive, but further gains after the bonanza of the last one and half years will be difficult to achieve. We continue to advocate higher-yielding paper in the expectation that the default outlook is still benign enough; however, we would caution investors to move up in credit quality.
  • Thus far this year, longer maturity corporate bonds outperformed as U.S. Treasuries rallied and the yield curve flattened. With the Fed expected to begin balance sheet reduction later this year and raise rates multiple times next year, we would now look to reduce overall portfolio duration to below 5 years and focus largely on the short end and belly of the curve.
  • Within the bond space, we continue to prefer Emerging Market High Yield bonds. In an environment of Fed policy normalisation, we believe that coupon/carry will become an increasingly important component of total return. With its higher corporate spread component, High Yield bonds should be somewhat better insulated from the adverse impact of higher rates.
 
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