“We see more reasons to be selective within credit markets than we did at the beginning of the year as future returns are likely to be more muted compared with the recent past, and tight spreads leave little room for error.”
– Vasu Menon, Senior Investment Strategist, Wealth Management Singapore, OCBC Bank
The global monetary policy outlook, especially among the major developed markets, will have an important impact on the outlook for bond markets.
Overall, we still see selective opportunities in bond markets but returns will not be as strong as in the past. With spreads close to all-time tights, we expect modest spread tightening for the remainder of the year, which should be balanced by a modest back-up in U.S. Treasury yields. As a result, coupon income will likely drive asset class performance for the rest of the year. We recommend reducing overall portfolio duration and a move up in credit quality to reduce risk.
In the U.S., the Fed’s policy dilemma has intensified and continued low readings on inflation suggest it might opt for a break from the sequence of interest rate hikes. By some measures, no rate hike in September could be seen as a pause, but it is better viewed as providing space for the market to absorb the likely September announcement of plans for balance sheet reduction.
Strong labour markets and looser financial conditions, despite three rate hikes since last December means that the Fed should want to continue to normalise interest rates. However, its confidence that slippage in inflation was just a temporary aberration has been undermined by a several months of soft data. It seems that the Fed might need more convincing that the underlying pressure on inflation has faded, so we expect another hike in December before a pause in March, but it could skip the year-end move. We now see three rate hikes in 2018 compared to four previously.
If the U.S. struggles to pass a budget or to lift the debt limit to avoid the risk of a default then we would hear talk of another ratings agency downgrade of U.S. debt. However, this typically has no impact on the performance of the sovereign debt of large developed economies. S&P cutting the U.S. to AA+ in August 2011 was soon forgotten, while Japan has seen multiple downgrades but can still issue 10-year debt at a zero interest rate.
Increasing confidence about the prospects for growth means the European Central Bank is set to bring its quantitative easing policy to an end in the first half of 2018, with an announcement likely before the end of 2017.
In Japan, inflation remains a long way from the 2 per cent target so a policy shift is still far in the future. Short-term interest rates will remain at -0.1 per cent and bond yields targeted around zero for most, if not all, of 2018.
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