Bonds (December 2016/January 2017)

Shift in Outlook for U.S. Rates

“A Trump Presidency could mean a faster pace of rate hikes in the next two years. Previously we had expected five 25 basis point rate hikes in 2017-2018 but now we provisionally raise this to seven rate hikes.”

- Vasu Menon, Senior Investment Strategist, Wealth Management Singapore, OCBC Bank

  • Trump will inherit an economy in its eighth year of expansion (admittedly a slow-paced one) and near to full capacity. Inflation is increasingly evident, in both consumer prices and wages. In this situation, the planned fiscal stimulus and a more restrictive approach to immigration will heighten inflationary pressures, as would tariffs on imports.
  • This implies a faster pace of Fed tightening over the next couple of years, although much depends on the policy choices of the Trump administration. However, as financial markets anticipate this change, through a firmer U.S. dollar and higher bond yields, these act as a drag on activity and reduce the need for the Fed to be too aggressive.
  • The Fed seems happy to allow the economy to “run hot” in order to pull away from deflation risk and perhaps repair some of the damage to the labour market. However, core inflation is already at 1.7 per cent, so there is not much room before it breaches the Fed’s 2 per cent target.
  • Also remember that at some point the Fed is likely to let the size of its balance sheet shrink. It has been stable for the past two years as the proceeds of maturing bonds are being re-invested. We doubt that the Fed would run down its balance sheet before interest rates are over 1 per cent which probably rules out 2017. However, it could announce its future policy intentions at any point and there is a risk that this has an impact akin to former Fed Chair Bernanke’s infamous “tapering” remark in May 2013.
  • The bond market has already started to respond to the new outlook for U.S. policy. After the initial jump, yields could stabilise until the Trump’s policy priorities become clearer, hopefully in 1Q2017. After that we can see Fed tightening pushing up the curve, with 10-year US Treasury yields approaching 3 per cent by end-2017. Investment grade returns will be dull in this environment – barely better than cash.
  • We are moderately defensive in our asset allocation and continue to prefer credit over equity. On credit, we do not foresee credit spreads widening significantly, as any fiscal stimulus would delay recession risk. As a result, we are turning less bearish on developed market high yield bonds. However, we are careful not to take on too much bond duration risk because higher inflation expectations will push long-dated bond yields higher.
  • We recently lowered our positive stance on Emerging Market high yield bonds given expected headwinds emanating from anticipated changes under a Trump administration, which moderates our expected 2017 return for the aggregate asset class. However, given our expectation of modest spread tightening going forward, the higher coupon of High Yield should help buffer and insulate returns to at least some extent from rising U.S. Treasury yields and place it in a position to outperform Emerging Market investment grade bonds.
  • Given the potential risks posed by Trump’s policies, there will be greater differentiation among Emerging Market bonds with those operating in countries and sectors which are less affected by global trade and with relatively strong external balances, showing more resilience. On the other hand, Emerging Market bonds with a bigger exposure to external trade and poorer economic fundamentals would probably be more vulnerable.