Outlook For The U.S. Yield Curve

Our U.S. bond strategists expect the U.S. yield curve to steepen further in 2017.

din-20161206-155253

The steepening should be driven by improving growth, rising inflation expectations and a lagging Fed. We believe that the Fed will remain accommodative at least until TIPS breakeven inflation rates are in a range that is more consistent with the 2% inflation target. That range is between 2.4% and 2.5% for long-dated TIPS breakevens.

However, we are reluctant to initiate a curve steepener one week before the Fed is poised to lift rates. We view a “dovish hike”, i.e. an increase in the fed funds rate with no upward revision to the Fed’s interest rate forecasts, as the most likely outcome. However, if we are wrong, an upward revision to the Fed’s forecasts would cause the curve to bear-flatten on the day.

At present, the market expects 59 bps of rate hikes during the next 12 months. If expectations remain at these levels until after next week’s FOMC meeting, they will be consistent with the Fed’s median forecast, assuming there are no upward revisions.

Also, as we pointed out in a previous Insight, the selloff at the long-end of the Treasury curve appears stretched relative to fundamentals and is likely to take a pause. This should provide us with a more attractive level from which to enter curve steepeners heading into next year.

ECB Pulls Off A Dovish Taper

The European Central Bank (ECB) announced that it will taper asset purchases from €80 billion per month to €60 billion beginning next April. Long-term bund yields increased on the news, but other markets responded as if the ECB had eased policy: Eurozone stock indexes rose and the euro weakened.

din-20161208-115321

This market reaction suggests that investors have interpreted the ECB’s action as dovish, or at a minimum, benign. In part, this may reflect the extension of the program to year end, and perhaps beyond that if inflation is expected to remain below the ECB’s 2% target. The market was expecting an extension of the €80 purchase pace until September. Instead, the ECB will buy at a €60 billion pace until (at least) the end of the year, which works out to a larger accumulation in total.

Moreover, President Draghi was careful to manage expectations, which limited market fears that the central bank is getting closer to ending the purchase program and beginning to lift interest rates:

  • The ECB trimmed its inflation forecast for the coming years. Draghi emphasized that inflation is too low and that, outside of base effects from energy prices, there is little upward momentum in inflation at the moment.
  • Draghi also emphasized that the asset purchase program is open-ended and could be ramped up again were the economy to need it. Moreover, he said that “the presence of the ECB on the markets will be there for a long time.”
  • The ECB removed the self-imposed rule that it cannot buy bonds with a yield that is below the deposit rate (-40 basis points), while also lowering the minimum maturity for bond purchases to one year. This depressed yields at the front end of the sovereign Eurozone curves and reinforced the notion that the ECB is a long way from raising interest rates.

The implication is that a liberal dose of “forward guidance” has limited the damage from the reduction in the pace of asset purchases.

Our bond strategists shifted tactically to benchmark on global duration following the past month’s major selloff. On a 12-month horizon, we still believe that global yields will be higher than forward rates, but this is largely due to our bullish view on the U.S. economy. Bund yields will be dragged higher by the global selloff, but the U.S./Eurozone monetary and fiscal policy divergence will likely see Treasury/bund spreads widen further. The divergence should also weaken the euro.

Catalysts For Higher Global Bond Yields

From the U.S., the most likely catalyst for sharply higher bond yields will be the Fed signaling that it will adopt a quicker pace of rate hikes.

din-20161129-153244

With inflation still below target and market-based measures of inflation compensation still depressed, the Fed will be in no rush to signal a more hawkish policy stance. We expect the Fed will follow through with an expected rate increase in December, but the median expectation will continue to call for only two more hikes in 2017.

The Fed is only likely to shift toward a more hawkish policy stance once inflation expectations are more firmly anchored around their 2% target. This corresponds to a range of 2.4-2.5% on the 5-yr/5-yr forward TIPS breakeven inflation rate. Assuming that U.S. economic growth continues to accelerate into next year, then the 5-yr/5-yr breakeven rate could reach this target sometime in the middle of 2017. At that point, a more hawkish Fed policy becomes more likely.

Bottom Line: The “Trump Tantrum” is likely to take a pause soon. If U.S. growth is strong in 2017 and the Trump administration is making progress in implementing its stimulative policies, a hawkish Fed could send bond yields higher in the second half of 2017.

Long-Term EM Currency Trends

Poor economic fundamentals should drag EM currencies lower.

din-20161130-162113

Despite the latest pullback in EM currencies, the EM ex-China real effective exchange rate is still elevated. Given their poor productivity growth outlook, the real effective exchange rates will be inclined to depreciate. Furthermore, to limit the upside in domestic interest rates – both in bond yields and interbank rates – many developing nations’ central banks will inject more local currency liquidity into their financial systems. This might help cap local interest rates, but will be bearish for their currencies.

Bottom Line: EM exchange rates will continue depreciating. Our EM strategists recommend short positions in the following basket of currencies versus the U.S. dollar: KRW, MYR, IDR, TRY, ZAR, BRL, COP and CLP.

Dollar Strength Warrants Caution On U.S. Equities

The strong U.S. dollar is tightening global liquidity conditions, putting the post-election jump in stock prices at risk unless growth accelerates imminently.

din-20161121-171012

In a closed economy driven more by consumption than investment, a strong currency can be supportive via increased purchasing power and a dampening in corporate sector input costs. But what’s good for the economy should not automatically be extrapolated through to profits. U.S. net earnings revisions fall when the dollar is strong (second panel in the above chart).

Labor costs are now on the upswing and productivity growth has deteriorated. If the economy strengthens, it may only serve to boost wage inflation. Meanwhile, a strong dollar means the U.S. will be importing deflationary pressures, undermining corporate pricing power. Rising wages and a lack of corporate pricing power will continue to squeeze profit margins.

U.S. dollar appreciation also saps growth in developing countries. Capex in emerging markets is already contracting and financial strains are flaring up again. Not only does dollar strength make U.S. companies less competitive, but they will also be selling into weaker demand growth abroad. Just under half of S&P 500 sales come from abroad.

Finally, U.S. dollar-based global financial liquidity is contracting as the greenback strengthens. If excess liquidity and low rates were previously supporting high valuations, tighter liquidity and rising rates can’t justify current multiples, especially if global growth is soft.

The bottom line is that the outlook for the broad averages has soured as a consequence of a strong dollar, rising yields and the prospect for tighter Fed policy. These dynamics augur well for domestic vs. global bias, small vs. large caps and defensive vs. cyclical sector strategies.