Fixed Income Macro Outlook
First Quarter 2015
Our Global Macro Strategy Team's Perspective
Moderate growth with increased possible upside
- Moderate Growth with Increased Possible Upside: Our most likely (55% probability) scenario continues to call for moderate growth, producing near-term annualized economic growth rates of 2-3%. However, we also see a significant possibility (35%) of an upside breakout of over 3% growth.
- Improving U.S. Fundamentals: The U.S. economy seems to have achieved sustainable growth, despite global economic weakness. Corporations are generating profits, unemployment is grinding lower, consumer debt levels are falling, tax revenues are growing, and inflation, interest rates, and corporate default rates remain relatively low.
Muted in near term but still long-term concerns
- Muted in Near Term: A 1.5% to 3.0% increase over 12 months in the overall Consumer Price Index (CPI) appears most likely to us (60% probability). (CPI is a government index derived from detailed consumer spending information.)
- Long-Term Concerns: We think that the longer-term trend from here is upward, assuming the U.S. economy continues to strengthen. We believe higher inflation (a 12-month CPI change over 3.0%) could occur in the coming three to five years because of monetary and fiscal policies enacted since 2008 and improving U.S. economic growth.
- Don’t Be Complacent: We believe strongly that some level of inflation protection be incorporated into investor portfolios.
U.S. Monetary Policy
QE3 completed; possible rate hikes on the horizon
- QE3 Completed but Other Stimulus Continues: The Federal Reserve’s (the Fed’s) third bond-purchase program (quantitative easing, QE) since 2008 ended in October. But the Fed still owns a large portfolio of bonds it purchased through QE, and will continue to reinvest its coupon income. And short-term interest rates remain very low, even if the Fed starts raising them.
- Rate Hikes on the Horizon: Some time in 2015, the Fed is likely to begin raising short-term interest rates from their near-zero level. But we think low inflation will allow the Fed to push rate increases out to the second half of 2015.
U.S. Interest Rates
Range-bound with upward bias toward normalization, but constrained by non-U.S. factors
- Range-Bound With Upward Bias: Given our expectations for moderate, sustained, and possibly higher U.S. economic growth, we expect the 10-year U.S. Treasury yield to rise to between 3.00% and 3.50% in the next 12 months. We think this longer-term trend is fundamentally supported, assuming the economy strengthens. We expect an eventual normalization of long-term interest rates after years of artificially low levels caused in part by the Fed’s QE programs.
- Near-Term Non-U.S. Headwinds for Higher Interest Rates: Weaker global economic fundamentals, aggressive non-U.S. monetary policies, low inflation, a strong dollar, uncertain global geopolitical factors, and demand due to the wide yield disparity between U.S. bonds and those of other developed countries are working together to keep interest rates low in the near term, despite the improving U.S. economic fundamentals.
Growing divergence from the U.S. in terms of weaker economic growth and more aggressive monetary policies
- Global Divergence in Economic Growth: Outside of the U.S. and U.K., the global economy is struggling. Japan is in recession, Russia appears headed that way, Europe faces possible deflation, and China’s growth is slowing.
- Global Divergence in Monetary Policies: While the Fed and the Bank of England are contemplating tighter monetary policies, most of the world’s other central banks in developed economies are still considering or implementing additional monetary easing.
- Low Inflation: As in the U.S., inflation is unlikely to be a near-term threat. However, the amount of monetary and fiscal stimulation that has been prescribed could create longer-term inflationary pressures.
What Our Fixed Income Experts Are Saying
Macro Observations - Changes Since Last Quarter
- Further “Global Divergence”: We saw a multi-faceted divergence between the U.S. and the rest of the world that included relative economic growth, monetary policies, and currency values. While the U.S. reported an annualized economic growth rate of 5% for the third quarter of 2014, Japan reported two consecutive quarters of negative growth and the eurozone was barely positive. The U.S. dollar rallied against its counterparts as the Fed ended QE3 and hinted at possible higher rates in 2015, while other central banks of developed countries were mostly continuing or expanding their monetary easing policies.
- Declining Commodity Prices and Lower Inflation Expectations: The broad global economy shared two key conditions: 1) declining commodity prices (related to weakened economic conditions and reduced demand), and 2) lower inflation expectations. Oil prices and inflation expectations plunged to levels not seen since the Great Recession.
G. David MacEwen & Victor Zhang, Co-Chief Investment Officers — Look Back Beyond Five Years to Find Normal Benchmarks
- Our Global Macro Strategy Team has identified “Market Normalization” as a prominent theme—at least in the U.S.— for 2015 as the Fed unwinds its extraordinary monetary easing programs. These programs muted risks and encouraged greater risk exposure.
- The degree of “risk-on” bias is changing, we believe. If the U.S. pursues progressively less-accommodative monetary policy, we expect the markets to return to more normal, two-way behavior, with increased volatility and risk, unlike the past five years.
- We believe recent five-year track records focus too much on just one side of the latest investment cycle—the risk-asset “snapback rally” since 2009. We have to look back farther to find more normal risk/return patterns.
- Reflecting the five-year focus of investors and advisors, portfolios may still be positioned for lower-risk, higher-return conditions, with elevated exposure to more-aggressive assets. Bond investors went lower in credit quality and to less-liquid assets to get the yields and returns they sought.
- It’s appropriate to ask now if portfolios are balanced and positioned to withstand potentially greater volatility and dispersion of returns. We see this as an environment where bond investors scale back overweight positions in less-liquid and lower-credit-quality securities.
G. David MacEwen — Bond Market Normalization, with Higher Risks and Yields
- 2014 was an unexpectedly strong year for U.S. Treasuries that is unlikely to be repeated in 2015 unless the U.S. economy threatens to slide into recession.
- We think there’s a relatively low probability of a U.S. recession. U.S. fundamentals seem to indicate that the U.S. economy is more likely to surprise to the upside of our most likely scenario (2-3% growth) than the downside.
- This fundamental upside bias should put upward pressure on Treasury yields. Higher Treasury yields should also be supported by the Fed, which is likely to begin raising short-term interest rates in 2015 toward more normal levels.
- High-quality short-to-intermediate maturity “spread” (non-Treasury) sectors and municipal investments look relatively attractive to us in this environment, as well as select non-U.S. bonds hedged to counteract the dollar’s expected strength. High-quality bonds can remain resilient in rising rate environments, especially in buy-and-hold strategies where investors match their bond maturities (or better yet, their duration) to the length of their bond portfolio holding periods.
Duration measures the price sensitivity of a bond or bond fund to changes in interest rates. Specifically, duration represents the approximate percentage change in the price of a bond or bond fund if interest rates move up or down 100 basis points.
The opinions expressed are those of American Century Investments (or the fund manager) and are no guarantee of the future performance of any American Century Investments fund. This information is for educational purposes only and is not intended as investment advice.
Diversification does not assure a profit nor does it protect against loss of principal.