Fixed Income Macro Outlook
Second Quarter 2015
Our Global Macro Strategy Team's Perspective
Moderate growth with increased possible upside
- Moderate Growth with Increased Possible Upside: Our most likely (52% 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 (39%) of an upside breakout of over 3% growth.
- Improving U.S. Fundamentals Despite Soft First Quarter: The U.S. economy seems to have achieved sustainable growth, despite global economic weakness and a soft first quarter. 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 (64% probability). (CPI is a government index derived from detailed consumer spending information.)
- Long-Term Concerns as Economic Conditions Improve: 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
Interest rate normalization depends on data, particularly inflation and wage growth
- 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 2014. 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.
- Policy Change Indicators Switched from Forward Guidance to Data Dependency: In March, the Fed switched from forward guidance (language triggers) to data dependence (data triggers) to indicate when it might begin interest rate normalization. This could result in more financial market volatility as markets try to anticipate the Fed’s response to economic news.
- Rate Normalization Expected; Timing and Magnitude Are Data Dependent: The Fed is expected to begin raising short-term interest rates from their near-zero level some time in the next 12 months. But we think global economic weakness and low inflation will allow the Fed to temper the timing and magnitude of possible rate increases.
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 2.00% and 2.65% 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 improving U.S. economic fundamentals.
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., the global economy is mostly struggling. Japan is easing out of recession, Russia appears headed toward recession, Europe has been fighting deflation, and China’s growth is slowing.
- Global Divergence in Monetary Policies: While the Fed is contemplating tighter monetary policy, 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
- More Global Divergence; Possible Delayed U.S. Interest Rate Normalization: Illustrating the divergence between the Fed (which ended its bond-buying program last year) and other major central banks (which are maintaining or expanding their economic stimulus programs), the European Central Bank (ECB) embarked on a massive bond-buying program, driving down some European sovereign bond yields to record-low, negative levels. Low European interest rates helped make the U.S. dollar and Treasuries more attractive. Meanwhile, the Fed continued to prepare for interest rate normalization, switching from forward guidance to data dependency, but also tempering rate hike expectations by lowering its economic forecast numbers.
- Divergence, U.S. Normalization Expectations Translated to Market Volatility: The U.S. dollar and Treasuries continued to rally, commodity (including oil) prices continued to decline, and there were intermittent bouts of risk-on versus risk-off trading in other markets as investors responded to changing earnings, inflation, monetary policy, and economic growth expectations. Renewed concerns about Greece and Middle East geopolitical turmoil helped create a recipe for market volatility, which we expect to continue through the remainder of the year.
G. David MacEwen & Victor Zhang, Co-Chief Investment Officers — Oil, Currency Volatility Illustrate Recent Themes, Risks, Opportunities
- Recent big moves in the oil and currency markets help illustrate themes we’ve discussed over the past six months regarding global divergence and normalizing markets. With regard to global divergence, the U.S. is zigging (benefiting from relatively stronger growth) while much of the rest of the world is zagging (slower growth). Divergence has driven the U.S. dollar higher and the euro lower, with global ramifications for monetary policies, interest rates, and the earnings of multi-national corporations.
- With regard to normalization, markets have been heavily managed by central bank policies since 2008, which created artificial conditions that encouraged risk-taking and suppressed the volatility and market differentiation that can reward active investment managers. We believe Fed policy changes (the end of bond buying and the start of interest rate hikes) could re-establish more historically normal two-way risks and flows, and increase opportunities for active managers.
- We've already seen the impact of Fed moves toward normalization expressed in various market volatilities, particularly oil and currencies. Oil and currency volatility can be disconcerting, but they can open up areas of differentiation and windows of opportunity for active investment managers in a variety of markets and investment disciplines.
G. David MacEwen — Global Risks, Volatility Could Keep U.S. Interest Rates Relatively Low
- U.S. interest rates (particularly long-term rates) could stay lower in 2015 than investors originally anticipated. Fears of a repeat of 2013’s mid-year “Taper Tantrum”—when U.S. Treasury yields soared merely on the expectation that the Federal Reserve (the Fed) would soon begin tapering its bond purchase program—could prove unfounded, as they were in 2014.
- Last year, the Treasury market enjoyed a surprising, historically large rally, even as the Fed wound down its bond purchases. Now the Fed is poised to raise (normalize) short-term interest rates from their near 0% level. There’s been concern again in the financial media about rising rates, but those concerns haven’t yet expressed themselves much in bond market prices. Reasons: The global economy is not booming, inflation remains low, the dollar has soared, and oil and other commodity prices have declined. These factors could delay and reduce the Fed’s initial interest rate hikes, and help keep long-term U.S. interest rates relatively low.
- Another factor working in the U.S. bond market’s favor is the big yield spread (difference) between U.S. Treasury yields and other sovereign yields. This is especially true in Europe, where some sovereign bond yields have turned negative as a result of the ECB’s expanded program of bond purchases. When U.S. Treasury yields greatly exceed other sovereign bond yields, yield-seeking investors will buy Treasuries.
- There’s an important theme here: Think globally. We believe U.S. investors have grown too accustomed to being U.S.-centric, focusing primarily on the U.S. economy and events. Now, the U.S. bond market is being shaped largely by global events. And we believe that investors should also think globally in terms of fixed income investment opportunities, including non-U.S. bonds and currencies.
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.