Fixed Income Macro Outlook
Third Quarter 2015
Our Global Macro Strategy Team's Perspective
Moderate growth with increased possible upside
- Moderate Growth with Increased Possible Upside: Our most likely (54% probability) scenario continues to call for moderate growth, producing near-term annualized economic growth rates of 2.0% to 3.0%. However, we also see a significant possibility (36%) of an upside breakout of over 3.0% 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 (66% probability).
- 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 2.25% 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 actors, 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. Europe has required monetary stimulus to fight deflation, Japan is easing out of recession, and Russia, China, and Brazil are 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
- Trend Reversals—Dollar Down, Oil Prices Up, Bond Yields Higher: Market trends that had been in place since last summer reversed in the second quarter, due, in part, to signs of stronger economic growth, particularly in Europe. Indications that the European Central Bank's aggressive stimulative policies were working caused the euro to rebound against the U.S. dollar and European sovereign bond yields to soar from their negative levels. This helped trigger a broader bond sell-off that resulted in longer-maturity U.S. Treasury yields finishing higher during a calendar quarter for the first time since December 2013. Meanwhile, oil prices stabilized as the U.S. dollar lost some of its upward momentum as investors pondered when and by how much the Fed might raise interest rates (see below).
G. David MacEwen & Victor Zhang, Co-Chief Investment Officers — We Think the Fed Should Raise Interest Rates
- With short-term interest rates still extraordinarily low, Fed rate hike expectations are building. But the path to more normal rates remains uncertain, and is triggering market volatility as investors anticipate these moves. This volatility is particularly notable because we’re coming out of a period when the Fed’s policies and programs helped suppress volatility.
- When will/should the Fed raise rates, and by how much? “Hawks” think the Fed should start soon, while “Doves” believe more patience is prudent. On one hand, a decision to hike rates seems clear-cut. Rates have been historically low since 2008 and the U.S. economy is growing, with inflation pressures building in the services sector. However, global factors are constraining economic growth and keeping inflation in the goods sector low. And the capital markets are sensitive to change. The Fed doesn’t want a repeat of 2013’s “Taper Tantrum.”
- We side with the Hawks, but are carefully considering both sides. We believe higher rates give the Fed more future policy flexibility, help limit financial risks from asset bubbles and inflation, and can reward fixed income investors in the long run (income is a big component of bond total returns over extended time frames).
- Increased volatility is likely. But that’s part of normal market behavior. Volatility favors active portfolio management, and it can be addressed with diversified, risk-adjusted investment approaches and long-term holding strategies.
G. David MacEwen — Prepare for Periods of Bond Price Volatility as Markets Normalize
- After reaching for higher yields in recent years, we believe some bond investors are unprepared for more volatile market conditions as the Fed moves toward raising short-term interest rates.
- Since 2008, the Fed has suppressed bond market volatility and encouraged risk taking with low interest rates and massive bond-buying programs. Bond investors reached for yield by moving into higher-risk asset classes like high-yield corporate bonds.
- Investors took on multiple risks, particularly credit (default) risk. Liquidity and price risks are other concerns, particularly if investors put themselves in the position of having to become sellers in short-term stress periods. These risks number among several important market risks across all asset classes that investors should prepare for as markets re-normalize after years of volatility suppression.
- Investor preparedness for more-normal market conditions is a growing issue as we anticipate Fed interest rate hikes in an environment in which: 1) individual portfolios hold more bonds, 2) banks and other dealers hold fewer bonds because of post-Financial Crisis regulations, and 3) defaults could increase as interest rates rise.
- Can these factors result in bond market volatility and illiquidity in stress periods, similar to what happened in 2008? We believe economic fundamentals are better than in 2008, and that the markets will most likely adjust in price terms that would facilitate trading, not complete illiquidity. We saw this in the corporate high-yield market in 2008.
- Prepared investors don’t have to become sellers in stress periods. By holding short- to intermediate-maturity bond positions diversified by sector and credit quality, and realistically assessing risk exposure ahead of time, investors can put themselves in a better position to hold, not sell during short-term periods of market volatility.
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.