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First Quarter 2014

Our Fixed Income Macro Strategy Team's Perspective

U.S. Economy

Still subpar recovery, but conditions are modestly improving
  • Subpar Recovery: Our base case (most likely) scenario continues to call for a subpar recovery (low growth compared with prior recession recovery periods), producing near-term economic growth rates of approximately 1.0% to 3.0% (67% probability).
  • Signs of Improvement: The economy seems to have achieved sustainable growth, but not strong growth. The housing market has posted gains, tax revenues have grown, corporate default rates remain relatively low, the stock market rallied strongly in 2013, and unemployment is trending lower.
  • Lingering Headwinds: Headwinds to recovery include stubbornly high U.S. unemployment, lingering fiscal sequester and federal budget issues, higher taxes, and higher interest rates.

U.S. Inflation

Contained in near term, but most likely on an upward path thereafter
  • Contained in Near Term: A 1.5% to 3.0% increase over 12 months in the overall Consumer Price Index (CPI, a government index derived from detailed consumer spending information) appears most likely to us (63% probability). That's largely because of subpar economic growth.
  • Long-Term Concerns: We believe higher inflation (a 12-month CPI change over 3.0%) could occur in the coming three to five years because of the unprecedented monetary and fiscal policies enacted in response to the 2008 Financial Crisis and the slow recovery.
  • Don't Be Complacent: We believe strongly that some level of inflation protection be incorporated into investor portfolios.

U.S. Monetary Policy

No changes in overnight rate target in near term, but QE tapering is beginning
  • No Near-Term Changes Foreseen in Near-Zero Overnight Rate Target: The Federal Reserve (the Fed) has indicated that its historically low overnight rate target has become data dependent--it won't be raised until unemployment and/or inflation reach certain stated levels. This anchors short-maturity U.S. Treasury yields. The Fed also appears more focused on reducing its monthly bond purchases than on raising its rate target at this time.
  • QE3 Tapering Has Begun: The Fed's third round of monthly bond purchases (quantitative easing, or QE3) totalled $85 billion per month. In May 2013, the Fed began suggesting that QE3 might be tapered soon if economic conditions improved. The markets responded poorly to this suggestion, economic conditions weakened, and the Fed delayed tapering. Economic and market conditions improved by year end, and the Fed announced in December that tapering (starting with a $10 billion per month reduction in its bond purchases) would begin in January 2014.

U.S. Interest Rates

Last year's "Taper Tantrum" started interest rate normalization, but the subpar U.S. economic recovery and low inflation have kept rates range-bound
  • Range-Bound With Upward Bias: Given continued subpar economic growth, we expect interest rates to remain in trading ranges as they normalize rather than shooting straight higher. We expect the 10-year U.S. Treasury yield to trade between 2.50% and 3.75% for the next 12 months. We think rates will continue to trend higher over time, assuming the economy strengthens.
  • Heavily Fed-Managed Interest Rate Environment: With a near-zero percent overnight target harnessing short-maturity U.S. Treasury yields and tapered QE3 still compressing long-maturity yields, U.S. interest rates remain heavily managed by the Fed, even as it begins tapering QE3.
  • "Taper Tantrum" Started Normalization: The Fed's initial QE tapering talk triggered a violent reaction last year--the 10-year U.S. Treasury yield jumped from 1.63% in May to 3.00% in September. From our perspective, this was the start of a normalization of long-term interest rates after years of artificially low levels caused in part by the Fed's QE programs.

Global Economy

Slow growth with widespread stimulative policies and low inflation
  • Slow But Improving Global Growth: Overall economic activity slowed in the first half of 2013 but found better footing in the second half, led by improvements in Europe and Japan.
  • Widespread Stimulative Policies: Central banks responded aggressively in 2013, reducing interest rates and buying government securities. We expect this trend to continue in the near term.
  • 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

  • Fed's Tapering Decision: The Fed decided in December to reduce its $85 billion per month QE3 purchases to $75 billion, starting in January. Tapering was anticipated by the markets, so it didn't have much immediate impact (unlike in May, when long-maturity Treasury yields soared). Bernanke also appeared to suggest that further $10 billion reductions could be expected at subsequent Fed policy meetings, barring a significant economic downturn.
  • Fed's Forward Guidance on Interest Rates: The Fed also updated its forward guidance on interest rates in December, stating that it expects to keep its overnight rate target at its current level "well past the time that the unemployment rate declines below 6.5%." We believe this guidance is intended to help anchor short-maturity yields through the taper process while discouraging a surge in longer-maturity yields.
  • Federal Budget Compromise: Congress reached a bi-partisan compromise on a two-year federal budget agreement. It essentially locks in sequester-level spending, with modest adjustments, and provides more fiscal clarity. It reduces sequester spending cuts in fiscal years 2014 and 2015, and should, we believe, help reduce the brinkmanship that triggered the government shutdown in October.
  • Housing Recovery Lost Momentum: Last year's Taper Tantrum and government shutdown slowed the U.S. housing market's recovery. Higher mortgage interest rates and increased economic and fiscal uncertainty in the second half of the year appeared to slow the housing market's momentum, which had picked up earlier in the year.

G. David MacEwen, Co-CIO--Markets Still Heavily Managed by Monetary Policies

  • Despite tapering by the Fed, we believe monetary policies will remain a major force in determining market behavior. We expect the Fed to maintain highly accommodative monetary policies (a near-zero overnight interest rate target and additional, though reduced, QE) in the face of continued economic headwinds.
  • One of the big questions for 2014 is how the markets will react to the Fed's QE tapering. We think additional market volatility is possible, even though the Fed has shed further light on its QE exit strategy.
  • For the first half of 2014, we think low inflation and a continued subpar recovery should keep money market interest rates anchored near 0% and the 10-year Treasury yield under 4%. In the second half, we believe economic conditions should improve, inflation pressures will grow, and the 10-year Treasury yield will rise on a normalization track toward 4%.
  • We believe investors can prepare for higher interest rates by keeping bond portfolio durations relatively short, choosing sectors wisely, and holding investments for at least the length of portfolio durations so the bonds have time to mature and be reinvested at higher yields.

Steven Permut, Municipal Markets--2013 Performance, Detroit, and Puerto Rico

  • 2013 was a volatile year for the municipal bond (muni) market, in contrast to two consecutive prior years (2011-12) of outperformance. That two-year rally followed the late 2010/early 2011 sell-off triggered in part by a forecasted wave of muni defaults. No such wave materialized, but isolated high-profile muni credit events cropped up, most notably the Detroit bankruptcy and fiscal problems in Puerto Rico.
  • 2013's muni volatility can be attributed to: 1) the Fed's taper talk, which caused bond yields to rise sharply, triggering massive muni fund withdrawals; 2) the fiscal cliff and sequester, which reduced funding for local projects and raised questions about the future tax treatment of munis; and 3) headline risk, after Detroit's bankruptcy and negative publicity about Puerto Rico, one of the largest muni issuers.
  • We believe both Detroit and Puerto Rico are relatively isolated events, created by their own individual circumstances. Detroit's woes stemmed primarily from an extended period of fiscal mismanagement and population loss. Puerto Rico's problems include a weak economy, high debt, unbalanced budgets, and underfunded pensions.
  • While both situations could generate further ripple effects, we have limited Detroit exposure and we do not think a default is imminent in Puerto Rico, where underlying credit fundamentals (such as dedicated revenue streams and first claims on resources) still support many of these bonds, and actions have been taken to reduce budget deficits and enact pension reforms.
  • These situations help point out the potential advantages and benefits of professional municipal portfolio management, and owning a diversified, well-selected municipal bond portfolio.

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 the Fixed Income Macro Strategy Team at American Century Investments 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.

Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.

International investing involves special risks, such as political instability and currency fluctuations.

Diversification does not assure a profit nor does it protect against loss of principal.