The era of extraordinarily accommodative monetary policy seems to be ending. The question is, how quickly and whether central banks can become a source of volatility rather than calm. The Jackson Hole conference taking place the third week of August may play an important role in disseminating changing views of how central banks will approach the normalization process. In addition, after four successive U.S. inflation misses, there seems to be a good chance that inflation is likely to surprise on the upside given stable to improving underlying economic conditions and call into question the benign rate path currently priced into the U.S. yield curve. Anticipating increased policy noise ahead, we are being selective in what we invest and will focus on opportunities, such as in emerging market (EM) and credit-sensitive securitized markets, where fundamentals, yields and spread levels provide some cushion against potential rises in rate volatility.
Developed Market (DM) Rate/Foreign Currency (FX): Risk-free yields were relatively unchanged in July. U.S. 10-year yields fell 1 basis point, while Germany 10-year yields rose 8 basis points and European periphery spreads tightened on the back of improving European fundamentals. The dollar continued to weaken. The Federal Open Market Committee (FOMC) mentioned at its July meeting that balance sheet normalization should start “relatively soon,” a possible indication for its commencement in September.
We believe higher U.S. Treasury yields will depend on higher U.S. inflation. If inflation improves, we believe that the U.S. Treasury 10-year yield may end the year close to 2.60 percent and the 2-year to 10-year yield curve will be near 80 basis points. We do expect the Fed to start reducing its balance sheet in September and hike rates in December. Of course, this is highly dependent on the economic data, particularly inflation.
Emerging Market (EM) Rate/FX: EM fixed income asset returns were positive in the month with investment-grade assets outperforming high-yield, currencies generally strengthened versus the U.S. dollar, and corporates outperformed sovereigns within dollar-denominated debt.
Many EM central banks remained de-coupled from the rate-hike cycle in the U.S. as they continued cutting policy rates to support growth and inflation targets. EM assets should be able to weather Fed rate hikes if driven by increasing U.S. growth; however, assets remain vulnerable to spikes in U.S. policy uncertainty from undue Fed hawkishness, or Chinese policy tightening triggering a sharper-than-expected growth downturn.
Credit: The United States investment-grade credit market enjoyed a quiet summer month, as index spreads continued to grind toward post-crisis lows. U.S. bank earrings were a focus early in July, with the money center and large brokers reporting revenues and earnings that generally beat expectations.
We are slightly more constructive on the U.S. market compared to the European market, mainly due to relative valuation. Given valuation levels, we do not expect a drastic move tighter in spreads; however, spreads are likely continue to grind tighter if the current environment persists.
Securitized: Agency mortgage-backed securities (MBS) continued to perform in line with expectations in July. Non-agency MBS spreads widened slightly in the month, giving back some of the substantial gains of 2017, but cash flow and credit performance continued to improve. European MBS spreads were marginally tighter in July, and remain 30 to 60 basis points tighter in 2017. Low interest rates and moderate signs of economic growth in Europe seem to be outweighing any material concerns over Brexit fallout.
Across most securitized markets, we have increased concerns about whether risk premiums (credit spreads) are sufficient compensation for even low fundamental risk levels at current valuations. Although we are less optimistic that spreads can continue to tighten meaningfully, we still maintain a credit bias in our portfolios given the broad strength of fundamental real estate and asset-backed conditions.