In 2017, we may see for the first time since 2013 a combination of bearish factors for bonds: improving economic data/rising inflation, less easy monetary policy and rising risk premiums. As forces dragging down term premium dissipate, we could shift towards a regime where Treasury prices are driven more by fundamentals than technicals. If so, yields could have more room to rise—our longer-term fundamental “fair value” estimate would put yields at around 3 percent. Historically, rising rates have been associated with spread tightening. Better growth prospects could outweigh the rise in risk-free yields and USD, which is bullish for risky U.S. assets. We think cyclically sensitive sectors in credit and securitized could do well, with underweights in U.S. rates continuing to act as a good hedge.
We expect historically low developed market (DM) yields to still support the “right” carry opportunities and spreads in EM. We also expect an ongoing “push” factor of inflows into higher-yielding assets, including select emerging market (EM) fixed income. Given that the “Trump Tantrum” has not been EM-specific, we believe that the various factors both pushing and pulling investors into EM fixed income remain in place. However, assets remain vulnerable to spikes in U.S. policy uncertainty and the Trump Tantrum will likely somewhat delay rate-cutting cycles in Russia, Indonesia and Colombia.
Pro-growth rhetoric, higher inflation expectations and continued demand for U.S. credit should create a bullish environment for U.S. credit. We anticipate the divergence between the U.S. and European markets to continue in December and 2017.
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