While the first half of 2017 was about reflation, a unique aspect of the second half stems from central bank policies to remove accommodation, which is creating unknown risk factors. The U.S. Federal Reserve (Fed) remains above the U.S. Treasury market in terms of rate expectations. The primary reason for the divergence is that inflation has been declining. The success of these planned policy moves will mainly depend on how global economic and financial conditions evolve. Our base case is that the normalization process will be orderly, supporting risky assets. The main risk will be a policy error in China.
Developed Market (DM) Rate/Foreign Currency (FX): Yields in DM rose in June, led by Europe. Germany 10-yr yields rose 16 basis points (bps), while the periphery spreads to bunds tightened as a result of good data and more hawkish European Central Bank (ECB) comments. In the U.S., the Fed raised rates by 25 bps at its June meeting.
We believe the ECB as well as the performance of bunds holds the key to performance across global treasury markets, with higher bunds leading the rest upward. In addition, higher U.S. Treasury yields will depend on higher U.S. inflation. If inflation improves, we believe that U.S. Treasury 10-year yields may end the year close to 2.60 percent.
Emerging Market (EM) Rate/FX: EM fixed income asset returns were mixed in June with investment-grade assets outperforming high-yield, currencies weakening versus the U.S. dollar, and corporates outperforming sovereigns within dollar-denominated debt.
We believe that DM yields will continue to support the “right” carry opportunities. We think that (eventual) steeper DM yield curves warrant the shortening of duration exposures with a focus on attractive higher-yielding currencies/countries.
Credit: Investment-grade corporate spreads are now at the tightest level in nearly three years, returning to post-crisis lows of July 2014. In Europe, the restructuring of weak banks in Spain (Popular) and Italy (Veneto/Vicenza) were viewed as positive, as they bailed in subordinated bondholders while protecting senior bondholders. Financials outperformed other sectors.
We are slightly more constructive on the U.S. market compared to the European market, mostly due to relative valuation. Given current valuations, we do not expect a drastic move tighter in spreads; however, spreads may continue to grind tighter if the current backdrop persists.
Securitized: Agency mortgage-backed securities (MBS) had a mixed performance in June, positive relative to U.S. Treasuries but still negative on an absolute basis, while credit-related securitized assets saw continued gains from spread tightening and lower rates-oriented risk exposure.
The Fed is on pace to purchase over $300 billion agency MBS in 2017, and we believe that ending this reinvestment could have a significant negative impact on agency MBS. The increasing distress in the retail commercial mortgage-backed securities (CMBS) market represents both a significant risk and a significant opportunity. We believe that careful security selection can prove to be particularly beneficial in this market.