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Fixed-Income Insights

Here’s a look at how economic, fiscal, and monetary developments could influence interest rates in the United States and elsewhere.

Weak consumption, reduced inflationary pressures, and delays to fiscal-stimulus programs encouraged investors to push longer-term interest rates lower in the first half of 2017. The yield on the 10-year U.S. Treasury note, for example, declined, from 2.44% at the end of 2016 to 2.16% during the last week of June 2017, according to Bloomberg. 

But the interest-rate picture could change in the second half of 2017. Higher wage pressures from near full U.S. employment could finally unfold. The prospect of corporate tax reform and infrastructure spending finally being passed in 2018 could affect expectations for U.S. economic growth and related rate movements toward the end of this year. Efforts by the U.S. Federal Reserve (Fed) to normalize interest rates, while reducing its portfolio holdings, could further influence upward shifts in both short- and long-term rates.  Even the prospect of the European Central Bank (ECB) tapering its securities purchases could help push U.S. rates higher. 

Such rate pressures seem set to build gradually, with a potentially adverse effect on the high-quality segment of the fixed-income market, but not the U.S. economy overall. Higher-yielding and more economically responsive fixed-income securities are poised to perform better in such an environment than higher-quality, interest rate-sensitive U.S. debt. [Non-investment-grade debt securities are subject to increased risks, including the possibility of price volatility, illiquidity, and defaults.]

In what follows, we take a closer look at the key factors that could influence the direction of interest rates in the second half of the year.

Economic Growth
Persistent job growth, rising wages, reduced personal debt, appreciating home prices, and improving equity valuations are poised to combine to support consumption as a continued driver of growth in U.S. gross domestic product (GDP). Business investment—which was substantially higher in the first half as a result of increased drilling activity—likely will taper lower, but reduced regulation in other industries should allow sectors other than energy to contribute to second-half GDP. Government spending, at both the federal and local level, also is poised to increase year over year, supporting U.S. growth. 

Meanwhile, economic growth in Japan and the European Union (EU), as well as in some emerging markets, will further enable U.S. exports and GDP growth. Collectively, continued economic improvement and the associated demands for capital to finance consumption, investment, and spending seem positioned to push interest rates higher, though at a moderate pace, over the balance of 2017. Any increased likelihood that fiscal programs such as tax reform and infrastructure spending may become enacted could accelerate growth expectations for 2018, and adjust inflation and rate expectations higher by the end of 2017.

Monetary Policy
Continued economic improvement also could increase market expectations that the Fed will be able to follow through on its intended pace of rate normalization and portfolio reduction. Fed funds futures currently suggest investors expect only one more rate hike over the next 18 months, according to Bloomberg. This expectation is in contrast to the Fed’s June projections for one more rate hike in 2017 and three more in 2018. Any shift in market sentiment toward Fed intentions could tilt short rates higher.  Further, the onset of the Fed’s reduction of its portfolio will occur later this year. While market reaction to the Fed’s planned approach has been calm, expected changes in the composition of Fed leadership (including that of the chair) could increase rate volatility later this year. 

Outside the United States, any shift in monetary policy from the ECB to reduce its portfolio holdings of debt securities could influence U.S. rates higher. A reference to the possibility of such a move by ECB president Mario Draghi, on June 25, caused 10-year U.S. Treasury yields to move, from 2.15% to 2.30%, over the balance of that week.

Inflation
Inflation is one factor that could restrain a move toward higher rates. Persistent low inflation in the first half of 2017 helped contain yields on longer-term high-quality bonds, such as the 10-year U.S. Treasury.  Despite an unemployment level of only 4.3%, wage growth remains around 2.5%, while low oil prices have at times pushed inflation lower, and weak industrial commodity prices have had a similar effect.  Inflation in 2017 seems unlikely to be boosted by rising energy prices or higher industrial commodity prices, given the responsiveness of U.S. shale production, and some decline in Chinese industrial commodity consumption, respectively. However continued job growth and a need for companies to retain employees in a growing economy could translate into higher wage growth over the balance of 2017. 

The prospect of a 2018 economic boost from tax reform and infrastructure spending could accelerate wage growth.  If fiscal stimulus coincides with immigration reform that reduces availability of workers, wages could respond quickly.

Investment Implications
The factors that could push rates higher, including inflation, will, however, take some time to have their effect. If these factors do build up pressures, a small and gradual rise in rates over the balance of 2017 as a result of economic, fiscal, and monetary developments is more likely to affect investments than the economy. That is, just as the decline in the 10-year U.S. Treasury yield did not promote a spurt in economic growth over the past six months, a gradual rate rise seems unlikely to weigh on growth, let alone produce an economic downturn.  Instead, a rise in rates likely would compromise returns of high-quality, interest rate-sensitive debt. At the same time (and which has occurred in past cycles), more economically sensitive securities could offer relatively attractive returns as they respond to underlying economic strength that improves balance sheets and reduces the likelihood of default. [Of course, these securities may not perform in the same manner as in similar situations in the past.]

Outside the United States, fixed-income opportunities in the European Union are likely to be scarce, as improved economic growth allows the ECB to consider a change in its negative interest-rate policy.  Expectations of that shift will push yields on many EU debt securities higher—and prices lower. Similar to U.S. high-yield debt, emerging market corporate debt may offer relatively better return prospects, as improved global growth supports the balance sheets of emerging market corporations and as investors seek yield that is difficult to find elsewhere. [Non-U.S. debt securities can pose greater risks than domestic securities, including market, political, and currency risk.]

As we enter the second half of 2017, then, it may be appropriate for investors to reassess their fixed-income holdings after longer-term yields have declined, given that an alignment of potential economic, fiscal, and monetary developments seems set to tilt rates slightly higher. 

 

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