To many, the outcome of the 2016 U.S. Presidential election was an unconventional result from an unconventional election, carrying with it vast uncertainty regarding the implications for both fiscal, foreign and monetary policy. While market participants must wait for further clarity on President-elect Trump’s full agenda, the U.S. Treasury market has reacted strongly. Following the election, the 10-year U.S. Treasury yield has increased nearly 40 basis points as inflation expectations quickly adjust to the likelihood that the new administration’s pro-growth policies will get support from Congress. To be sure, a number of the policies under consideration— i.e., lower corporate tax rates and significant infrastructure spending– are reflationary in nature, particularly over the near-term. However, absent details on key issues such as their funding, it is still too early to judge their longer-term effect on economic growth. On the issue of funding, it is important to note that both President-elect Trump and his nominee for U.S. Treasury Secretary, Steven Mnuchin, share the view that the government should further utilize long-dated securities to fulfill its borrowing needs.
On the monetary policy front, Fed fund futures are implying a 100% probability of a rate hike at the Fed’s December meeting. Given that key economic indicators such as third quarter GDP and personal income growth have exhibited strength, consistent with the FOMC’s prior policy directives, we anticipate a 25 basis point increase in the Fed funds rate to a range of 50 to 75 basis points. Furthermore, in our view, it is likely that the Fed will use the increase in benchmark interest rates as an opportunity to add some hawkish language. Our core thesis remains the same, i.e. that when it comes to policy implementation, the Fed will continue to err on the side of caution. Therefore, all else equal, we anticipate the future pace of rate increases will likely remain gradual, while the Fed’s balance sheet holds steady. Accordingly, until such time that the central tendencies demonstrate a risk of overheating, it is fiscal policy that poses the higher probability of surprises over the near term.
On November 30, the Organization of Petroleum Exporting Countries (OPEC) announced an agreement to curtail oil supply by introducing its first cut to crude oil production in eight years. Under the agreement, OPEC will reduce output by 1.2 million barrels to 32.5 million beginning in January. The agreement, which is aimed at reducing an oil supply glut, would provide some relief to the economies of oil-producing countries. The deal was also welcomed by the U.S. credit markets with most debt issued by energy companies tightening between 15 and 25 basis points.
Although we do not anticipate that the Fed will abandon its restraint in 2017, we anticipate that future U.S. fiscal policy could be stimulative. While the 10-year U.S. Treasury is nearly 100 basis points above its post-Brexit yield, it is merely 10 basis points above where it began 2016. Therefore, as we head into the final month of 2016, we are reaffirming our defensive stance on duration positioning. On balance, expectations regarding significant infrastructure spending, coupled with revisions to U.S. trade and regulatory policies, continue to suggest some additional upside to benchmark yields. We continue to utilize our cross-sector, fundamental analysis to identify attractive relative value opportunities. For example, heightened interest rate volatility and a steepening of the U.S. Treasury curve has repriced mortgage-backed securities in anticipation that their duration may extend further. Additionally, within credit markets, factors such as the OPEC production cut and potential changes to the U.S. Affordable Care Act and Dodd-Frank now suggest a changing set of circumstances (and potential outcomes) for certain sectors.