Asset Management: Fixed Income Insights

February 2017 Fixed Income Market Update

WALL

Donald Trump became president on January 20th. He began his presidency with a rapid series of executive orders instituting new policy directives. Several Trump positions are having an effect on markets, in particular discussions around trade deals with China and Mexico. Additionally, talk of building a wall on the United States’ border with Mexico, possibly in tandem with a tariff to fund its construction and/or renegotiation of NAFTA continues to create uncertainty.

The legislative process for more significant policy changes have yet to begin. Among the expected initiatives to come, those with significant economic considerations include: fiscal stimulus and infrastructure spending, corporate tax reform, lowering personal income taxes and a healthcare system overhaul. Detailed plans have yet to be proposed for most of these policies, suggesting further information is required to evaluate the impacts.

Eurozone inflation surged in December, rising 0.5% to 1.1%, the highest level since 2013. Despite this increase, Mario Draghi, President of the European Central Bank (ECB), cautioned that it is premature to declare the brief increase sufficient to change policy. Core inflation was lower at 0.9%, though both fell well short of the ECB’s 2% goal.

The Eurostat estimate for January is that inflation continued to rise, increasing 1.8%. Unemployment in the Eurozone fell to 9.6%, the lowest level since May 2009. Fourth quarter GDP growth was 0.5% and for the full year 2016, GDP grew 1.7%, slightly ahead of U.S. growth.

The Bank of Japan (BOJ) raised its growth estimates for the Japanese economy for 2017 and 2018 by 0.2% each year to 1.5% and 1.1%, respectively. At the same time, Japanese inflation has not exceeded 2% since early 2015 and the BOJ does not project inflation to hit its 2% target until March of 2019. As expected, the BOJ did not adjust monetary policy.

Fed minutes from the December 2016 meeting were released in January. Referring largely to the U.S. Presidential election, the committee highlighted the “substantial changes in financial market conditions over the intermeeting period – including the increase in longer-term interest rates, the strengthening of the dollar, the rise in equity prices, and the narrowing of credit spreads – to expectations for more expansionary fiscal policies in coming years or to possible reductions in corporate tax rates.” As a cautionary note, the minutes also reflected the “uncertainty about how federal spending, tax, and regulatory policies might unfold and how global economic and financial conditions will evolve.”

In a January 12th speech, Federal Reserve Chair Janet Yellen shared her view that for the short term “I don’t think there are serious obstacles. I see the economy as doing quite well.” She noted that “unemployment has now reached a low level, the labor market is generally strong and wage growth is beginning to pick up.”

At the time of this writing, the Fed is conducting its January 31 – February 1st meeting – there is not a press conference scheduled at the conclusion of the meeting. Fed Funds Futures suggest a very low probability (less than 15%) of a rate hike at this meeting. Rather futures imply the next rate hike will be at the June meeting.

In our view, much of the necessary adjustment to interest rates in light of the revised expectations post-U.S. election have already been factored in by markets. However, the modestly improving economic growth prospects and inflationary outlook at home and abroad suggest rates continue to drift higher on the margin. In particular, the possible reemergence of inflation bears monitoring given the priority central banks globally have placed on combatting deflationary pressures in recent years. While none of the key central banks are yet shifting positioning based on the recent data, they have expressed acute awareness of it and the potential for adjusting policy. More attractive yields are benefiting U.S. fixed income broadly and the strengthening growth picture provides additional support to nongovernmental sectors within fixed income.

 

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