Asset Management: Fixed Income Insights

November 2017 Fixed Income Market Update

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Economic and market perspective

The House of Representatives passed a budget resolution, which will make it easier for Congress to pass tax cut legislation. The resolution allows the federal deficit to increase by up to $1.5 trillion over 10 years. The Senate can now pass tax legislation with a simple 51-vote majority as opposed to requiring a filibuster-proof 60 votes. After several failed attempts at healthcare reform and a delayed start to the tax reform process, the current effort has moved faster than many anticipated. However, several more contentious issues such as state and local deductions as well as the final number of tax brackets still need to be resolved. The bill was expected to be released on November 1, but has been pushed back by at least a day.

The European Central Bank announced that it will reduce new monthly debt purchases to €30 billion a month starting in January. The purchases are currently set to run through September 2018. For the balance of this year, the ECB will continue to purchase €60 billion a month. To date, the ECB has purchased over €2 trillion in assets as part of its quantitative easing program. If the program follows the path currently laid out, the balance sheet will grow close to €2.6 trillion. According to Eurostat, the unemployment rate in the Eurozone hit its lowest level since January 2009 at 8.9% in September. Growth has improved as well, with GDP increasing at 0.6% (2.4% annualized) for the third quarter. Markets are placing a near 90% probability on the Bank of England (BOE) hiking interest rates at their next meeting on November 2. This would be the first hike since 2007 and represents a change in tone from when the BOE cut rates following the Brexit vote. However, many view this rate hike as a one-off move as opposed to the beginning of a rate hike cycle.

The S&P CoreLogic Case-Shiller home price index increased 6.1% year-over-year in August, bringing U.S. home prices to all-time highs.

President Trump decertified the Iran nuclear deal in mid-October. The move does not withdraw the U.S. from the deal, but the president indicated that could be the ultimate outcome pending further work with Congress and U.S. allies. At the same time, President Trump also authorized the Treasury Department to impose sanctions against the Islamic Revolutionary Guard Corps.

Minutes from the Federal Open Market Committee’s September 19-20th meeting were released in October. The minutes indicate that the Fed expects to raise the Fed Funds rate one additional time this year. Markets project no chance of a rate hike at the October 31-November 1 meeting, but a two-thirds likelihood at the December meeting. The minutes also showed inflation to be a topic of debate at the Fed, with members questioning if low inflation levels should impact future rate hike decision or if low inflation was more temporary in nature.

President Trump is expected to announce his selection for the next Chair of the Federal Reserve on November 2. The current front-runner for the nomination is Jerome Powell, a Fed Governor since 2012. Other known contenders include John Taylor, the academic known for the “Taylor Rule” that offers prescriptions for monetary policy, and the current Chair Janet Yellen. While the market views Taylor as more hawkish and Yellen and Powell as more dovish, all three are well respected, well established candidates, who the market would view as good stewards of monetary policy.

Outlook and conclusions

In our view, an equally compelling and cogent argument could be made for interest rates to move either higher or lower from their present levels. On the one hand, geopolitical pressures continue to surface and the much anticipated fiscal stimulus, which appears priced into risk assets, has not come to fruition. On the other, slack in the labor market continues to abate, bringing with it expectations that the gap between realized inflation and the Fed’s target will narrow in the coming quarters. Though a case can be made that the directional nature of interest rates remains less certain than a number of participants suggest, it is the magnitude of any such changes for which we are much more confident. Simply put, we don’t foresee where interest rate changes will be too dramatic near-term, in either direction. With growth in the 2.0-2.5% range and core inflation bracketing 1.5%, there is not a lot of room for the Fed chairperson—any Fed chairperson—to push through dramatic changes in monetary policy. Likewise, the world has come a long way from Brexit, and while that story continues to develops, global economic growth has stabilized sufficiently to make the lows tested during that period unlikely to resurface. With a fairly neutral view on duration, and cross-sector analysis quite pedestrian as well, we have turned-up our focus on bottom-up security selection, as within this realm both volatility and differentiation still exists. We continue to identify stories where the market has overreacted entirely, or not at all, making for attractive opportunities to both build and exit positions. In short, despite the Home Run derby like performances during the World Series, in a bottom-up fixed income world, it’s time to hit singles.

 

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