No one likes the messenger who brings bad news—unless, of course, that news leads the Fed to cut interest rates.
Several months ago we analogized market fears to “hyenas” lurking on the edges of the economic savanna and the Federal Reserve to a “lion,” calling the shots at the top of the food chain. Recent market events have reinforced this analogy.
President Trump threw monkey wrenches into the global financial markets by suddenly escalating trade frictions with China, and then unexpectedly weaponizing tariffs against Mexico. As the hyenas advanced, the lion roared: Fed Chair Jerome Powell said that if the data warranted it, the central bank was open to cutting interest rates — scarcely two weeks after he saw no reason to raise or lower them. The hyenas backed off: when May nonfarm payrolls came in weak, rather than retreat, stocks rallied as investors bet the Federal Open Market Committee would cut rates, perhaps as soon as its July meeting.
The negative market reaction to the December rate hike prompted the Committee to drop plans for hikes in 2019. In June, Chairman Powell asserted the Fed “will act as appropriate to sustain the expansion,” proffering the possibility of a rate cut. While the market believes a cut could be justified by slowing job growth, too-low inflation and trade war impacts, this makes two pivots in the last six months and raises questions about the extent to which the Fed is effecting a strategy or simply reacting to events. We believe further negative economic and market developments are necessary for Fed action, as longer-term payroll trends are healthy despite the latest report and inflation continues to trend around 2%.
As the trade war escalation continues, risks of it spilling into the broader economy grow, as evidenced by softening global PMIs. With these headwinds, we expect U.S. growth to slow to at or slightly below trend levels, but ultimately remain resilient. We maintain a late-cycle investing stance, keeping our focus on avoiding downside velocity. We continue to prefer securitized credit to corporate debt. Within securitized, we like both agency and non-agency residential mortgages, as recent volatility has led to attractive valuations. Furthermore, the decline in rates will support housing fundamentals, while an uptick in prepayments will lead to security selection opportunities.
Source: Bloomberg, JPMorgan, Standard & Poor’s. All spreads are to U.S. Treasurys and are option-adjusted except for emerging markets, which are nominal. All returns are total returns including dividends, expressed as percentages, in U.S. dollars.
Bond Market Outlook
Global Rates: U.S. rates effectively acting as safe haven, little catalyst for large move higher; German and Japanese rates to stay negative
Global Currencies: U.S. dollar rangebound against developed market currencies, weaker versus select EM FX
Investment Grade: valuations fair and dovish Fed supportive, but downside remains high due to trade tensions
High Yield: spreads more attractive after recent pullback, but trade noise, growth concerns warrant caution
Securitized: residential mortgages attractive after recent volatility, rally in rates to support housing fundamentals
Emerging Markets: geopolitical uncertainties could impact sentiment, but Fed policy, growth divergence in 2H19, should be supportive
Global Rates and Currencies
The Fed is open to delivering cuts but has not signaled as strongly as market pricing. Recently, the December 2019 30-day fed funds futures contract priced in a 54-basis point (bp) decline by the end of the year — the largest amount of cuts priced in six months since the financial crisis. Given the trade uncertainty and potential for cuts, we look for 10-year U.S. Treasury yields between 2.0–2.4%, with a steeper twos-to-tens yield curve. We expect the U.S. dollar to remain range-bound against developed market currencies. Ten-year German Bunds have traded down to -20 bp, a historical low, with 10-year Japanese government bonds not far behind. We expect German and Japanese rates to remain in negative territory.
Investment Grade (IG) Corporates
IG spreads sold off in May as trade fears took center stage; the long end was hardest hit as the credit curve steepened; BBB-rated credits widened more than A-rated credits. We expect this to be temporary, however, as falling hedging costs should keep U.S. IG looking attractive to foreign buyers. A resolution of the trade dispute with China could lead to spreads moving back to mid-April levels; by contrast, further escalation could prompt a drift back to January levels. The backup in spreads leaves us more comfortable with current valuations, particularly with the Fed acting somewhat as a backstop to the market; however, downside risk remains high while trade tensions percolate.
High Yield Corporates
Trade war escalation in May caused a pullback in the high yield market, a true risk-off as lower-rated tranches materially underperformed. While spreads are clearly more attractive at their new levels, trade tensions and weaker global PMIs make us cautious about jumping back to positive. A quick cooling in trade rhetoric would be one of our criteria for becoming constructive; others would be a rate cut or an equity rally.
Agency residential mortgage-backed security (RMBS) sharply outperformed early in May but then deteriorated as volatility spiked and rates fell. Technical factors have declined as refinancing concerns materialize, but housing market fundamentals will remain sound in a low rate environment. RMBS are likely to outperform riskier credit sectors, but may lag Treasurys until rates stabilize and refinancing fears abate.
Non-agency RMBS have continued their strong performance, leading to tighter valuations compared to alternatives. While the market has become more comfortable with mortgage credit risk through periods of volatility, we think non-agency subsectors are vulnerable to broader macro developments. We remain positive long term, as sector attributes continue to resonate with investors.
After outperforming in May, lower all-in yields and a heavy June supply calendar are likely to weigh on commercial mortgage-backed securities (CMBS). We have shifted to a negative tactical outlook due to diminished relative value, higher levels of new issuance and a degraded macro backdrop.
Asset-backed securities (ABS) were the only constituent of the Bloomberg Barclays U.S. Aggregate index to post positive excess returns in May. We think over the short term ABS will remain well bid and offer outperformance opportunities when market beta is negative. Over the long term, ABS provide access to a unique combination of attributes: U.S. consumer driven, housed in robust structures with shorter spread durations and favorable liquidity conditions.
Emerging Market (EM) Debt
The growth differential between emerging markets (EM) and developing markets (DM) should increase in 2H19 as DM growth continues to soften. Risk sentiment remains poor and may deteriorate further if the U.S. and China fail to reach a trade deal at the G20 summit. Volatile oil and commodity markets highlight the differences between winners and losers: exporters versus importers and the impacts on GDP, fiscal policy and inflation. Fed policy should be supportive for financial conditions and carry trades.
Past performance does not guarantee future results.
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