One of the big surprises in the first half of the year was the decline in benchmark yields on US Treasuries and German Bunds, which paved the way for extraordinary returns across nearly all segments of the fixed income market. According to Thomas Fahey, senior global macro strategist at Natixis. “Even 30-year Treasuries managed to outperform equities, with a return of 12% versus 6% for the S&P 500® (as of 20/6/2014) – underlines Fahey -. Very few analysts believed that bonds would beat stocks in 2014”.
However, hoping that yields will continue to be as strong in the second half of the year does not guarantee such an outcome: “We expect yields to rebound globally on the back of stronger economic data and healthy risk appetite – continues Fahey -. Inflation appears to be bottoming out in the US and other developed markets, while GDP is recovering. The Bank of England has already signaled the possibility of early rate hikes in 2015. As 2015 approaches, we also expect the Fed to prepare the market for possible rate hikes”.
Fahey believes all of these factors will keep global bond prices exposed to rising interest rates, resulting in lower total yields in the second half of 2014.
The Fed's policy outlook
Fahey expects the Fed to start raising the federal funds rate only in 2015. However, other segments of the rate curve should start rising much sooner in anticipation of higher short-term rates. “We believe the US economy will prove unusually sensitive to rate hikes and, as a result, the Fed will raise rates at an unusually slow pace, perhaps by 25 basis points at each Federal Open Market Committee (FOMC) meeting and not any faster until it is clear that the economy can handle the monetary tightening,” adds Fahey. He also believes that the sustainable growth rate of the US economy is declining, and concludes that the Fed, in all likelihood, will gradually continue this upward cycle and then stop it once the federal funds rate reaches around 3 %. As a result, Fahey expects the 10-year yield to hover around 3,0%-3,25% over the next six to nine months.
Directionality of interest rates
Globally, the steepest increase in long-term interest rates is likely to occur among the strongest economies and where central banks are keen to raise rates. “Despite the weakening Chinese economy, we believe banks will raise interest rates consistently across Asia. New Zealand, Colombia and South Africa are expected to impose the steepest rate hikes over the next six to nine months, while Brazil, Turkey and India may delay hikes in response to political pressure,” says Fahey.
According to the analyst, interest rates are likely to remain low in Europe due to the European Central Bank's commitment to maintain an accommodative stance for the next four years and the possibility that the quantitative easing plan will push bond yields lower rulers. Norway, Sweden and several Eastern European countries, exposed to weak inflation dynamics, could also cut rates. The UK is the exception in Europe. It could embark on an upward path in the first months of 2015, even before the Fed. As for Japan, Fahey does not expect a rate hike in the short term. Instead, more quantitative easing could occur in the not-so-distant future.
The main macroeconomic risks
Given the tense situation between Russia and Ukraine, geopolitical risks play a primary role. There are also geopolitical events that continue to worsen, for example in Iraq, with the related consequences in terms of a rise in oil prices. Fahey is also watching developments in southern China closely. In fact, China is the country that worries him the most. “China is clearly in the throes of a veritable credit flood. The fact that the banking system is both directed and supported by the government is one of the main reasons for reaching such large debt levels so quickly. However, government control makes the probability of a "Lehman effect" very low compared to the situation that would have occurred if China had an open and free market economy. China is continually faced with the choice between deleveraging and economic stimulus. For now, China is avoiding the implications of rapid deleveraging and doing just what is necessary to stave off its own problems,” Fahey argues.
Opportunities today
Some segments of emerging markets are showing an attractive risk premium that investors could benefit from over the next 12-18 months. Fahey is particularly fond of emerging dollar-denominated corporate bonds. “Local currency bond markets in many emerging countries also exhibit very high nominal yields, although we need to be careful about currency risks.” Fahey believes there are also opportunities with European banks which, as they continue their recovery and deleveraging process, are well positioned within the credit cycle.
Current trends
Long-term trends that Fahey looks favorably on include the shale gas revolution and the possibility of an energy self-sustaining US economy; the future path of the European Monetary Union; the prospects for the global peace dividend and its impact on global trade; the growth of emerging markets and new frontier countries; rising global prosperity and demographic trends; and the crisis of traditional macroeconomic paradigms with the related proposed solutions.
