Ariel Bezalel – The end may be near for US rate hikes
Ariel Bezalel, Head of Strategy, Fixed Income
The US Federal Reserve might be too optimistic about its ability to raise rates three to four times this year. Ariel Bezalel, Head of Strategy, Fixed Income, examines the dynamics of the US rate environment and explains why he believes the end of the rate hiking cycle could be in sight.
In the US, we are in the late stage of the cycle, with corporate leverage high and consumers under pressure. If the US Treasury yield breaks through 3% there could be more volatility to come.
Concerns in the market about the impact of the Treasury supply on the yield curve appear overdone. Based on empirical data, there is little evidence suggesting that supply causes upward pressure on yields over the medium to long term in the US. Yields are ultimately guided by growth and inflation expectations.
The market is currently pricing in four rate hikes from the Federal Reserve (Fed) for this year, but we expect only two or three. Furthermore, we think that could be the end of the hiking cycle, after which there could be a return to unconventional policy-easing measures as the US economy begins to falter.
Our current overall positioning is cautious, but in addition to US Treasuries, we are positive on certain emerging markets, particularly India, and Russia from a yield carry perspective.
How we reacted to US Treasury weakness
US Treasuries have had a tough start to 2018, but as yields climbed higher we slightly increased our exposure. We also gradually increased the duration of our strategy, to about five years.
In doing so, we have tried to pinpoint the most attractive parts of the yield curve. An example is the 7-year US Treasury. The belly of the curve from 5 to 7 years is relatively steep, which means that as those 7-year bonds get closer to maturity you could get a positive return contribution from the bonds as they roll down the steep slope. This is appealing to us from a performance attribution perspective. A large part of our US Treasuries exposure remains in the long end of the curve (10-30 years), an area which mainly reflects medium to long-term growth and inflation expectations.
Ultimately our view remains cautious, we believe that the long end of the yield curve will compress lower to reflect lower growth and inflation expectations. That is based on our opinion that the market is in a late stage of the cycle and we are getting closer to the next recession. We are seeing corporate leverage at record highs, and the US consumer is under stress, with three consecutive month-on-month falls in retail sales and rising delinquencies on credit card debt and auto loans. Savings rates in the US have also plummeted to multi year lows.
We have recently seen that whenever the US Treasury yield gets close to 3% (on the 10 year), risk asset volatility increases significantly. We believe that if the yield breaks through 3%, there could be more volatility.
The law of supply and demand is sometimes broken
The US treasury market has seen a record amount of issuance of late, and I’m often asked: “who is going to buy all these bonds?” It’s a reasonable question, but in fact the data shows no evidence that long-term or even medium-term supply has any impact on the direction of US Treasury yields.
As the chart below shows, between 1960 and 1980 the amount of marketable US Treasuries fell by half and yet the yield went from 3% to 15%. So despite a dramatic reduction in supply, yields shot up.
If you look from 1980 to today, yields fell from 15% to 2% despite there being a significant rise in the US government debt levels and the amount of US Treasuries being issued. This isn’t a dynamic that is restricted to just the US. The same can be seen in Japan, where the amount of government debt outstanding has increased significantly and yet the yield still hovers around zero. So we are not concerned about the effect of greater supply on the US Treasury curve, and think that any jitters in the market with regards to Treasury issuance are overdone.
The law of supply and demand is sometimes broken
Source: HSBC, Federal Reserve, Bloomberg, February 2018.
The end is near for the hiking cycle
So rather than supply, we focus on the outlook for inflation and growth as the main factor for government bond yields, and believe that both of them will drive rates lower.
Ultimately, our belief is that the Federal Reserve will come unstuck in trying to tighten policy further from here. The market is currently pricing in four rate hikes, but our view is that two or three is more realistic for this year. There are problems in the US that have yet to fully surface. Slumping retail sales and rising credit card / car loan delinquencies are some of the indicators we look at. Additionally, the rising yields on 30 year Treasuries has been putting pressure on the housing market year-to-date, because mortgages are tied to those rates.
So two or three rate rises could be the end of this hiking cycle, after which we could expect to see a return to unconventional policy measures as the US economy takes a step backwards over the next year or two.
Where we see opportunities
Our view is cautious, and on an aggregate level valuations are very stretched. US high yield in particular as a whole looks expensive to us and has been under pressure lately. However, there are naturally some parts of the fixed income universe where we are positive, and our highly flexible strategy gives us the freedom to access them.
In emerging markets, for example, India is a prime example. It has been volatile recently, but we have used that as an opportunity to increase the duration of our Indian sovereign position. Elsewhere, in Russia, we see value in the carry of local currency government bonds. Real yields are too high in our opinion. In developed markets, we are confident that the bull market in US Treasuries is intact and yields will head lower. There are also a number of high yield opportunities across Europe and the US we are excited about.
Overall, we still expect that markets will be challenging and this will be a year for capital preservation rather than chasing returns. However, one has to remain attentive to take opportunities when valuations become attractive again.
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All figures correct as at 19.11.2018.