Morningstar's "Perspectives" series features investment insights from third-party contributors.
US interest rates have moved higher since Donald Trump’s surprising victory, boosted by the prospect of expansionary fiscal stimulus, aggressive tax cuts and protectionist policies under his new administration. While many are pointing to Trump's election as the driver, rates have actually been moving up since July on the potential for an improving economy.
But have rates moved up too far and too fast? And what are the potential implications for stocks, bonds and the US dollar?
Are Interest Rates at Fair Value?
Global yields have been on the rise. Ten-year government bond yields have climbed to around 2.6% in the United States and 0.5% in Germany, and back into positive territory in Japan.
An objective measure of an equilibrium US rate, shown in the chart below, plots long-dated US Treasury forwards against a smoothed measure of US GDP growth. After the recent move, we would argue that long rates are in line with fair value based on this measure.
On the other hand, short rates are likely too low given that the Federal Reserve raised rates in December and Fed Chair Janet Yellen has communicated via the “dot plots” that another three hikes are expected for next year.
We expect a flattening of the yield curve as short rates eventually move higher, while long rates hold steady. Historically, the 10-year Treasury yield has been 150 to 200 basis points over the federal funds target rate, and we are near the upper end of that range now.
A Supportive Backdrop for Credit?
Early in 2016, spreads were wide, pricing in the probability of recession, and our active fixed income portfolios were overweight in investment grade and high yield credit. Now the situation on spreads is much different: As expectations of economic growth have improved, the spreads between Treasuries, investment grade and high yield are as tight as they’ve been for the year. But while the relative value is narrow, the absolute level of yields remains low and the added value of credit continues to be attractive in our view.
Our asset allocation portfolios are overweight in investment grade and high yield. Default risk in high yield, with the exception of deep within those rated CCC, remains low. Within investment grade credit, the winners from Trump’s plans so far have been banks, pharmaceuticals and some technology issuers; the losers have been global auto suppliers, which have priced in the adverse implications of potential US protectionism.
Upside for the US Dollar?
A mix of politics and policy has created a strong environment for the US dollar. The move in US rates, both short and long, has made the US the net recipient in the global carry trade. This is tied to potential policy moves that are intended to boost growth, potentially creating a differential between the performance of the US and the rest of the world. That divergence could lead to a discrepancy in US interest rates, causing capital inflows and the dollar to rise. While this ultimately has impact on global trade, we consider the case for a stronger dollar remains and we have built up our first significant long dollar position in months.
Three Ways Forward
Rates at today’s levels are likely to stay range bound, with economic growth continuing to constrain how much higher rates can go. Moving forward, we see three options:
Favour credit over duration. While spreads have narrowed, we still see value in overweighting credit relative to duration given the more constructive backdrop for economic growth. A focus on higher credits within high yield could be a good risk mitigator.
Mitigate inflationary pressures. Depending on the magnitude of the US fiscal stimulus, the term premium in inflation markets may pick up even more, so investing in Treasury Inflation Protected Securities and other real assets could make sense.
Isolate and exploit risk premiums on a standalone basis. Stripping out the underlying return on cash and implementing an investment strategy that focuses on factors could be another way forward.
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