With the Federal Reserve on the cusp of its first tightening cycle in nearly a decade and questions mounting regarding the health of liquidity in the fixed income sector, we thought it would be a good time to talk to a couple of veteran bond traders to assess the market. Jay Feurstein of Manning & Napier and Sheryl King of Roubini Global Economics give their views of the Fed and fixed income markets.
Modern Trader: What is your outlook for Fed activity for the remainder of the year and into 2016?
Jay Feuerstein: I believe the Fed will raise rates 25 basis points in September and another 25 in December. The economy and stock market will tolerate the rate rise in September, but the reaction to the December [action] will be volatile; stocks and bonds will not like it and the stock market will react by falling nearly 10% in the first quarter of 2016. The Fed will then back off their pace of rate rises and not raise rates again until September 2016; stocks will rebound but bonds will not. The Fed will say the lack of inflation, especially in wage growth, will keep rates stable in 2016 but the market will react as though the Fed is more concerned about stocks and global liquidity.
Sheryl King: We expect the Fed to start raising interest rates at the September meeting, with a 25-basis-point increase in the Fed funds target range. The Fed will continue on this path, raising the reference range to 1.75% to 2.00% by the end of 2016.
MT: What do you think the tempo of tightening will be?
SK: The pace of increase will be more or less 100 basis points per year but perhaps not at regular intervals. For example, the Fed wants to execute the first rate increase in at a meeting where Chair Janet Yellen is scheduled to hold a press conference. Rate increases thereafter may not be in meetings with a scheduled press conference. December is a meeting date with a press conference the Fed may opt to skip due to the high level of market volatility normally associated with December. This could be particularly troublesome this year due to the heightened level of illiquidity in the Treasury market in recent months, and the size of the Fed’s balance sheet and insufficient tools to drain excess liquidity currently in place. The last thing the Fed wants to do is announce an increase in the target rate and not have the effective Fed funds rate follow suit — that would mean the Fed did not tighten policy. Therefore, there is a possibility the Fed will not raise rates in December, but then opt to raise rates at the next meeting in January 2016.
MT: What effect will it have on the Treasury market and yield curve?
JF: The Fed will be perceived as being behind the curve, and by mid-2016 the markets will price themselves as if the Fed is behind the curve. In fact, the Fed will be behind the curve. Stocks will like this and corporate spreads will narrow. However, the yield curve will steepen as inflation begins to pick up. I do not believe that housing will suffer from the increase in rates because its cost will still be low by historical standards. In fact, housing costs currently comprise approximately 16% of consumer spending. Historically, housing has used closer to 20% of a consumer’s paycheck, so even if the Fed raises rates twice, housing will remain affordable and continue to increase in price at an annual rate of about 7%, which could add further worry to the bond market.
SK: We expect to see a steepening in the short end of the curve from Fed funds for two years while the two-year to 10-year curve flattens. The bulk of the flattening in the coupon curve will come from [the] longer end of the curve, from five-years to 10-years. The long end of the curve will remain relatively anchored, with the 10-year finishing 2015 at 2.5% and 2016 at 2.7%. We expect the U.S. economy to sustain growth of around 2% to 2.5% through the normalization process, [based on] heightened demand for sovereign bonds, increased demand from financial institutions due to regulatory requirements and a general low inflation environment.
MT: How do you expect the Fed to handle its large holdings of various debt instruments? Does this give them extra leverage to affect policy? For example, can they can sell off assets if inflation becomes a greater concern, or continue to roll or let bonds expire?
JF: Once the Fed starts to raise rates, it will do so with traditional means rather than use a “reverse” QE. Rather than add more stress to global liquidity by selling a large share of its holdings, the Fed will likely keep most of them until maturity. Instead, the Fed will do reverse repos with just a few coupon sales in the Treasury market to express its tightening policy. Still, the global bond market will work — until it doesn’t.
SK: We expect the Fed to keep its balance sheet large for a considerable time. Starting in early 2016, there is a sizable number of Treasuries slated to mature.
For at least the first few months of 2016 we expect the Fed to reinvest and maintain the balance sheet at the current size. Depending on how the economy holds up to the gradual rise in interest rates, it is possible that the Fed will start to only partially reinvest subsequent maturing assets. The gradual contraction of the Fed’s balance sheet will occur initially through reduced holdings of Treasuries while mortgage-backed securities are reinvested.
MT: There has been a lot of concern over the liquidity in both the corporate bond world and U.S. Treasuries. How big of an issue is it? Has it been overplayed? Will it affect how you trade this market?
JF: The absence of traditional primary dealers to handle liquidity will be felt across all credit markets. I feel that a “buyer’s strike” will occur such that bonds of all types will plummet. It will be twice the volatility of the “taper tantrum” of 2013. By mid- 2017, the 10-year will yield 4.25%.
SK: The Treasury market has become less liquid, although we do not have a convincing metric to assess how acute the issue is — nor do we believe any other analyst has created a robust estimate. Anecdotal evidence, such as the frequent “specialness” in the repo market, is definitely a symptom of this illiquidity. This makes the market at risk of abrupt repricing such as the moves in the Treasury market this spring when the long end of the bond market suddenly repriced.
MT: What is your outlook on U.S. Treasuries? Foreign treasuries? Corporate bonds? Mortgage- backed securities?
JF: The most hurt by the sell-off will likely be Treasuries. Corporates should do somewhat better because the Fed will be seen as “easy,” and stocks will be OK. The bond route should not hurt them because the two-year will still be below a 1.25% yield. However, it is my view that the massive amount of “underwater bond supply” at such low interest rates will overwhelm the bond market. The spike in rates will happen furiously and only those investors anticipating the rate rise will be safe.
SK: The long end of the curve will remain relatively anchored, with the 10-year finishing 2015 at 2.5%.
The UK will be the next market to start policy normalization after the Fed, but not until early next year. Ahead of that normalization, we expect 10-year gilts to rise to 2.10% by the end of this year and then move slightly higher though next year to finish 2016
We expect German bunds to trade in the 0.5% to 1.0% range over the balance of the year and then move toward 0.7% by the end of 2016. The Eurozone is seeing a modest cyclical recovery, but potential growth remains very low at under 1.0%, and high debt and restrictive fiscal policy ultimately will overwhelm the cyclical rebound and require multiple rounds of QE from the European Central Bank.
Japan faces similar weak domestic fundamentals and we expect the Bank of Japan to continue to ease policy for some time as well. [Japanese Government Bonds] should end 2015 at 0.5% and 2016 at 0.7%. The BoJ currently faces a dilemma in that the economy is already slowing but it must refrain from further quantitative and qualitative easing (QQE) and knock-on currency depreciation ahead of the ratification of the Trans-Pacific Partnership trade agreement in the U.S congress.
In corporate bonds, we are negative on U.S. investment-grade bonds and neutral on high-yield bonds.
MT: In what sector of the fixed income world do you see the most opportunity? The most risk? Why?
JF: The best areas of the bond market to be in will be the short end of the yield curve: High-coupon mortgages and high-coupon corporates. High yield will be relatively safe as well since the stock market will continue to perform well given the Fed’s accommodative policy. The most risk will be in long-term corporates and on-the-run Treasuries, 10 years in maturity and longer. Not only will those instruments be risky to hold but investors will likely “short” them as hedges, making the initial sell-off in those markets even more volatile. Nonetheless, the market will be ruthless in its repricing of interest rates; it will happen suddenly and completely, and rates that took eight years to achieve will normalize in months.
SK: Emerging market external debt as an asset class remains among the most vulnerable to rising U.S. rates given that spreads are already tight for investment grade bonds (210 bps). Oil producers could suffer renewed spread widening, although emerging market corporates (especially in Latin America and Asia) look more exposed to weak investment and dollar strength than sovereigns. Tighter fiscal policy in Latin America should stabilize rating outlooks for now.
Regarding local emerging market debt/swaps, it was relatively resilient to the recent G4 rate sell-off and curves have begun to steepen already. The hikes we expect in key emerging markets in 2016 look well priced in, aside from Turkey and Colombia. The possibility of slightly more dovish Asian central banks should support local debt, if not currencies.