Mackenzie Fixed Income Team
Outlook & Positioning
The focus for markets through much of the fourth quarter was the political drama surrounding the US tax bill and, of course, the price of Bitcoin. The US tax bill was debated and passed by both the House and Senate, and signed by President Trump before year-end.
The tax bill is likely to provide some boost to the US economy in 2018. This expectation was factored into the Federal Reserve’s December rate hike, and into the Governors’ most recent projections (the “dot plot”) of the path of the Fed Funds rate in 2018. The median estimate is at three hikes of 0.25% each. Equity and corporate credit markets embraced the growth-is-good forecast, and inflation expectations rose as 2017 came to a close.
In December, the Bank of Canada left its policy rate unchanged. Further comments by Governor Poloz indicated that the Bank may let the economy run for a bit. Given their recent history of sudden shifts in monetary policy bias, and with the economy producing jobs at a rapid pace in both November and December, there is no guarantee that the Bank will refrain from hiking rates.
2018 could be a more interesting year with regard to global monetary policy. The Fed will likely follow through with two to three hikes while continuing to reduce the size of its balance sheet, but this will happen under the guidance of new Chairman Jerome Powell. The European Central Bank will taper its bond purchases, and EU growth is expected to be stronger than it has been in years. The Bank of England faces some inflation pressures but must also navigate an uncertain domestic political scene and the Brexit process.
As with past monetary policy tightening cycles, developed market yield curves have now been flattening over many quarters. The accelerated flattening of the US curve over Q4 caught much attention. Most often in past tightening cycles, the curve flattens as rate hikes pressure the front end higher, while the back end rises by less, or sometimes falls. These curve movements have happened over many quarters in previous cycles. Consider that since the 2013 “taper tantrum”, the Fed Funds rate has been increased five times totaling 1.25%, with the US 10-year yield having increased by about 0.85%. Over this timeframe, the US 30-year yield is roughly flat.
Recent concerns over the curve flattening are due to the fear that it portends a recession around the corner. While economic growth may come under pressure from rising yields due to tighter monetary policy, as it usually does every cycle, there is no immediate evidence this is happening at the start of 2018. In fact, short bursts of steepening aside, the yield curve will probably continue to flatten this year while growth continues. Eventually, we could see a completely flat curve that stays with us for a while, as was the case in the mid-2000s.
Potential upward pressure exerted on short- and mid-term yields by the Fed in 2018 will eventually have a negative effect on the economy. It remains likely that this cycle will end at a lower terminal Fed Funds rate and yield curve than was the case in 2007, before the last recession. Back then, Fed Funds was 5.25%. If the Fed follows through on its dot plot projection, then in about 18 months the rate will be about 2.75%, or pretty close to today’s 30-year US Treasury yield. Given the rising amount of government and non-financial corporate debt in the post-Financial Crisis global economy, it may not take much more than that to reduce prospects for greater economic growth.
In the near term, we continue to look for the best risk-adjusted bond and loan investments. As 2018 kicks off, we are maintaining shorter durations than our benchmarks, and have been reducing areas of corporate holdings that are fully valued.