Dagmara Fijalkowski, Head of Global Fixed Income and Currencies, shares her outlook for bond yields and interest rates. In addition, Dan Mitchell, Senior Portfolio Manager, dives into how the U.S. dollar may benefit following the country’s recent economic resilience.
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Dagmara Fijalkowski - What is your outlook for bond yields and interest rates?
Since the Fed started hiking rates, we have been experiencing much more volatility than investors grew accustomed to before, and especially during Covid. This year’s poor bond performance contrasts with a great end of 2023. We note that since last October, bond returns are about 8%. Higher yields, of course, set up investors in bonds for higher expected returns.
With US10 yield near 4.5%, investors may expect similar return over the life of this bond. Of course, few investors hold just one benchmark government bond. Diversified universe bond portfolio should deliver higher returns just from coupons. While focus remains on the Fed, we are recording this video before the Fed announcement in June.
The fact is that rate cut cycles have already started in Europe, Canada and many emerging market countries. So what about the Fed? The market prices the Fed’s full cut only towards the end of the year. More importantly, markets imply that the Fed will not lower Fed funds rate below 3.6% over the next decade! That would imply no recession risk over that entire time. Seems unlikely.
So, markets are rather hawkish with regards to the beginning and the pace of the cutting cycle. Continuation of solid growth, and/or inflation stubbornly above the 2% target are needed to justify this pricing. We would take the other side, believing that over the course of a decade, the U.S. economy will experience at least one recession and central bank will have to cut rates below 3.6%. One plausible explanation for the elevated policy rates assumptions is that definition of what rates are restrictive has risen since the pandemic.
Possibly due to high government deficits, expected to continue for years. But higher debt alongside the higher interest costs can slow rather than accelerate economic growth. We are not as convinced about the higher neutral fed funds rates as many are in the market. We are convinced that markets should price higher term premia for longer dated debt, leading to normalization of the yield curve.
10-year yields which are now 40-50 basis points below 2-year yields, will at some point rise above 2s, easily by as much as 100 basis points. Fed embarking on the easing cycle will be the most likely driver of that curve steepening. When that happens, bonds in addition to the decent yield, will deliver some capital gains.
Dan Mitchell - Will the U.S. dollar benefit from the country’s recent economic resilience?
One big theme in markets this year has been the resilience of the U.S. economy in light of higher interest rates after the Fed's two-year fight against inflation.
The term ‘U.S. exceptionalism’ has been popularized by media just to describe not only that economic resilience, but also to the extent to which the U.S. economy is out performing its global peers, particularly in Europe and China. The interesting bit is that amid all this discussion about U.S. exceptionalism, the U.S. dollar returns have been far from exceptional. The currency has only rallied by 3% so far from its lows this year, and it's stuck really within this tight range that it's been confined to for the past 18 months.
Now, we think this is evidence of opposing forces in currency markets between short-term and long-term factors. On the one hand, we have higher interest rates and the impact of fiscal stimulus that are supporting the currency. But then we've got these long-term headwinds that are capping any currency gains.
These are things like the currency's overvaluation and concerns about the long-term fiscal trajectory in the country and worries about some of the policies that are being floated by both presidential candidates ahead of the 2024 November elections. More recently, we've seen U.S. economic activity start to slow a little bit in the second quarter. The same time as global economic data and the rest of the world starts to improve.
And so that theme of U.S. exceptionalism has really faded into the background, and that leaves these longer-term headwinds to sort of weigh on the U.S. dollar. We may have to wait just a little bit longer to see that U.S. dollar weakness materialize since interest rates are really the most important influence for foreign exchange and the Fed hasn't yet started its cutting process yet.
But we remain bearish on the U.S. dollar over a one-year horizon, and our forecasts for other currencies imply sort of mid to high single digit returns as the U.S. dollar starts to falter.