Currency, credit and bond markets are out of step at the moment. This presents an unusual opportunity to reduce duration risk while maintaining income and currency exposure
US Treasuries up (yields down) and fully valued
The US economy continues to strengthen steadily. The 1Q17 is likely to grow at around 2.4%pa thanks to good weather and rising consumer confidence. Inflation, using the US Fed’s preferred measure “PCE” (Personal Consumption Expenditure), is steady at 1.7%pa where it has sat for the past 12 months, just below the 2.0%pa target of the Fed. Wage growth is at 2.4%pa and underemployment has fallen by nearly half since the worst of the GFC.
Without Trump’s inflationary policies, US interest rates would have crept back up due to domestic economic strength, albeit held back by the slow recovery in Europe and Japan and the related ongoing currency wars. But add Trump’s policies to the mix and the risk of inflation in the US is going to be strong enough to force the Fed to push up rates as much as twice this year and probably 2-3 times next year.
This will likely push the US 10 Treasury rate to a fair value range of around 2.25%-2.75%pa. If the rest of the world starts to recover, an unlikely scenario at this stage, the Fed could go higher still. If Trump fails to get his tax policy and infrastructure spending programs through, rates will slide back down below 2%pa again.
But otherwise, the new equilibrium level is around 2.25%-2.75% and at the current yield of 2.33%pa, they are at the lower end of this range.
Corporate bond prices up (yields down)
Of course government bond yield benchmarks only make up around 30-50% of high yield corporate bond yields. Credit spreads are the majority of the return. Spreads are tighter now than at Trump’s election, falling 6-18% depending upon credit quality. Unlike equity markets however, they are still a long way off record levels and in fact not even at their lows in the post GFC period.
There are two factors strongly supporting tightening credit spreads in the coming months:
- Continuing strength in the US economy, creating stronger cashflows and therefore improving credit quality
- Trump’s proposed tax changes
Trump proposes to lower the corporate tax rate but to remove deductibility of interest payments. This will likely result in many corporate bonds being bought back by companies, tightening supply and therefore narrowing spreads.
Countering the tightening is the risk of Trump’s tax policies falling short of what has already been priced into equity and credit markets, although this would be a relatively slight widening depending upon exactly what tax changes do get through.
On balance the odds are well in favour of considerable tightening, particularly at the short to medium end (say seven years and less).
USD down on short term uncertainty despite economic strength and likely appreciation impact from Trump policies
The USD has fallen back over recent weeks. Its weakness has been attributed to comments from Trump’s administration that they want to push down the currency. Trump can only push down the USD by damaging the real economy or causing unexpected and persistent volatility in inflation. His proposals to cut corporate taxes and to spend more on infrastructure and defence and less on foreign aid are positive for the US real economy. It is only his tariff proposals (or “border tax” as US Congress is calling it) that worries markets.
The problem at the moment is that very little analysis has been done to attempt to quantify the impact of these tariffs. The Economist had a ridiculous commentary suggesting that a 25% tariff would lead to inflation of 20%. More sensible analysis ranges from Barclays’ estimate that a 7% tariff on Mexican imports and a 15% tariff on Chinese exports would results in around 0.2% increase in inflation to Deutsche’s estimate of an impact of 1.4%-2.1%, using Trump’s headline figure of 30% across the board border tax.
Both of these estimates are for the year in which the border tax is introduced, with much smaller inflationary impact thereafter.
This is not what we would call “an unpredictable spike in inflation”, and in fact at the moment some level of extra inflation would be welcomed as it brings the Fed back into line with their target and allows some room to increase rates back to normal levels.
Regardless of the forecaster, everyone expects the US dollar to appreciate in line with the border tax, for example a 30% border tax would result in a 10-25% appreciation in the dollar, depending upon the specific policies.
Bottom line therefore is that Trump’s ability to push down the USD is limited to tariffs and even then, he is likely to have a minor impact relative to the boost his other policies will give to growth.
The recent selloff in the USD is therefore all about the market’s fear of the unknown. Frankly more analysis of the range of possible impacts would show the extreme reactions like that from The Economist are misleading to investors. The logic is at least strong enough to take a second look and it wouldn’t be the first time markets have been well out of whack with fundamentals.
In fact, as shown in the chart below, the USD has fallen out of alignment with the interest rate differential, one of the strongest relationships in financial markets. This relationship rarely stays out of alignment for more than a few months unless underlying economic conditions are expected to deteriorate meaningfully.
Source: Bloomberg, Goldman Sachs Conclusion and investment strategy
Given the health and momentum of the US economy the level of dollar appears too low, as do Treasury yields, even with an erratic, seemingly incompetent administration.
Our view is that the US economic model is far more market driven than the European or Australian economies, and therefore it is much harder for an administration to mess it up. I’m not quite the Ameriphile that Buffett is, but if readers need affirmation of the idea that the Trump administration won’t have much of an impact on the underlying economy, read Warren Buffett’s recent letter to shareholders
, particularly page six.
Markets are out of alignment. Bond yields have fallen and the USD fallen even harder, suggesting economic risk in the US is up. Equities and credit spreads have both rallied strongly, suggesting economic risk in the US is down. On balance of the above analysis, we believe that the USD will appreciate under almost all scenarios, even those that cause some temporary damage to the US economy. And of particular relevance to Australian investors, the most damaging policies for the US are actually worse for us: the anti-trade policies like the border tax.
For Australian investors, that means there is an unusual strategy available at the moment: take advantage of the higher bond prices at the long end by reducing duration while maintaining credit exposures and the USD exposure. For example, investors could look at opportunities to sell long dated USD corporate bonds and buy shorter dated bonds with slightly higher credit risk to maintain income.
Glossary
Duration
Duration is a useful measure of risk in bond investment represented in years. Developed in 1938 by Fredric Macaulay, duration measures the number of years needed to recover the cost of the bond, taking into account the present value of all coupon payments and the principal payment received in the future. Bonds with higher duration typically carry more risk and thus have higher price volatility. For vanilla fixed rate bonds, duration is always less than time to maturity, for floating rate notes, duration is typically very short and based on the next coupon reset date.