Optimistic Fed, not bad for bonds

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Robert Tipp, chief investment officer at PGIM Fixed Income discusses the US Federal Reserve meeting decision yesterday.

The statement remarked on improvements in the US economy and maintained their confidence that inflation, although low, would rise towards their target. Although rates were held steady, one voter was so convinced that a hike was needed that she did not vote for the unchanged decision and dissented.

A couple quarters of weak GDP in the US, and Brexit leading off a very long and growing list of international ‘issues’ piling up alongside an at best tepid global backdrop, were not topics worthy of note in the statement.

Why the relatively optimistic take? They want to keep the door open so they can hike rates later in the year—just in case things heat up and hikes become clearly warranted.

Given where they left off at the June meeting, perhaps that is to be expected: Most participants back in June expected to hike rates one or two times this year—so they have to keep the window open, keep a stiff upper lip, despite the clear, present, and numerous risks on the horizon.

Will an optimistic Fed inclined towards hiking rates this year, at the end of the day, be bad for bonds? We think not, and the market appears to agree; since the announcement yesterday the US Treasury curve has rallied.

We see a few probable drivers for the positive reaction. One is that the market may see the Fed’s erring on the bright side as raising the odds that they end up being too hawkish, pushing the US into an economic slowdown, and pushing inflation even further below target, which could ultimately depress US Treasury yields.

Perhaps slightly more apt in our view, there appears to be strong demand from abroad for US fixed income products, which are quite high yielding in the international scheme of things.

Some investors may have taken a break from their buying to wait out the Fed, and now that the Fed has at least held its fire, it is back to ‘game on.’

More fundamentally, however, today’s moves aside, we see the probability that the current level of rates is actually near fair value—and not overvalued—as quite high. The economy has changed over the years, and along with it, the neutral level of rates may have dropped significantly.

In keeping with that view, the clear economic evidence that hikes are needed continues to elude the Fed, and the yield curve remains correspondingly low. Fundamentals may have changed, and we may be near equilibrium levels.

Where to from here? With the Fed either slow-go or no-go, in our view the outlook for US fixed income remains solid. The muted global backdrop, characterized by low inflation and an imbalance of down-side risks, is likely to keep US yields low and range bound for the foreseeable future.

Additionally, we see a range of opportunities for adding value in the spread sectors, from structured products, emerging markets debt, and municipals to investment grade and high yield corporate bonds. So whether the Fed is able to get a clear shot at a hike this year or not, we expect bonds to hold their ground over the intermediate-to-long term—especially the higher-yielding sectors.

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