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Q2 Fixed Income Survey: The U.S. Growth Domino Effect

Traders Magazine Online News, July 11, 2018

Adam Smears

Over the course of 2017, we highlighted the dichotomy between interest rate managers’ bearish views on U.S. growth relative to credit managers, who have been more bullish. However, over the last two surveys,1 we have seen a significant change in the direction of travel. It appears as though the impact of U.S. growth is having a domino effect, which is seeing market participants come toward a more general consensus. However, as we will see, some areas have suffered.

Today, we’ve put the spotlight on:

  • U.S. interest rates and inflation expectations
  • Credit markets: cracks starting to appear?
  • Casualties from rising U.S. interest rates

In May, we received answers from 62 investment managers from across the world.

U.S. growth: Interest rates and inflation

Where are we in the cycle?

Overall, managers are recognizing that the U.S. Federal Reserve (the Fed) is determined to act. This is particularly clear from the expected increase in the Fed terminal rate, or the peak—i.e., the interest rate that is consistent with full employment and capacity and therefore the interest rate at which the Fed stops hiking.

  • Managers are expecting more U.S. rate hikes compared to last quarter. The majority anticipate there will be between three and four 0.25% interest rate hikes over the next year, whereas last quarter the majority expected three hikes. Managers expect the peak in this hiking cycle to reach 3%, up from 2.65% last quarter. This level is still low relative to long-run nominal growth, but confirms a multi-quarter trend of rising rate expectations.
  • However, this has not been mirrored by rising inflation expectations. While we have seen an increasing trend since the Q1 2018 survey, core Consumer Price Index (CPI) expectations have only increased from 2.06% to 2.16% this quarter on a 12-month horizon. This result somewhat implies that the Fed will be successful at controlling inflation.

Is a recession in the cards?

As the Fed continues down the path of hiking interest rates, we’ve also seen a rise in interest rate expectations for 10-year U.S. Treasuries—now expected to rise to 3.28%, up from 2.92% last quarter.

Managers also expect to see a flattening of the U.S. Treasury yield curve. As history tells us, if this goes far enough, it usually signals a recession.2 With this in mind, we can infer that the majority of managers feel that the Fed is likely to over-tighten interest rates throughout the next 12 months.

Credit markets: Cracks starting to appear?

Global leveraged credit fundamentals: the bullish view weakens

An aligning of views by market participants is also evident in the bullish view of leveraged credit, which has now come down relative to the previous quarter. When asked to describe the overall corporate fundamental picture for global leveraged credit, we received a mixed bag of results:

  • Managers expecting an improvement fell from 89% down to 55%
  • 35% see corporate fundamentals remaining the same
  • 10% see modest deterioration (versus 5% last quarter)

Although we’ve seen a deterioration of the level of bullishness towards improving fundamentals, the large majority (70%) continue to maintain current portfolio positioning, similar to last quarter’s 68%.

Credit spreads

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