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U.S. Rates Strategy
First Quarter 2017
Norris, view
CFA, Rates Strategist
AUIM short-term Calvin
duration
relative to benchmark
0% duration view
AUIM short-term
25%
-25%
relative to benchmark
Can the Fed Follow Through?
As we move into the 2nd quarter, the U.S. economy continues to improve.
Ongoing strength in the labor market has been steadily nudging the U-3
unemployment rate lower, with the index now standing at 4.5%. This is
well below the OECD’s 4.9% estimate of the non-accelerating inflation
rate of unemployment (NAIRU). In a healthy labor market, wage pressure
should start to build when unemployment falls below the level of NAIRU.
However, at present, the ongoing sluggishness of U.S. productivity has kept
wages relatively stagnant and other measures of core inflation appear to
be well behaved. This suggests that while the labor market has improved
greatly since the 2008 recession, it still hasn’t fully healed.
Nevertheless, the Federal Open Market Committee (FOMC) believes the
economy has improved enough, and the labor market is sufficiently close
to full-employment that they have raised short-term interest rates twice
since December. The FOMC has indicated they intend to remove monetary
accommodation gradually, before inflation becomes problematic, in an
attempt to avoid having to raise interest rates more aggressively later.
They believe this go-slow approach will be least disruptive to the economy,
minimizing the risk that higher policy interest rates push the economy into
recession.
> Complicating the dynamic monetary policy
landscape is the potential for substantial changes
to U.S. fiscal policy in the coming months.
With Republicans now in control over both houses of Congress and the
White House, Party leaders have indicated a desire to achieve substantial
tax reform, regulatory rollbacks, and infrastructure spending. If enacted,
this could provide a substantial tailwind to the economy, with measures like
tax reform potentially contributing to economic growth for an extended
period of time. This potential boost to the economy is why interest rates,
equity valuations, and overall confidence have risen sharply following the
election. The FOMC has not been immune to this optimism, with about half
its committee members admitting to incorporating this potential fiscal
tailwind into their forecasts. This is one of the reasons the FOMC hiked
rates in both December and March, even though they hadn’t hiked for a
year prior. Similarly, FOMC members have been strongly reiterating their
expectations for three hikes in 2017, which is roughly in-line with current
market consensus. However, political infighting could derail the best parts
of structural reforms, and cause the FOMC to re-evaluate their forecasts.
We have already seen the Republicans fail, despite a House majority, to
repeal the Affordable Care Act (a.k.a. Obamacare). Paul Ryan recently stated,
“Achieving consensus on tax reform could take some time as the House GOP,
Senate Republicans, and White House are further apart on this issue than
Contact AUIM at 877.234.6862
www.AegonInvestments.com
-50%
0%
-25%
25%
-75% -50%
50%
50% 75%
75%
100%
-75%
-100%
-100%
100%
Positioning: Short
Current Target = -5%
AUIM long-term duration view
relative to benchmark
AUIM long-term
0% duration view
25%
-25%
relative
to benchmark
-50%
0%
-25%
25%
-75% -50%
50%
50% 75%
75%
100%
-75%
-100%
-100%
Positioning: Short
Current Target = -10%
100%
The case for lower rates
Republican-led government fails to deliver sufficient fiscal stimulus
US economic/employment growth fails to materialize as expected
FOMC hikes too aggressively, risking curtailed economic growth
Excessive dollar strength
Additional global macroeconomic weakness
Foreign demand for Treasuries v. local sovereigns increases
Significant oil/equity weakness
Geopolitical turmoil/EU rancor
The case for higher rates
Republican-led government enacts significant fiscal stimulus
US economic/employment growth surprises to the upside
FOMC hikes too slowly, risking economy overheating
Dollar strength remains subdued
Inflation accelerates upwards
Global growth improves
Further foreign outflows from Treasuries
Aegon USA Investment Management, LLC (AUIM) is a U.S.-based SEC registered investment adviser and a
member company of Aegon Asset Management, the global investment management brand of the Aegon Group.
Title
U.S. Rates Strategy
First Quarter 2017
Date
> Another potential source
for volatility comes from
the FOMC’s recent signal
they may start to unwind
their U.S. Treasury and
agency-guaranteed MBS
holdings by the end of
the year.
Exhibit
Exhibit 1:
1 Aggregate Surprises Index: Hard v. Soft Data
2.5
1
2
1.5
0.5
1
0.5
0
0
-0.5
-0.5
-1
-1
-1.5
-2
-1.5
17
16
7/
1/
15
7/
7/
1/
14
1/
13
7/
1/
12
1/
7/
11
7/
1/
10
7/
1/
09
7/
1/
08
7/
1/
07
1/
7/
06
7/
7/
1/
05
1/
04
7/
1/
03
7/
1/
02
7/
1/
01
7/
1/
7/
7/
1/
00
-2.5
1/
they were on healthcare.” This could be
a risk to economic confidence given the
wide disparity between recent upward
surprises in “soft” economic data relative
to surprises in “hard” economic data (see
exhibit 1). If the “soft” data converges
towards the “hard” data, it could have a
negative influence on equity valuations,
bond yields, and the FOMC’s ability to
hike two more times in 2017. However,
we remain optimistic Republicans will
ultimately find a way to overcome their
differences and pass meaningful tax
reform, but it may not be until 2018.
From this perspective, it may not matter
all that much if the FOMC hikes once
or twice more in 2017, as any potential
pause by the FOMC would probably be
viewed by the market
as temporary.
Bloomberg SoB Data Surprises Index
Bloomberg Hard Data Surprises Index
Source: Bloomberg
Q1 2017
At this point, it seems unlikely the FOMC will sell their positions outright, but instead
taper the reinvestment of principal cash flows each month. This tapering is likely to
continue for about five years, both allowing the FOMC to “smooth out” the upcoming
maturities in their portfolio and prevent a repeat of the 2013 “taper-tantrum”. We
currently estimate they taper the reinvestments of Treasuries and MBS equally, by
about $15 billion/month for each asset class. As such, we don’t think the FOMC’s taper
plans will have a material impact to longer-term rates; perhaps 10-15 basis points per
year once the plan is formally announced.
For the time being, we believe interest rates are unlikely to change materially and the
market will remain in “wait and see” mode until more clarity emerges on the fiscal
front. As such, we are recommending duration positioning near neutral, with a slight
bias to the short side in deference to our ongoing optimism on the U.S. economy. Our
curve positioning outlook is for a flatter curve due to additional FOMC rate hikes, but
modestly less than what is priced into the forward market over the next 6-9 months.
Strategy Team
Brian Westhoff, CFA, Head of Strategy
(443) 475-3040 [email protected]
Calvin Norris, CFA, Rates Strategist
(319) 355-2603 [email protected]
Francis Rybinski, CFA, Director of Macro Strategy
(443) 475-3133 [email protected]
D. Harris Kere, CFA, Investment Strategist
(443) 475-3191 [email protected]
Contact AUIM at 877.234.6862
www.AegonInvestments.com
We use our investment management expertise to help people achieve a lifetime of financial security.
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Title
U.S. Rates Strategy
First Quarter 2017
Date
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