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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. 2 Title U.S. Rates Strategy First Quarter 2017 Date Disclosures Aegon USA Investment Management, LLC (AUIM) is a U.S.-based SEC registered investment adviser and is also registered as a Commodity Trading Advisor (CTA) with the Commodity Futures Trading Commission (CFTC) and is a member of the National Futures Association (NFA). AUIM is a member company of Aegon Asset Management, the global investment management division of the Aegon Group. This material is to be used for institutional investors and not for any other purpose. The enclosed information has been developed internally and/or obtained from sources believed to be reliable. This material contains current opinions of the manager and such opinions are subject to change without notice. AUIM is under no obligation, expressed or implied, to update the material contained herein. This material contains general information only on investment matters; it should not be considered a comprehensive statement on any matter and should not be relied upon as such. If there is any conflict between the enclosed information and AUIM’s Form ADV, the Form ADV controls. The information contained does not take into account any investor’s investment objectives, particular needs, or financial situation. Nothing in this material constitutes investment, legal, accounting or tax advice, or a representation that any investment or strategy is suitable or appropriate to you. The value of any investment may fluctuate. Past performance is not indicative of future results. The information presented is for illustrative purposes only. Individual accounts may vary based on restrictions, substitutions, cash flows and other factors. This document contains “forward-looking statements” which are based on AUIM’s beliefs, as well as on a number of assumptions concerning future events based on information currently available to AUIM. These statements involve certain risks, uncertainties and assumptions which are difficult to predict. Consequently, such statements cannot be guarantees of future performance and actual outcomes and returns may differ materially from statements set forth herein. Duration meters reflect AUIM’s recommended duration positioning relative to the benchmark on a 0-3 month basis and 6-12 month basis for short-term and long-term meters, respectively. To normalize recommendations for differences between each portfolio’s benchmark durations and relative positioning flexibility, meters are reflected as a percentage of the portfolio’s allowable relative duration range. Recipient shall not distribute, publish, sell, license or otherwise create derivative works using any of the content of this report without the prior written consent of Aegon USA Investment Management, LLC, 4333 Edgewood Rd NE, Cedar Rapids, IA 52499. Copyright © 2017 Aegon USA Investment Management, LLC Contact AUIM at 877.234.6862 www.AegonInvestments.com We use our investment management expertise to help people achieve a lifetime of financial security. Marketing Ref Code: SISMP12417 AdTrax: 1549687.16 Exp: 4/30/2018 3