Download AGF Fixed Income – Will rates continue to rise?

AGF Fixed Income – Will rates continue to rise?
MARKETS REACT
The surprising election victory by Donald J. Trump caught investors off guard as market participants had largely
priced in the scenario of Hillary Clinton claiming the White House with a divided government. The Republican
sweep, which prevailed, allows for a pro-business agenda, along with accommodative fiscal policy and an easier
regulatory environment. Government bond yields have risen globally alongside a rise in U.S. Treasury yields on
the prospects of expansionary fiscal policy and the potential for higher inflation and a higher-term premium1. The
10-year U.S. Treasury yield has risen close to 100 basis points from its July 6, 2016 low. While inflation
expectations have risen, the yield curve has steepened and the U.S. dollar has strengthened.
Several market sectors have benefited subsequent to Trump’s victory, as investors have shifted into areas that
appear to benefit from Trump’s proposed policies. The Health Care sector has rallied as investors reversed prior
trades that bet on Clinton expanding the role of government within healthcare and curbing price increases by drug
makers. The Financials sector has also benefited strongly from higher interest rates and the potential for
decreased regulation. Industrial sectors, such as engineering and construction-related companies, and
commodities, such as copper, have gained strongly on expectations of higher demand as a result of Trump’s
proposed infrastructure spending plans. However, a stronger U.S. dollar has weighed on the emerging markets,
as well as higher interest rates, which has also negatively impacted interest-sensitive securities such as
government bonds and equities that act as bond proxies, including telecom and utility companies paying high
dividends.
GOVERNMENT BOND YIELDS COULD RISE BUT AT A MORE GRADUAL PACE
Following the dramatic rise in bond yields, it is natural for investors to question whether rates can continue to rise.
Technical indicators such as the relative strength index (RSI) of the U.S. 10-year yield is at the highest level since
1990, signaling that Treasuries may be oversold. While there has been a material rise in rates in a short period of
time, we believe there is scope for further increases, albeit at a more gradual pace going forward. Based on
recent cycles, 10-year rates could move higher from current levels of 2.3% to potentially over 3%. At these yields,
bonds may become more attractive to investors again. Furthermore, a market rate increase that substantial is
likely to start crimping economic activity. Already, higher mortgage rates appear to be affecting demand for
housing loans.
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The premium required by investors to hold long-term as opposed to short-term bonds.
GROWTH LIKELY TO RISE NEXT YEAR BUT TO REMAIN SUBDUED
Going forward, it is likely that markets will continue to adapt to a new U.S. political regime, which at this stage
remains uncertain as to what policy proposals may be enacted and to what magnitude. Drags on capital
spending, inventories and energy are likely to fade if Trump’s policies are implemented, which could be supportive
for growth. As well, a confident consumer and a healthy labour market with commensurate wage gains should
prop up consumer spending and economic growth.
Trump has recently stated that his top three priorities are tax cuts, immigration reform and a renegotiation or
repudiation of the NAFTA Agreement. Trump’s opposition to the Trans-Pacific Partnership and his threat to
impose tariffs on goods from countries such as China and Mexico remain risks to the outlook as the uncertainty
and potential impact could weigh on U.S. economic growth.
While economic growth is likely to accelerate next year following the slow growth environment in 2016 and as a
result of Trump’s proposed policies, growth is likely to remain subdued due to several structural headwinds that
still face the global economy. These headwinds include an unfavourable demographics profile and high debt
levels in developed economics, as well as weak global demand.
EXPECT FED TO HIKE RATES IN DECEMBER 2016 AND AGAIN IN 2017
As economic data have improved, the U.S. Federal Reserve (Fed) is set to raise interest rates in December 2016,
one year after their initial move off the bottom. The market has priced in the move 2 and increased their
expectations further following Janet Yellen’s recent comments in which she stated that a rate hike "could well
become appropriate relatively soon" and acknowledged that taking no action in December could potentially
"encourage excessive risk-taking."3 Subsequent to Trump’s victory, markets have speculated as to what impact
this would have on Fed policy in 2017. This is highly speculative at this point and will depend on fiscal policy and
its impact on economic growth, unemployment and inflation. As well, the Fed may have less pressure to tighten
policy should interest rates stay at a higher level and the U.S. dollar remain strong. For now, we expect the Fed
will stick to their initial expectations of a gradual pace of rate increases. Looking to 2017, however, we believe the
market is not pricing in enough rate hikes next year with only one additional hike priced in 4. Should the economic
data prove to be favourable, more rate hikes will likely be anticipated, which could put further pressure on rates.
ENVIRONMENT TO REMAIN SUPPORTIVE OF THE U.S. DOLLAR
The direction of the U.S. dollar relative to other major developed market currencies will be dependent on U.S.
growth and inflationary expectations, political developments in Europe and the Bank of Japan’s monetary policy.
However, EM currencies are quite cheap relative to the U.S. dollar, with the JP Morgan EM currency index at a 5-
Bloomberg, November 22, 2016. Probability of 100%.
Bloomberg, November 17, 2016.
4 Bloomberg, November 22, 2016
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year low. The Canadian dollar will likely be challenged in an environment of rising U.S. yields and widening
interest rate differentials, which supports our view of a modestly stronger U.S. dollar relative to Canadian dollar
over the intermediate term.
SUMMARY
While asset markets have reacted sharply to Trump’s surprise victory and particularly a sharp rise in bond yields,
we believe that rates will not rise significantly as overall economic growth is likely to remain subdued despite an
acceleration in growth next year. The Fed is likely to hike rates in December 2016 and again at some point in
2017 as the economy improves further, but the path of future interest rate hikes will continue to depend on the
health of economic data. Higher rates in the U.S. and a widening interest rate differential should remain
supportive of a stronger U.S. dollar.
For more information, contact your AGF sales representative or visit AGF.com/Institutional.
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The commentaries contained herein are provided as a general source of information based on information available as of November 22,
2016 and should not be considered as personal investment advice or an offer or solicitation to buy and / or sell securities. Every effort
has been made to ensure accuracy in these commentaries at the time of publication, however accuracy cannot be guaranteed. Market
conditions may change and the manager accepts no responsibility for individual investment decisions arising from the use or reliance on
the information contained herein.
AGF Investments is a group of wholly owned subsidiaries of AGF Management Limited, a Canadian reporting issuer. The subsidiaries
included in AGF Investments are AGF Investments Inc. (AGFI), AGF Investments America Inc. (AGFA), AGF Asset Management (Asia)
Limited (AGF AM Asia) and AGF International Advisors Company Limited (AGFIA).
AGFI is registered as a portfolio manager across Canadian securities commissions. AGFIA is regulated by the Central Bank of Ireland
and registered with the Australian Securities & Investments Commission. AGF AM Asia is registered as a portfolio manager in Singapore.
The subsidiaries that form AGF Investments manage a variety of mandates comprised of equity, fixed income and balanced assets.
This document is for use by Canadian accredited investors only.
Published Date: November 24, 2016
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