After eight consecutive Fed rate hikes, investors finally have an alternative to risky assets: USD cash. Treasuries will follow.
TINA, the well-known acronym for ‘there is no alternative’, has been widely used to justify moving into risky assets. In other words: the only way to make decent returns is, it was thought, to take on additional risk. But these days, there is an alternative: USD cash. After eight consecutive Fed rate hikes in the past three years, US cash is emerging as an attractive asset class. The flipside, however, is downward pressure on bond returns. We see this downward pressure on bond returns as just a temporary setback which ultimately creates a good buying opportunity for US bonds.
In recent years, the Fed has carefully guided the market through quantitative tightening and multiple rate raises. This has taken place against a favorable backdrop of positive but not exceptional economic growth, improving but below target inflation, and quantitative easing programs by other central banks.
The Fed’s ‘better safe than sorry’ approach and a market that continued to lag the central bank in pricing in rate hikes created a highly supportive environment for financial markets. But as things stand now, we think we are moving towards a different phase of the cycle. This is illustrated by factors such as US growth, which accelarated to an annualized rate of 4.2% in the second quarter of 2018.
Inflation is also currently above target, while unemployment is far below its natural rate. And if that isn’t enough, the US administration is pursuing an extremely procyclical policy that includes substantial tax cuts and deregulation. As a consequence, the US is facing the exceptional situation of rising budget deficits and accelerating economic growth – something we normally only see when the country is at war.
From both a policy and an economic perspective, we think that higher rates are warranted. To make things worse, there are developments that could tip the balance of supply and demand for US bonds towards supply.
The policy of the US government is putting pressure on budget deficits across the board. These deficits need to be funded, so bond issuance should increase. Unfortunately, this will happen at a time that the demand for these bonds is likely to waver. We will have passed the peak of quantitative easing by the ECB and the BOJ, and the Fed will accelerate the pace of its balance-sheet wind down. This will release the global bond market from the grip of the central banks.
Another compounding factor is the flat US yield curve. This makes it less appealing for non-US residents to buy US bonds on a hedged basis. Hedging the currency risk almost completely wipes out the advantage of higher US rates – unless, that is, investors believe that the positive difference in rates outweighs the higher volatility of their portfolios.
In the Trump era, everything is extremely politized – a factor that also needs to be taken into account. The US president has complicated the job of the Fed by publicly announcing that he was “not thrilled” and “should be given some help” by the central bank. “Every time we do something great, he raises the interest rates,” said the president, adding that Mr. Powell “almost looks like he’s happy raising interest rates.”
This pressure won’t however keep the Fed from hiking rates at a modest pace. But it will err on the side of caution. As a consequence, the bond market will tighten and the US yield curve will steepen – basically doing the job for the Fed. The bond market vigilantes will stage a comeback as the bond market awakes from its Fed-induced coma.
We have yet to reach a peak in long-term yields. Throughout the cycle, central banks have been very transparent about their actions. This has enhanced the effectiveness of these actions as market participants have had time to adjust and stay ahead of the game. Given where we are in the cycle now and the steady ascent towards 3% of the federal funds rate, which is widely regarded as the neutral rate, we think that uncertainty will grow among market participants as forward guidance from the Fed recedes.
All of this means that US Treasuries are not yet a good alternative for risky assets. However, as we highlighted in our general view, we believe the market may have two faces in 2019. If this happens, market participants would do well to move into Treasuries at some time next year. Tightening at the middle and long end of the yield curve will be carried over to the short end: the Fed will hike rates above neutral.
This could spark fears of a recession. In such an environment, we expect Treasuries do to well. Given their attractive starting yields, we can finally say that the TINA story is over.
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