Major changes in fiscal and monetary policy are on the horizon, significantly altering the outlook for the bond market in 2017. The era of boosting growth with loose monetary policy is giving way to a new era of expansive fiscal policy.
The transition began this summer, and we expect it to accelerate under the incoming administration. After seven years of gridlock in Washington D.C., it now appears that a slew of legislative initiatives involving taxes, spending and other matters relevant to the economy will move forward next year. Most of the proposed changes are likely to boost growth and inflation, which should send interest rates higher. But there are some risks—the known unknowns.
Growth and inflation
The incoming administration has proposed a slate of tax cuts (discussed below) and a $1 trillion infrastructure program that would feature a mix of new spending and tax credits for private developers. Though Congress could end up reining in some of President-Elect Donald Trump’s plans, the likelihood that some of these measures will pass is pretty high, in our view.
Since the end of the recession, the contribution of government spending to gross domestic product has been small or even negative. Reversing that should boost growth over the next few years from the 2.2% average rate of the past seven years.
Change in three components as a percent of real GDP
Source: Bureau of Economic Statistics (BEA). PCE as a % of GDP refers to personal consumption expenditures, a measure of consumer spending. Data are quarterly as of Q3 2016. Not seasonally adjusted. Shaded areas indicate past recessions.
Moreover, all this new stimulus would likely spur inflation. Unemployment is already below 5% and wages are already rising. Broad-based tax cuts could raise consumer spending, as well, especially if the cuts affected the lower income brackets, where people tend to have the highest propensity to spend.
Atlanta Fed Wage Growth Tracker and average hourly earnings are trending higher
Source: Federal Reserve Bank of Atlanta (Atlanta Fed Wage Growth Tracker) and U.S. Bureau of Labor Statistics (Average hourly earnings). Federal Reserve Bank of Atlanta Calculations for median wage growth and average hourly earnings of production and nonsupervisory employees: total private, percent change from year ago, monthly, seasonally adjusted. Shaded areas indicate past recessions. Data as of 10/2016.
Monetary policy
Stronger inflation could lead the Federal Reserve to raise interest rates faster than the market currently expects. The Fed is already on track to raise short-term interest rates at its December 2016 meeting.
Based on its most recent projections, the Fed expects the federal funds rate to end 2017 between 1.1% and 1.8%, which would mean at least three increases of 25 basis points. As you can see in the chart below, the Fed foresees a faster rise in rates than the fed funds futures market.
Market expectations lag the Fed’s interest rate projections
Note: The “forward curve” (blue dotted line) represents future interest rates implied by the market for interest rate swaps. Market estimate for “Longer Run” represents the Euro Dollar Synthetic Rate for 12/2022.
Not all interest rates increase when the Fed raises the funds rate. Bond yields are driven largely by growth and inflation expectations, as well as by global demand for income. However, the prospect of steeper Fed rate hikes next year, along with rising inflation expectations, will likely keep bond yields moving higher.
Tax policy
Of course, there are some unknowns. There appears to be broad consensus in Washington in favor of tax cuts for individuals and corporations. Trump’s tax plan calls for reducing today’s six individual income brackets to three: 12%, 25% and 33%, as well as other cuts. He has also called for cutting the corporate rate to 15% from a top rate of 35% now. But, again, Congress may not be willing to adopt all of Trump’s proposals.
In general, cutting taxes for individuals should mean more disposable income and consumer spending. Cutting business taxes could leave more money for investment. Both would contribute to economic growth.
However, without offsetting spending cuts, it’s likely that tax cuts would lead to larger deficits and more debt, which is a worry for the bond market. Increased issuance of Treasury bonds at a time when the public debt-to-GDP ratio is already at 77% could cause investors to demand higher yields.
In addition, broad-based tax cuts could weigh on the municipal bond market, since demand for tax-exempt income from high earners could diminish with tax rates, while issuance of municipal bonds to finance infrastructure spending could increase. We would expect municipal bonds to underperform Treasury bonds if taxes were broadly lowered. (See article by Cooper Howard and Rob Williams.)
Trade policy
Perhaps the biggest unknown is trade policy. The incoming administration has made protecting domestic industry a major goal, with promises to declare China a “currency manipulator,” impose import tariffs and withdraw from trade agreements.
Moreover, the Republicans in Congress have also embraced the idea of trade restrictions, with a proposal to adopt import taxes and export subsidies of approximately 20% as part of tax reform. The idea is that a 20% adjustment on the cost of goods going in and out of the country would equalize the difference in corporate tax rates between the U.S. and other major countries.
In theory, U.S. exports would be more competitive with a subsidy, while imports would be less attractive with a tariff, encouraging companies to bring production, investment and jobs home. Such a policy would represent a major shift from the policies of the past several decades.
The chart below shows how the share of the global economy covered by free trade agreements has grown over the past two decades. Reversing the trend could have unexpected consequences.
Free trade agreements
Source: International Monetary Fund (IMF). Data as of 10/2016. The “average number of trading partners” measures the average number of trading partners with which a given representative country is in a free trade agreement. The “percent of global GDP” refers to the average share of global GDP of those trading partners.
Imposing tariffs on imports would fuel inflation, all else being equal. However, currency movements can quickly offset trade tariffs. In a free-floating exchange rate system, a 10% tariff could lead the currency to jump by an equal amount, leaving the price to importers unchanged. The dollar has been moving higher for over a year as U.S. monetary policy has diverged from the looser policies of other major central banks. Since the election, the dollar has jumped to its highest level since 2003 on expectations of stronger economic growth and higher Fed policy rates compared to the U.S.’s major trading partners. The potential for corporations to repatriate capital held abroad could give another boost to the dollar.
Trade weighted U.S. dollar index – major currencies
Source: Federal Reserve Bank of St. Louis. Data as of 11/25/2016.
As the dollar rises, it puts downward pressure on growth and inflation. Imposing import taxes could lead to a stronger dollar as the market adjusts to the increase in import prices. Moreover, a stronger dollar means labor and goods cost less abroad.
Protectionist legislation can also be disruptive to companies with global supply chains and could trigger retaliation from other countries. Most economists believe trade protectionism is negative for economic growth, making it an area of concern.
What to do
Markets have been quick to adapt to the change in outlook since the election. We suggest investors take a cautious approach to making any major changes in their fixed income investments until there is more clarity about the timing and magnitude of policy changes coming our way.
We do believe that the trend in bond yields is higher moving into 2017. Ten-year Treasury yields are unlikely to plumb their low of 1.37% from last summer again until at least the next recession or perhaps even longer. It wouldn’t be surprising to see bond yields move up to the 2.5%–3.0% range next year, assuming inflation trends higher. Therefore, we continue to suggest investors keep their average portfolio duration in the short-to-intermediate term.
Corporate bonds tend to perform well relative to Treasuries when the economy is growing and interest rates are rising. We suggest the bulk of an investor’s allocation to taxable bonds be concentrated in investment grade bonds to reduce the risk of volatility. With the yield spread between corporate bonds and treasuries below the long-term average, we are neutral on both investment grade and high yield bonds.
Given our outlook for a stronger dollar, we continue to suggest underweighting international bonds.
Investors may want to consider an allocation to Treasury Inflation Protected Securities (TIPS) to provide some inflation protection. TIPS are still bonds and may decline in value as interest rates rise, but since the principal will adjust with changes in inflation, TIPS are likely to outperform traditional Treasury bonds if inflation rises.
Summing it up
We expect higher interest rates in the year ahead, but with so many policy decisions still to be made, we think investors should take a cautious stance for now. Down the road, as there is more clarity, higher bond yields could provide an opportunity for long-term investors who have been hoping to add more income to their portfolios. We are going to be looking for those opportunities.