While US corporate bonds have proved resilient in the face of rising interest rates they may start to struggle from 2019, according to Capital Economics’ Oliver Jones.
A decade on since the global financial crisis, central banks have just now begun to unwind the unprecedented measures employed to help shore-up the financial system and stimulate economies.
Indeed, several central banks have begun to withdraw quantitative easing (QE) and increase interest rates from historic lows.
The Federal Reserve has been the main raiser of interest rates among central banks in developed markets and is expected to continue to do so as the US economy storms ahead.
Indeed, as the ‘dot plot’ below shows, the Federal Open Market Committee is anticipating a higher Fed Funds rate over the longer term.
Federal Open Market Committee ‘dot plot’
Source: Federal Reserve
Mike Bell, Global Market Strategist, JP Morgan Asset Management, said low unemployment levels and concerns that “overly accommodative” monetary policy could increase financial stability risk are likely to drive further rate hikes by the Fed.
He said: “So absent a major negative shock to the US economy the Fed are likely to raise rates every quarter until rates get to at least 3 per cent.”
With the September rate rise fully priced in, market attention is likely to focus on any changes to the Fed’s projections as a sign of what’s to come as we head towards 2019.
Capital Economics’ Jones said rising rate expectations have pushed the 10-year US Treasury yields to near seven-year highs.
And the markets economist believes the Fed could hike rates faster than many investors are anticipating to as high as 3.25 per cent.
While the yield on long-term US Treasuries has risen, however, there has been little reaction from corporate bonds.
“Despite the latest jump in Treasury yields, US corporate bond yields have not risen by much, and are still low by past standards,” said Jones.
The economist said that there were several reasons for this lack of reaction by markets, noting that yields have moved in two main phases since 2010.
The first phase, he said, was characterised by low or falling Treasury yields, contributing to ‘the hunt for yield’ following the global financial crisis, with the exception of several spikes during the eurozone and China crises of 2011 and 2015 respectively.
10yr US Treasury constant maturity rate since 2007
Source: St Louis Federal Reserve
The second phase, said Jones, began in 2016 as risk-free rates in the US rebounded, although the hunt for yield has continued supressing spreads.
Yet, Jones warned that the impact of rate hikes by the Federal Reserve and higher borrowing costs could start to take a “clearer toll” on the US economy in 2019, prompting tougher times for the corporate bond market.
“We have been arguing for some time that rising rates alone were not likely to see corporate credit spreads in the US rise dramatically, so long as the US economy also remained in good health,” said Jones.
The economist said such a trend was observed during the Federal Reserve’s last tightening cycle in the early 2000s.
He explained: “After a similar first phase between 2001 and 2003, credit spreads also narrowed further, or remained tight, from 2003 to 2007, while the US economy showed no sign of faltering despite gradually rising risk-free rates.”
The second phase was followed by a third phase, however, from mid-2007 – around the time of the financial crisis – when “fault lines in the US economy finally became apparent”, according to the economist.
“Treasury yields peaked around that time, and subsequently fell back, but credit spreads surged by much more, causing corporate bond yields to rise sharply,” said Jones.
“We suspect that we will eventually see a similar third phase this time too, albeit on a smaller scale.”
He added: “While we are not forecasting another global financial crisis, we do think that the US economy will slow next year, as Fed tightening bites and fiscal stimulus fades.
“This would probably bring the Fed’s current tightening cycle to an end, pulling Treasury yields back down. But we expect corporate bonds yields to rise a long way again, as credit spreads surge.”
After broad synchronised growth in recent years, the US economy has begun to outstrip other developed markets.
The economy expected to grow by 2.9 per cent during 2018, according to forecasts by the International Monetary Fund, outstripping the eurozone economy’s 2.4 per cent rise and 1.6 per cent for the UK, as the below chart shows.
Real GDP growth (annual per cent change) 1980-2018
Source: International Monetary Fund
Yet, Capital Economics is anticipating a slow-down in the US economy next year and has previously warned of a significant risk of recession by 2020.
Investors have highlighted the removal of a one-off fiscal boost from US president Donald Trump’s tax cuts and growing concerns over a spiralling trade war with China, which could impact business sentiment.
Further tightening by the Fed would also likely impact growth although this would be likely to stop or even reverse if needed to again stimulate the economy, according to the markets economist.
“So, rate expectations would probably decline, and term premiums might fall back too, as investors seek safety in government bonds,” said Jones.