Will trade tensions trigger a rate cut?

07 June 2019

By Michel Vernier, CFA, Head of Fixed Income Strategy

Given the latest comments from Chinese and US officials and that both countries could not find an agreement in May, it is now evident that both sides are willing to maintain a hard line in order to push for a better deal.

It has become more likely that the US Federal Reserve (Fed) will adopt a more pro-active stance, making one or two rate cuts likely. Markets, in the meantime, have started to price in several rate cuts over the next 12 months which at this point seems premature.

Rate cut, but no need to fight a recession

First: The Fed’s primary inflation indicator, the PCE core deflator, is around 1.6% and below the central bank’s long-term target of 2%.

In the past, lower inflation in isolation rarely was a trigger for the Fed to start a full rate cut cycle. In 1990 for example it was the asymmetric downside risk to the economy which led to rate cuts rather than lower inflation. At that time, gross domestic product (GDP) growth was expected to be at -0.5% (Q2) while the Institute for Supply Management (ISM) Index was well under 50, suggesting a contracting economy. The four-week average for initial jobless claims was at 370,000.

This brings us to the second factor: the economy. Today the US economy looks very different than it did in 1990. The ISM purchasing managers’ index suggests expansion, real GDP growth, although likely to slow in the second half of the year, is at a healthy 2.9% while the unemployment rate stands at a 49-year low. Of course the big elephant in the room is the trade dispute. And if all announced measures were implemented and persisted over a long period, they would dampen the economic outlook, which the Fed will likely consider in its assessment.

The third factor is financial conditions: The S&P 500 Index is around 7% away from its all-time high. If the Fed looked at the equity market in isolation, it would most likely keep rates at current levels to avoid asset-price inflation.

Meanwhile, the loan survey as well as corporate bond spreads suggest that both consumers and corporates have healthy access to capital. Financial conditions, therefore, would not provide sufficient ammunition for the Fed to make several rate cuts.

Treasury yields to remain low

Although the trade tensions and a slower growth outlook make it more likely that the Fed will cut rates one or two times towards the end of the year, we think that it would take much more for the Fed to enter a full interest rate cutting cycle as priced in by the market.

We believe the momentum of lower Treasury yields will stay as long as the uncertainty around trade tensions persist. In this environment, longer duration provides a natural hedge in diversified portfolios.

We believe the momentum of lower Treasury yields will stay as long as the uncertainty around trade tensions persist.

BBB bond yields look attractive

The yield curve on BBB-rated bonds is steep. Longer dated BBB bonds offer an attractive yield pick-up while the longer duration helps in a period of economic uncertainty.

While the US sovereign rate curve is flat or slightly inverted, the BBB-rated corporate bond yield curve is steep by comparison. Here investors can find additional yield pick-up by extending the duration. While one-year USD BBB bonds yield around 2.7% on average, 10-year dated bonds yield roughly 100 basis points (bps) more and 15-year bonds offer a yield pick-up of 155 bps yielding 4.2% in average.

But not only the yield pick-up speaks in favour of longer dated BBB-rated bonds, longer dated BBB bonds also offer diversification benefits: long-dated BBB-rated bonds are exposed to duration risk and credit risk. The latter is primarily expressed by volatility in credit spreads during the investing period. Are these two factors reasons to stay away from investing in this segment of the market? No, we think quite the opposite.

Longer dated bonds in general gain in periods when yields are trending lower on the back of lower inflation expectations usually seen in an economic slowdown. In an environment where yields rise, longer dated bonds decrease in value. Spread premium on BBB bonds compared with investment grade bonds mirrors the above dynamic. Higher confidence in economic growth leads to flows into riskier bonds and compression of the premium. Although the two opposing factors do not eliminate price risk, they lead to lower price volatility on average.

BBB bonds spread graph

During December’s sell-off, BBB bond spreads widened disproportionately compared to similar A-rated bonds which resulted in relative attractiveness. Currently, BBB spreads (160 bps) are around 1.65 times higher than comparable A spreads (100 bps), which is at the higher end of the range seen in the last five years.

Although leverage has been built up in the corporate sector, the debt service costs compared to operating profits are still very manageable in average. BBB-rated issuers from defensive sectors like utilities and telecom companies, for example, are less exposed to earnings’ volatility during the economic cycle, which is credit positive. The combination of yield pick-up and longer duration, which offers a hedge in an economic downturn, together with manageable credit risk provides an interesting investment opportunity in our view.

BBB bond spread graph 2

Market Perspectives June 2019

Investment experts from Barclays Private Bank analyse intensifying geopolitical tensions hitting economic growth expectations.


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