Brian Rehling, CFA ®
Co-Head of Global Fixed Income Strategy
Lowering Our Year-end Rate Expectations (PDF) 2/17/2016

Highlights of our strategy and perspectives on the global fixed income markets for the week of February 17, 2016.

Wells Fargo Investment Institute - Global Investment Strategy

Global Fixed Income Strategy Report

 

February 17, 2016

Brian Rehling, CFA®
Co-Head of Global
Fixed Income Strategy

 

Analysis and outlook for the fixed income market

  • We are lowering our year-end 2016 interest-rate forecasts.
  • The energy-price collapse and weaker-than-expected growth have combined with central-bank action to suppress global and domestic inflation and interest rates.

What it may mean for investors

  • We now expect the Federal Reserve (Fed) to raise rates only once in 2016. We expect a flattening yield curve and increased fixed-income volatility in 2016.
  • We recommend that investors raise average credit quality. We favor the intermediate part of the yield curve and investment-grade, domestic holdings.

Lowering Our Year-end Rate Expectations

We are reducing our target for the federal funds rate to 0.50-0.75 percent for year-end 2016; this is down a quarter of a percent from our previous target of 0.75-1.00 percent. Our new target implies that we expect the Fed to raise short-term interest rates only once before year end. We are also reducing both our 10-year Treasury and 30-year Treasury targets by 0.50 percent. Our new year-end 2016 10-year Treasury yield target is 2.00-2.50 percent and our new 30-year Treasury yield target is 2.50-3.00 percent for year-end 2016.

In the most recent release of economic projections from Fed Board members and Fed Bank presidents, the median projection for the federal funds rate in 2016 was 1.4 percent. Such a rate would imply that the Fed would raise rates four times before the end of this year. Clearly, given the reduction in our fed funds rate target, we believe that the probability for four Fed rate hikes this year is extremely low. In our opinion, the Fed’s recent rate forecasts show the Fed is far behind the curve on their recognition of current challenges facing the market. Even if the labor market continues to show strength and meet the Fed’s objective, we believe that the challenging inflation environment will lead the Fed to significantly downgrade its rate-increase expectations.

Since we originally set our targets in October 2015, market and economic conditions have deteriorated. Energy prices have collapsed while Japan surprised the world with a rate cut that initiated a negative rate policy for the country. Furthermore, domestically, we experienced a weaker-than-expected fourth quarter and start to the New Year. Compounding these challenges is an outlook for inflation that has trended lower than we previously anticipated. Chart 1 shows the Fed’s five–year forward breakeven inflation rate. Future inflation expectations have fallen significantly since late last year and are currently near their all-time lowest levels.

Chart 1. Fed Five-Year Forward Breakeven Inflation Rate


Chart image of The Fed's five-year forward breakeven inflation rate. Contact your Relationship Manager for more information.

Source: Bloomberg, 2/11/16.

In most environments in which inflation expectations have fallen to these levels, markets would be discussing the potential for Fed easing rather than debating the timing of the next Fed rate hike. We do not see a significant recovery in inflation expectations in the near term and feel this data supports fewer rate hikes than we projected last October.

By reducing our year-end short-term rate target by 25 basis points and our long-term rate target by 50 basis points, we are implying a flattening yield curve as we expect short-term rates to gradually move higher while longer-term positions see just modest (but still positive) total returns.1 Domestic long-term rates continue to be influenced by global rates, and we are unlikely to see rates diverge further as investors search out value in the global interest-rate markets. Chart 2 shows the historical relationship between 10-year U.S. Treasury yields and 10-year German Bund yields. With central banks around the globe fighting disinflationary trends and weak economic growth, we see potential pressures on longer-term rates as minimal.

Chart 2. Spread between 10-Year U.S. Treasury Yields and 10-Year German Bund Yields


Chart image of the historical relationship between 10-year U.S Treasury yields and 10-year German Bund yields.. Contact your Relationship Manager for more information.

Source: Bloomberg, 2/11/16.

We remain convicted in our October opinion that the fixed-income markets are likely to be volatile in 2016. This theme has played out over the first month and a half of 2016, and we see the trend continuing. The mixed global growth environment, uncertain Fed policy and the twists and turns that come with a general election cycle are likely to continue to wreak havoc on fixed-income investors that crave stability. Ten-year Treasury yields are likely to move above the 2.50 percent level at times—and also below the 1.50 percent level. Ultimately, a continued slow growth and muddle-through scenario should allow the Fed to raise rates once while longer-term rates remain relatively low.

Lower for Longer

Global deleveraging, an aging population and low productivity growth are likely to keep interest rates below longer-term averages for some time. Even as the jobless rate continues to decline, meaningful wage inflation eludes policymakers. Given these dynamics and the collapse of commodity prices, we do not see a catalyst for significantly higher inflation at this time. A resurgence of global growth could cure the lack of inflation that continues to confound central banks and push rates higher than implied in our expectations, but a meaningful pickup in global economic growth does not appear to be on the horizon.


Risk Factors

Investing in fixed income securities involves certain risks such as market risk if sold prior to maturity and credit risk especially if investing in high yield bonds, which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than original cost upon redemption or maturity. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline of the value of your investment.

Targets and forecasts are not guaranteed and are subject to change.

Disclaimers

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII) WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

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1 One basis point is equal to one-hundredth of one percent, or 0.01 percent (.0001). One percent equals 100 basis points.