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Author: mirama   |   Latest post: Thu, 30 Aug 2018, 4:45 PM

 

Fixed Income – Should we worry about UST yield inversion?

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While the growing concern of a yield curve inversion remains high, it is equally important to ascertain if we are missing some other key points. Currently, the rate hike by the US Fed has led to high yields, while during the 2012 quantitative easing, the focus was on seeking high-risk debt instruments. Also in today’s setting, the Fed’s rate hike policy and trade war uncertainties have sparked volatility on the global capital market, and even raising the alarm on the possible risk of an emerging market crisis.

In the meantime, we expect the Fed to maintain its current hawkish forward guidance on the direction of the monetary policy on the condition that the economy continues to grow. If the economic growth scales above 3% over the next couple of years, we foresee both rates and the USD strengthening.

What happens if the Fed embarks on a more dovish forward guidance? Under such circumstances, the yield curve will steepen as shorter term yields fall. It will cast doubts on the Fed’s independence, especially after coming under criticism from US President Donald Trump on the aggressiveness in hiking rates. The dovishness can also be due to the economy losing steam.

Volatility in fixed income thus far in 2018 was driven by storylines of trade war, emerging market crisis and the US economy potentially overheating. These noises still remain. Hence, we suggest a more cautious approach to investing in global fixed income.

In Malaysia, with supply constraints from PDS estimated at RM20bil to RM70bil, govvies bond issuance projected at around RM103bil, plus factoring in the US Fed’s another two rate hikes in 2018 and BNM maintaining the OPR at 3.25% coupled with a low inflation to average at 1.5%, these provide an edge for slightly lower yields from the current level. Besides, MGS yields should continue to be well supported by onshore real money demand. Therefore, we are looking at 10-year MGS yields of around 3.95-4.00.

  • The US Treasury 2-year yield rose to 2.67% while the 10-year yield currently stood at 2.88%. This squeezed the spread between them to just 21 basis points, the lowest since August 2007. It is a step closer to falling into the flattening yield curve and soon into a yield curve inversion, unless the 10-year yield jumps due to the aggressive rate hike scenario.
  • In the past, an inversion of the yield curve tends to be accompanied by recession. Our question is whether we need to be worried about a downturn? While concern on a yield curve inversion remains high, it is equally important to ascertain if we are missing some other key points.
  • With global monetary policy gradually moving towards a tightening stance, it will raise the competition for global capital flows. Under such circumstances, we felt it is important to examine our strategies with regards to positioning ourselves rather than to merely focus on the noises of a US economic slowdown and its potential implications, though it is important to have these on the back of our mind.
  • Currently, the rate hike by the US Fed has led to high yields while during the 2012 quantitative easing, the focus was on seeking high-risk debt instruments. Besides, in today’s setting, underpinned by the Fed’s rate hike policy, it led to uncertainties and volatility on the global capital market, and even raising the alarm on the possible risk of an emerging market crisis.
  • In the meantime, we expect the Fed to maintain its current hawkish forward guidance on the direction of the monetary policy. We have factored in two more rate hikes in 2018, each by 25 basis points to settle at 1.75%–2.00%. Looking ahead, should Trump’s ambition to lift the economic growth above 3% over the next couple of years is achieved, we foresee both rates and the USD on a strengthening mode. This may pose a risk to the economic growth.
  • Thus, we foresee the Fed will mostly likely embark on a gradual rate hike going forward without jeopardizing the medium-term growth trajectory and causing a huge market disruption. US treasuries remain one of the safest place to park your money. And with the government debt still attractive, it will continue to contribute to the explosion of global capital market volatility, fuelling competition for capital. We are looking at another two rate hikes in 2019 to 2.75%– 3.00% and likely to stabilise at 3.25%–3.50% by 2020 should the GDP growth continues to remain strong.
  • What happens if the Fed embarks on a more dovish forward guidance? Under such circumstances, the yield curve will steepen as shorter term yields fall. It will cast doubts on the Fed’s independence, especially after coming under criticism from Trump on the aggressiveness in hiking rates.
  • Besides, the Fed may turn dovish if the economy starts to lose steam much earlier than anticipated. Under such circumstances, the Fed may loosen its monetary policy with rates being reduced by 50–100 basis points in 2019–2020. Under a reverse policy scenario, it will ease pressure on global rates to move up. Portfolio rebalancing can become trickier. Hence, we believe the need to embark on a more cautious approach.
  • Volatility in fixed income thus far in 2018 was driven by storylines of trade war, emerging market crisis and US economy potentially overheating. These noises still remain. Hence, we suggest a more cautious approach to investing in global fixed income.
  • In Malaysia, supply constraints with the estimated supply of PDS to drop by about RM20bil to RM70bil, govvies bond issuance projected at around RM103bil, pricing in an additional two rate hikes by the US Fed in 2018 and our OPR staying unchanged at 3.25% in 2018 given the low inflation to average at 1.5%, these provide an edge for slightly lower yields from the current level. Besides, MGS yields should continue to be well supported by onshore real money demand. Therefore, we are looking at 3-year; 5-year; and 10-year MGS yields at around 3.45-3.50; 3.65-70 and 3.95-4.00 respectively.

Source: AmInvest Research - 30 Aug 2018

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