November 02, 2017
At its monthly meeting in October, the MFS Fixed Income Strategy Group, which is made up of senior portfolio managers from across the various fixed income asset classes, expressed the view that US interest rates are set to rise modestly.
Global growth picking up as disinflation fades: Global growth has been surprisingly resilient and disinflationary forces have largely abated. The prospects for global inflation to surprise to the upside have risen, though this is not our base case. Consequently, above-trend, global nominal gross domestic product growth (i.e., reflation) is likely to continue, putting upward pressure on yields.
Looser US fiscal posture likely: With regard to fiscal policy, tax cuts and corporate tax reform appear more probable than markets expected earlier this year. And while the passage of a fiscal package would not provide a large boost to growth, it would probably shift market sentiment toward more risk-on activity and higher yields on Treasuries. Regardless of any new legislation, fiscal stimulus and private reconstruction in the aftermath of hurricanes Harvey and Irma will provide a short-term boost to economic activity.
Absent fiscal legislation, expect continued tepid growth: Beyond the short term and in the absence of tax legislation, US growth will probably languish around 2% and rates will remain historically very low through the remainder of the business cycle.
Additional rate hikes on track: Despite weak consumer price inflation, the US Federal Reserve (Fed) is set to raise rates again in December, and in our view, one or two more times over the next 12 months. However, the possibility of a new chair for the Fed, along with several other new members of the Board of Governors, risks tilting the central bank in a more hawkish direction.
Rate target unlikely to be reached: Beyond the next 12 months, the Fed is unlikely to raise rates to a terminal rate of 2.75% — where Fed members currently project the tightening cycle will end — unless labor productivity rebounds considerably from its very weak, post–global financial crisis pace. With capital spending remaining historically anemic, the prospects for such a recovery in productivity seem remote.
Risk of a policy error? However, if the Fed does continue to hike rates at a pace of 75 basis points per year, especially in the face of weak inflation, the market will likely become increasingly concerned that it could commit a policy error by over-tightening. That might undermine the business cycle by late 2018 or 2019.
Markets may rethink asset values post-QE: As the peak of global quantitative easing (QE) comes more clearly into sight — perhaps in the second half of 2018, when the Fed reaches its maximum run rate of balance sheet roll-off, the European Central Bank has tapered its QE close to zero and the Bank of Japan enters the very late stages of its QE program — the markets may be ripe for a major reconsideration of global liquidity and the sustainability of lofty asset valuations. Still, purely technical and well-telegraphed factors may not have a lasting effect on rates, especially as demand for government debt will continue to outstrip supply, even as global QE slowly reverses.
Taking these factors into consideration, we anticipate modest upward pressure on US rates in the months to come, but we expect yields to remain quite low from a historical perspective.
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