In Short: The bias on rates remains moderately upward

08-02-2017

Federated’s fixed-income duration committee continues to recommend a moderate short position on the view interest rates are more likely to rise than fall in the months ahead. Getting to this decision isn’t easy, however, as the factors influencing rates are somewhat contradictory.

For instance, even though U.S. economic growth is on a favorable path of about 2.5% (well above potential growth of around 1.7% to 1.8%) with an unemployment rate in the low-4% area, inflation keeps disappointing. Both core and headline indicators are stuck below the Fed’s 2% target and actually have been trending lower of late. This gives the Fed grounds to be patient and persistently gradual as it moves toward policy normalization, with a very slow pullback on reinvestments likely to be announced in September. The inflation shortfall also affirms the market’s persistent underpricing of the Fed’s dots trajectory, fueling speculation those projections will move even lower in upcoming meetings.

At the same time, with commodity prices rallying and unemployment on track to fall further amid the ongoing jobs and economic expansion, it seems inflation eventually will rebound. The timing and extent remain unclear to the market and the Fed. But remaining a bit short on duration makes sense given both this set of expectations and a global economy that is growing, a European Central Bank (ECB) on the verge of tapering bond purchases, a Chinese economy that’s expanding at a reasonable pace and financial conditions—most notably rising stock prices and narrowing corporate bond spreads—that are supportive of U.S. growth.

To be sure, the failure of health-care reform and a crowded fall policy calendar warrant skepticism. At least four items will require immediate attention when Congress returns from the August recess: 1) a continuing budget resolution; 2) a fiscal 2018 budget; 3) a debt-ceiling solution; and 4) initial work on tax reform. When combined with the ECB’s likely ultra-cautious approach to tapering and a potential risk-off trade depending on the Trump administration’s response to North Korea’s provocations, the upside on higher rates would appear constrained. On net, we expect some moderate upward pressure on Treasury market yields from here, perhaps toward 2.40% on the 10-year, and perceive lower risk of a rally back toward 2% over the remaining course of summer.