Can the U.S. Decouple from the Rest of the World and What Does That Mean for the Bond Market?

As we look back over the Third Quarter of 2014, the most salient theme in the financial world was that of U.S. domestic economic strength compared with global weakness. It is interesting to note that just six years ago the opposite was the case, and investors were questioning whether the emerging market economies could continue their double digit growth rates despite a recession here at home. As we saw in 2008-2009, the emerging markets were unable to “decouple” from the developed world as the U.S. financial crisis caused a global economic slowdown. This time, the question becomes that of whether the U.S. economy can “decouple” from the rest of the world. Based on the makeup of our economy, which is much less dependent on overseas activity, we think the answer will largely be yes. However, that economic bifurcation is unlikely to carry over into the U.S. rates markets, where global capital flows are likely to restrain US Treasury yields.

Over the last few months we’ve seen a negative GDP report from Japan, a sub-1% GDP report and dangerously low inflation readings from the Eurozone, and a miss to China’s 7.5% economic growth target. During this time, the Federal Reserve has continued to brace investors for normalized monetary policies (read: higher short-term interest rates) at some point in 2015. The warning from FOMC members is driven by strong U.S. employment and manufacturing data as well as a housing market that is showing some continued signs of life. So far this year, the divergence between the U.S. and major global economies has rippled through both the currency and bond markets, with the dollar rallying and U.S. Treasury yields well above that of their global counterparts.

DXY Index

10yr Yields U.S. vs. Germany

More recently, the U.S. bond markets have responded to the domestic and global data with a hint of caution, as yields have risen slightly, particularly in the front-end of the yield curve. Credit markets have shown signs of weakness as the possibility of a changing liquidity landscape have some corporate bond investors nervous. Going against this trend has been the municipal sector, which has generated strong returns as the supply/demand dynamic has been favorable.

Given the impact that consumer spending has on the overall U.S. economy, we think that growth can continue at its recent pace, if not slightly faster. Employment tends to be a significant driver of the economy, and strength in employment metrics along with a slight pick-up in wages give us confidence in a positive outlook. Under these conditions bond yields may continue to rise, but they are unlikely to break-out significantly higher unless the economic conditions improve overseas. In addition, a strong dollar should keep inflation numbers subdued, leaving the Fed with room to move slowly on their increases in rates.

We have taken steps to add exposure to the part of the yield curve that has underperformed significantly this year, namely 3-5yr maturity bonds, while reducing exposure to the longer 10yr sector of the curve. The risk/reward outlook on 3-5 year bonds has turned favorable in most interest-rate scenarios, which is a stark change to where things stood heading into 2014. This analysis, coupled with our fundamental outlook, has led us to keep a conservative duration profile with a laddered maturity profile, which we believe makes the most sense heading into year-end.

Source: Bloomberg