Central-bank policies will continue to play a major role in the fixed-income markets, not least through their effect on exchange rates. Fed chair Janet Yellen increasingly appears to be someone who is driven by the markets, rather than driving them. With better data having boosted markets’ expectations of a Fed rate hike in December, she will likely follow their lead. But the rate- rise trajectory in 2016 is still expected to be “low-and-slow” and the Fed is likely to try and signal this to the markets. Normally, a “low-and-slow” approach would not be expected to boost the U.S. dollar substantially. But whilst Ms. Yellen may not be pulling very hard at her end of the tug-of-war rope, ECB President Draghi may be deliberately loosening his grip at the other, repeatedly signaling further monetary-policy easing (probably including a cut in the deposit rate). The result could be a further significant appreciation of the U.S. dollar as the rope moves.
For a European-based investor, investing into more stable U.S. assets may therefore become increasingly attractive, as they could offer the potential for augmenting already decent returns with currency gains. Of course, yields may rise as the Fed hikes rates. But we believe that the rise in U.S.-Treasury yields will be contained and that currency and carry will continue to provide an attractive cushion.
For U.S. investors staying in their home market the story is less straightforward. While from a risk-return perspective U.S. investment-grade seems more attractive than U.S. high-yield debt, this view is very much dependent on assumptions about future U.S. high-yield default rates. The 5.5% rate currently expected by the market implies a sharp increase in energy-sector defaults. U.S. investors venturing into the European fixed-income markets may want to consider currency-hedging their investments, if they share our belief that the U.S. dollar is likely to strengthen further. Moreover, U.S. investment-grade debt overall already offers a higher return than euro investment-grade, although there are some interesting pockets in the latter – for example in European corporate hybrids. Euro high-yield debt may also continue to appeal. A diversification across those assets looks the most promising way of going into 2016.
A strong U.S. dollar can affect fixed-income markets in other ways. For example, the headwinds it creates for commodity prices could hurt many emerging-market issuers too. The recent improvement in sentiment on emerging-market debt is just that – sentiment. It is not supported by a real turnaround in emerging-market economic or corporate fundamentals . So we would stay neutral on emerging markets for now.
Spreads on U.S. investment-grade non-financial debt remain markedly higher than for equivalent euro debt. The gap is wider than it was for most of 2014.