Government Bonds: Caution Ahead

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Includes: BIL, BNDX, BWX, DFVL, DFVS, DLBL, DLBS, DTUL, DTUS, DTYL, DTYS, EDV, EGF, FIBR, FIXD, FTT, GBIL, GIM, GOVT, GSY, HYDD, IEF, IEI, IGOV, ITE, PLW, PST, RISE, SCHO, SCHR, SGQI, SHV, SHY, SPTL, SPTS, TAPR, TBF, TBT, TBX, TBZ, TLH, TLT, TMF, TMV, TTT, TUZ, TYBS, TYD, TYNS, TYO, UBT, UST, VGIT, VGLT, VGSH, VUSTX, ZROZ
by: Richard Turnill

Key points

  • We see Federal Reserve rate rise expectations returning as a market driver, justifying our cautious view of government debt.
  • Global stocks rallied, after the first round of the French election reduced perceived political risk and earnings news was upbeat.
  • We expect U.S. jobs growth to bounce back in April following moderately weaker growth in March due partly to bad weather.

Geopolitical forces suppressing global government bond yields have somewhat dissipated after the French first-round vote. We see Fed rate rise expectations returning as a bond market driver, justifying a cautious stance on sovereign debt.

Fed interest rate rises implied by markets, 2017

Sources: BlackRock Investment Institute and J.P. Morgan, April 2017.
Notes: The chart shows the number of additional quarter percentage point increases the Federal Reserve (Fed) will make by the end of 2017, as implied by overnight indexed swaps (OIS). The "dot plot" shows the path of interest rates expected by the median Federal Open Market Committee member.

The business-friendly Emmanuel Macron's clear first-round presidential election win reduced near-term European political risk. Markets are now pricing in nearly 1.5 additional quarter-percentage-point rate increases this year, but we think they still underestimate the Fed's resolve to tighten policy.

Focus returns to the Fed

The Fed has made clear it views the U.S. economy as nearing the central bank's employment and inflation goals and accordingly plans to stay on a gradual normalization path. We expect global government bond yields to rise - and prices to fall - as market expectations catch up to our base case of two more Fed rate increases this year.

Strong demand for income and still-accommodative central bank policies in much of the world should help keep rises in yields moderate, in our view. We do expect to see a steepening of the yield curve over time, with very long term yields in particular set to rise as we move from a period of accelerating growth to a new phase of sustained economic expansion.

We see yields on bonds with durations of five years or less as vulnerable in the near term to any jumps in Fed tightening expectations, and we are underweight U.S. Treasuries and European sovereign bonds. Bullish sentiment following the French vote sparked the selling of safe-haven assets. Rising European growth and inflation, and the prospect of a less supportive European Central Bank (ECB), may help push European and global yields higher. We expect the Bank of Japan (BoJ) to stay on hold until we see meaningful Japanese growth and inflation.

  • Global stocks rallied, following Macron's win in the first round of the French presidential election and consensus-beating U.S. and European earnings. The MSCI ACWI hit an all-time high.
  • U.S. Treasury yields rose, as demand for safe havens fell. Yen weakness versus the U.S. dollar (USD) buoyed Japanese stocks. Both the BoJ and ECB maintained their monetary stimulus policies.
  • The White House tax plan included deep cuts to corporate tax rates but lacked key details. The U.S. economy grew at a slower-than-expected pace last quarter, but business spending rebounded.

Global snapshot

Weekly and 12-month performance of selected assets

Equities Week YTD 12 Months Div. Yield
U.S. Large Caps 1.5% 6.5% 14.9% 2.0%
U.S. Small Caps 1.5% 3.6% 24.6% 1.3%
Non-U.S. World 2.5% 10.2% 12.3% 3.1%
Non-U.S. Developed 3.1% 10.0% 11.0% 3.3%
Japan 0.6% 5.6% 12.1% 2.2%
Emerging 1.7% 13.9% 18.6% 2.7%
Asia ex-Japan 2.0% 15.9% 20.2% 2.5%

Bonds Week YTD 12 Months Yield
U.S. Treasuries -0.3% 1.4% -0.5% 2.3%
U.S. TIPS 0.3% 1.9% 2.0% 2.1%
U.S. Investment Grade -0.1% 2.3% 3.2% 3.2%
U.S. High Yield 0.7% 3.9% 13.3% 5.6%
U.S. Municipals -0.4% 2.3% 0.2% 2.4%
Non-U.S. Developed 0.2% 3.9% -3.5% 0.7%
Emerging Market $ Bonds 0.2% 5.2% 8.5% 5.3%

Commodities Week YTD 12 Months Level
Brent Crude Oil -0.4% -9.0% 7.5% $51.73
Gold -1.3% 10.5% 0.2% $1,268
Copper 2.0% 3.6% 16.1% $5,736

Currencies Week YTD 12 Months Level
Euro/USD 1.6% 3.6% -4.0% 1.09
USD/Yen 2.2% -4.7% 3.1% 111.49
Pound/USD 1.0% 5.0% -11.3% 1.30

Source: Bloomberg. As of April 28,2017.
Notes: Weekly data through Friday. Equity and bond performance are measured in total index returns in U.S. dollars. U.S. large caps are represented by the S&P 500 Index; U.S. small caps are represented by the Russell 2000 Index; Non-U.S. world equity by the MSCI ACWI ex U.S.; non-U.S. developed equity by the MSCI EAFE Index; Japan, Emerging and Asia ex-Japan by their respective MSCI Indexes; U.S. Treasuries by the Bloomberg Barclays U.S. Treasury Index; U.S. TIPS by the U.S. Treasury Inflation Notes Total Return Index; U.S. investment grade by the Bloomberg Barclays U.S. Corporate Index; U.S. high yield by the Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Capped Index; U.S. municipals by the Bloomberg Barclays Municipal Bond Index; non-U.S. developed bonds by the Bloomberg Barclays Global Aggregate ex USD; and emerging market $ bonds by the JP Morgan EMBI Global Diversified Index. Brent crude oil prices are in U.S. dollars per barrel, gold prices are in U.S. dollar per troy ounce and copper prices are in U.S. dollar per metric ton. The Euro/USD level is represented by U.S. dollar per euro, USD/JPY by yen per U.S. dollar and Pound/USD by U.S. dollar per pound. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. Past performance is not indicative of future results.

Asset class views

Views from a U.S. dollar perspective over a three-month horizon

This post originally appeared on the BlackRock Blog.

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