The Outlook for Bonds
For a view of interest rates and the bond market, the Business Journal has excerpted from a fourth-quarter outlook published by influential bond fund manager Pacific Investment Management Co. in Newport Beach:
Pimco is optimistic about the cyclical outlook, forecasting an upturn in the U.S. over the next six to 12 months with a positive spillover effect into global demand.
This revival will, however, either exacerbate or fail to redress secular imbalances such as the U.S. current account deficit, structural rigidities in Europe and huge public sector debt in Japan.
We are pessimistic that the upturn will be sustained beyond a cyclical time frame because confronting these imbalances will constrain growth.
Weak labor markets, low capacity utilization and rapid productivity growth will keep inflation tame over the next year. With inflation under control, interest rates will fluctuate near current levels, with the 10-year Treasury yield hovering close to 4%.
There will be volatility around economic releases, however, as markets reassess prospects for growth.
Key elements of Pimco’s forecast are:
n Disposable personal income will get a boost from federal tax cuts and the lagged impact of the mortgage refinancing boom. The Federal Reserve will support recovery by keeping the federal funds rate at 1% for at least the next year.
n Recent strength in riskier asset classes will bolster confidence among investors and make corporate balance sheet repair, already well advanced, easier to accomplish. It remains unclear, however, whether corporate risk appetites will revive enough to fuel the rebound in capital spending and hiring that is critical for sustained growth.
n Growth prospects are improved in Europe, helped by the U.S. recovery and tax cuts in Germany. Growth will remain below potential, however, held back by rigid product and labor markets. Stronger external demand is sparking a recovery in Japan, especially among globally competitive Japanese corporations. A rally in Japanese stocks has bolstered the balance sheets of Japan’s troubled banks.
n China, struggling to employ workers leaving farms and troubled state-owned firms, will continue its export-driven economic policy. To keep its exports competitive, China will help fund the U.S. trade deficit on favorable terms and resist a currency revaluation. Over the longer run, however, China will allow its own consumers to gain from a stronger currency, implying a weaker dollar and eventual upward pressure on U.S. interest rates.
Bond Investing
With no clear trend expected in rates in the near term, we will target near-index duration. However, we will take exposure to the short end of the U.S. and European yield curves as markets price in more restrictive central bank policies than we foresee.
A steep yield curve presents the opportunity to reap gains via “roll down,” or price appreciation that arises as bonds are revalued at successively lower yields as they approach maturity.
Another way to exploit the steep curve is to buy bonds with longer settlement periods and invest cash backing the unsettled issues in short-term debt with relatively high yields.
Mortgage-backed bonds are fairly priced, so we will target a near-index weighting. We will remain underweight in corporates, because they generally pay slim yield premiums for credit risk.
Outside these core strategies, however, real return, municipal and emerging market bonds remain compelling.
Treasury inflation-protected bonds (TIPs) offer attractive yields relative to long-run averages and hedge against secular inflation risk. Municipal issues provide yields near those of taxable debt and are less vulnerable to selling from non-U.S. investors than Treasuries.
High-quality emerging market bonds also enhance portfolio yield and will benefit from a pickup in growth in developed economies in the near term.
,Pacific Investment Management Co.
