INVESTMENT INVESTMENT INSIGHTS INSIGHTS
FI X EDFOLIO INCOME PORT DISCUSSION
Rising rates: Preparing for the next cycle
October 2014
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IN BRIEF • In an environment of diminishing global slack, some central bank interest rates, in particular the Federal Reserve’s, are set to rise next year from historically low levels. We believe that the rise will be gradual, and that rates will peak at lower levels than in prior cycles. • Unlike in past cycles, the Fed confronts no substantial threat of inflation. Lingering labor market slack and caution over choking off the recovery mean rates are set to rise slowly, while lower trend growth means that they can peak at lower levels. • Wage growth in excess of productivity growth presents the central upside risk to our forecast, while persistently weak global growth is the main downside risk. • By the end of 2014, we see fair value in the 10-year U.S. Treasury at close to 3%. Longer term, we envision the yield rising to around 3.5%, not far above the forward curve.
AUTHORS
• Managing a fixed income portfolio in a rising rate environment will demand particular attention to individual security selection, correlation and risk control. In investment grade corporate credit, we are closely watching the dynamics of investor demand. In high yield, our portfolios reflect a constructive view of credit fundamentals. In emerging market debt (EMD), we favor high yield credit while in the mortgage-backed securities (MBS) sector we focus on mortgages that exhibit better convexity than newer issues.
After years of unprecedented monetary stimulus, central banks are edging towards increasing interest rates from their current historically low levels. David Tan Head of Global Rates J.P. Morgan Asset Management
Seamus Mac Gorain, CFA Portfolio Manager, Global Rates J.P. Morgan Asset Management
The Federal Reserve is set to announce the end of its asset purchases in October. We expect that around the middle of next year, the Fed will increase its policy rate for the first time in almost a decade. The Bank of England is likely to start tightening around the same time, or earlier. These rate increases are the natural consequence of the economic healing that has occurred slowly but surely since the global financial crisis. Even so, global monetary policy will not move in a single direction. We believe that Fed tightening will be somewhat offset by continued easing from the European Central Bank (ECB) and the Bank of Japan. The Fed’s balance sheet will remain elevated for at least the beginning of the rate tightening process. Global central banks’ foreign exchange reserve accumulation remains on an upward path. Together, these three factors will ensure that central banks will continue to provide substantial support to bond markets. This projection underlies our relatively benign view of the bond market cycle.
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This paper presents our outlook for the coming rate environment. We consider why, when, how and at what pace rates will rise. We then analyze how different fixed income sectors are likely to respond to rising rates, and explore how investors can best position and manage their fixed income portfolios in this challenging new terrain.
A health check on the global economy If we trace the beginning of the global financial crisis to around the middle of 2007, we have just entered the eighth year of post-crisis adjustment. It may not feel that way, nor has it happened in a straight line, but economies have made important strides towards recovery. One of the defining characteristics of the post-crisis economic environment has been very significant economic slack across developed markets, seen most clearly in unusually high unemployment rates (Exhibit 1). That excess capacity has in turn kept inflationary pressures, including wages, in check. Still, the ongoing recovery has eroded economic slack, bit by bit, especially in the U.S. and UK. There remains a lively debate about how best to measure spare capacity. For example, the Fed argues that any assessment of the health of the labor market must consider not only the rapidly declining unemployment rate, but also the large number of part-time employees who wish to work full time, as
well as “discouraged” workers who would return to the labor force if economic conditions improved. But however slack is measured, there can be little doubt that these economies are now operating much closer to full capacity, which is why their central banks can begin to contemplate a start to normalizing their policy rates. The labor market healing in the U.S. and UK represents part of a wider theme of economic divergence. We expect the U.S. and UK to grow above trend over the balance of the year, but growth in the euro area, Japan and the emerging markets (EM) is likely to come in below trend. That divergence is also playing out in inflationary pressures. For example, in the U.S. our models see some incipient price pressures, in particular from the housing sector (Exhibit 2). Our models forecast that pipeline price pressures, in particular from the housing sector, will cause a continued rise in inflation EXHIBIT 2: CORE CPI MODEL 3.0
Fitted*
Actual
Forecast
2.5 2.0 Percent
INVESTMENT INSIGHTS
1.5 1.0 0.5 0.0 08
The post-crisis environment has been defined by significant economic slack across developed markets EXHIBIT 1: LABOR MARKET OUTPUT GAP: WEIGHTED AVERAGE OF MOST OECD COUNTRIES
09
10
11
12
13
14
15
Source: J.P. Morgan Asset Management; data as of July 23, 2014. *”Fitted” represents J.P. Morgan Asset Management’s proprietary model for calculating core CPI.
1.0
But even this is somewhat offset by the lack of upward pressure from food and energy prices. Thus, while we do expect inflation to increase, we do not believe the Fed will have an inflation dragon to slay in this rising rate cycle. Meanwhile, in the eurozone, although inflation has likely troughed for now at just above zero, it appears set to remain well below the ECB’s 2% target for many years to come.
0.5
Percent
0.0 -0.5 -1.0 -1.5 -2.0 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14*
Source: J.P. Morgan Asset Management, OECD; data as of June 10, 2014. *2014 figure is a forecast.
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Negative real rates will persist for a record period of time EXHIBIT 3: REAL FED FUNDS RATE, DEFLATED BY CORE PCE* 12
Negative FF periods (months)
10 8
35
7 2
1
Real FFs (IMF effective less core PCE)
1
101
27
Average RFFs
Percent
6 4 2 0 -2 -4 1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
Source: J.P. Morgan Asset Management, Bloomberg, Bureau of Economic Analysis; data as of June 10, 2014. *PCE: The inflation rate of personal consumer expenditures.
The pace of U.S. rate hikes: slow and steady Our central expectation is that the Fed will start hiking rates in the middle of next year, and then continue at a gradual pace. We expect the cycle to pause for a time at a level of around 2% or 2.5%, though we do expect rates to reach a more normal level of 3.5% or higher in the longer term. At that pace, and assuming that inflation remains below the Fed’s 2% objective, the real fed funds rate would not return to zero until 2016, after almost a decade of negative real rates (Exhibit 3). This slow and steady cycle would be quite different from past Fed tightening cycles. As Exhibit 4 illustrates, in the past the Fed has increased rates much more quickly and indeed to higher levels.
Historically, FOMC tightening cycles have been steeper than the Fed’s current projections EXHIBIT 4: CHANGE IN FED FUNDS TARGET RATE
Traditional Taylor Rule
3.5 3.0
Jun-99 2015?*
Percent
2.0 1.5
2.5
Market curve
2.0 1.5 1.0 0.5
1.0
0.0
0.5
Source: Bloomberg, Federal Reserve; data as of September 17, 2014.
Oct-16
Dec-16
Jun-16
Aug-16
Apr-16
Feb-16
Oct-15
Dec-15
Jun-15
Aug-15
Apr-15
t+18
Feb-15
t+15
Oct-14
t+12
Dec-14
t+9
Jun-14
t+6
Aug-14
t+3
Apr-14
t
Dec-13
-0.5 Feb-14
Months
EXHIBIT 5: PROJECTED FED FUNDS RATE
Jun-04
2.5
0.0
The Taylor Rule shows how rates “should” rise, based on inflation and how far unemployment is from its equilibrium level
4.0
Feb-94
3.0
We think there are several reasons why U.S. rates will rise slowly. First, as discussed earlier, the unemployment rate somewhat overstates the health of the labor market. The Fed will be looking for an improvement in other labor market metrics, in particular faster wage growth, before pulling the trigger on rate hikes. Second, we believe that the Fed will judge the risks of mistakenly tightening slightly too early to be
4.5
Mar-88
3.5
Meanwhile, Exhibit 5 shows how rates “should” rise based on a traditional Taylor rule, in which the drivers of the rate decision are inflation, and how far unemployment is from its “normal,” or equilibrium, level. With the unemployment rate at 6.1%, only a little above its normal rate of around 5.5%, why shouldn’t the fed funds rate rise quickly in line with such traditional economic models?
Source: J.P. Morgan Asset Management, Bloomberg, Federal Reserve; data as of September 25, 2014.
*2015 line shows the second quartile of the Federal Open Market Committee’s latest projections on the path of the fed funds rate. J.P. Morgan Asset Management | 3
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4.0 3.5
10
3.0
8
2.5
6
2.0
4
1.5
2 0
1.0
-2
0.5
-4
0.0
Dec-74 Nov-76 Oct-78 Sep-80 Aug-82 Jul-84 Jun-86 May-88 Apr-90 Mar-92 Feb-94 Jan-96 Dec-97 Nov-99 Oct-01 Sep-03 Aug-05 Jul-07 Jun-09 May-11 Apr-13
Equipment investment (%)
12
Productivity (%)
Productivity (five-year lag)
Source: Bureau of Economic Analysis, Bureau of Labor Statistics; data as of June 10, 2014.
Another impediment to growth, frequently cited by the Fed, is that neither the government nor the private sector has completed the delevering cycle triggered by the financial crisis. A continued pressure to delever will depress demand for several years to come. A further reason for lower policy rates is tighter bank lending conditions, which means that for a given central bank policy
4 | Rising rates: Preparing for the next cycle
4.0 U.S.
3.5
UK
Eurozone
3.0 2.5 2.0 1.5 1.0 0.5
Dec-13
Dec-11
Dec-12
Dec-10
Dec-09
Dec-07
Dec-08
Dec-05
Dec-06
Dec-03
Dec-04
Dec-01
Dec-02
Dec-99
Dec-00
Dec-97
Dec-98
Dec-95
0.0
Source: Bank of England, European Central Bank, Federal Reserve; data as of June 10, 2014.
EXHIBIT 6: INVESTMENT AND PRODUCTIVITY GROWTH, FIVE-YEAR MOVING AVERAGE Equipment investment
EXHIBIT 7: BANK SPREADS ON NEW BUSINESS LENDING
Dec-96
Weak post-crisis investment may act as a near-term drag on productivity growth, but a recent rebound is encouraging
14
Bank credit is likely to remain persistently tighter than it was before the financial crisis
Dec-93
Further, there are a number of reasons to think that even once the Fed starts hiking, short-term rates will remain materially lower in this hiking cycle than they have been in the past. Most of these reasons essentially reflect lower potential economic growth, which would be expected to be associated with lower interest rates, and most of them apply not just in the U.S. but internationally. One important factor is a slowdown in labor supply growth, which partly results from the increasing retirement of baby boomers. Another is slowing productivity growth. This has been a medium-term trend, but it also has a cyclical element, in that productivity growth tends to be lower after a period of weak investment. The sharp fall in investment in the aftermath of the financial crisis is now contributing to weaker productivity growth, although a recent rebound is encouraging (Exhibit 6).
rate, the lending rates paid by firms and households are higher. To be sure, credit conditions have eased significantly in the past few years. But bank credit is likely to remain persistently tighter than it was before the financial crisis, reflecting both an appreciation that credit risk was underpriced in those years as well as more-stringent bank regulation (Exhibit 7).
Dec-94
greater than those of mistakenly tightening slightly too late. That is chiefly because, if early rate hikes were to choke off the recovery when the fed funds rate was still low, the Fed would have limited room to stimulate the economy.
Percent
INVESTMENT INSIGHTS
Where might we be wrong? Our outlook—that the fed funds target will rise slowly, and to a lower level than in the past—is rather benign. Where might it be too sanguine? One significant consideration is whether the labor market will continue to strengthen at the very brisk pace seen this year. We are mindful that once labor markets start improving strongly, it is normal for the unemployment rate to continue to fall by more than economists’ expectations for the rest of the expansion. The past few years have conformed to this historical pattern, as shown in Exhibit 8 (next page). On a related front, wage growth could rise to outstrip productivity growth significantly. As the labor market deteriorated during the recession, it was somewhat surprising that wage growth did not slow more sharply as unemployment rose (Exhibit 9, next page). The fall in unemployment in the past few years has seen wage growth pick up, albeit to a level that is still quite low. We will be monitoring wage growth closely. Because wages are among the best indicators of the underlying trend in inflation, the Fed would be forced to respond to a material pickup in this area.
Once labor markets start improving strongly, the unemployment rate often falls by more than economists’ expectations for the rest of the expansion
makes the task of controlling money market rates once the Fed starts hiking more challenging than in the past.
EXHIBIT 8: SURPRISES TO UNEMPLOYMENT RATE FORECASTS, ONE YEAR AHEAD
The main risk of lower yields comes from weaker global growth, triggered by China and the eurozone. China is seeking to smooth its transition to structurally lower growth, against the backdrop of a weakening housing market, while the eurozone is struggling to break out of the cycle of disinflation triggered by the euro area sovereign debt crisis. Even though the U.S. is a relatively closed economy, and so is less dependent on external demand than other major economies, weak global growth could stay the Fed’s hand for a time.
5 4
Worse than expected
Percent
3 2 1 0 -1 Better than expected
-3
Dec-75 Jun-77 Dec-78 Jun-80 Dec-81 Jun-83 Dec-84 Jun-86 Dec-87 Jun-89 Dec-90 Jun-92 Dec-93 Jun-95 Dec-96 Jun-98 Dec-99 Jun-01 Dec-02 Jun-04 Dec-05 Jun-07 Dec-08 Jun-10 Dec-11 Jun-13
-2
Source: J.P. Morgan Asset Management, Bloomberg, Philadelphia Fed; data as of September 25, 2014.
As the labor market deteriorated during the past recession, it was somewhat surprising that wage growth did not slow more sharply as unemployment rose EXHIBIT 9: WAGE PHILLIPS CURVE: WAGE GROWTH* AS A FUNCTION OF THE UNEMPLOYMENT GAP IN THE PAST THREE RECESSIONS 5.0
All
1990
2001
Now
What does this prospect of gradually rising short rates mean for longer-term bond yields? We expect that yields will rise, but modestly, and by only a little more than implied by the forward curve. We see 10-year U.S. Treasury yields approaching 3% by the end of this year before rising to 3.5% longer term. This view follows on from our expectation of a slow and steady Fed tightening cycle. Without a strong upward trend to yields (relative to the forward curve), we believe that duration trading needs to be relatively tactical. We are also conscious that in past Fed tightening cycles bearish positions have not tended to prove strongly profitable until shortly before the time of the first hike, whereas curve-flattening positions have been more consistently profitable than outright short duration positions (Exhibit 10).
4.5 4.0 Wage growth (%)*
The outlook for long-term interest rates
3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 -2
-1
0
1 2 Unemployment gap (%)**
3
4
5
Source: J.P. Morgan Asset Management, Bureau of Economic Analysis, Bureau of Labor Statistics; data as of August 1, 2014. *Wage growth: year-over-year change in average hourly earnings for production and non-supervisory workers.
In past tightening cycles, bearish positions have not tended to prove strongly profitable until shortly before the time of the first rate hike EXHIBIT 10: SHORT POSITION RETURN, NET OF CARRY: PERCENTAGE POINTS OF YIELD, CENTERED AROUND THE DATE OF THE FIRST RATE HIKE 1.5
**Unemployment gap: the difference between the level of unemployment that does not cause inflation to increase and the actual unemployment rate.
5s
10s
30s
1.0
Percent
0.5 0.0 -0.5 -1.0 -260 -238 -216 -194 -172 -150 -128 -106 -84 -62 -40 -18 4 26 48 70 92 114 136 158 180 202 224 246
We are also mindful that the enormous size of the Fed’s balance sheet—now $4.5 trillion and counting—poses new challenges. For example, the Fed intends to maintain the size of its balance sheet until after it begins hiking rates. Its bond holdings will continue to exert some easing influence on the economy, but to a degree that is hard to calibrate with any great precision. The counterpart to these bond holdings is the presence of $2.5 trillion of bank reserves in the money market, which
2s
Business days
Source: J.P. Morgan Asset Management, Bloomberg; data as of June 10, 2014. J.P. Morgan Asset Management | 5
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Though we certainly do not expect the coming tightening cycle to exactly repeat historical experience, it is useful to remember that in the past it has paid to wait to see the whites of the Fed’s eyes before positioning for much higher yields.
We are closely watching market technicals, including the dynamics of investor demand. Mutual fund inflows into investment grade corporate debt have been substantial, as retail investors have searched for higher returns in a low rate environment. As a rate rise negatively impacts total return, some retail assets might exit in search of greater return elsewhere. In this case, spreads would widen and market technicals would deteriorate.
How might different fixed income sectors respond to rising rates, and how can investors best position their fixed income portfolios in this challenging new terrain? In the following section, we spotlight four sectors: Investment grade corporate credit, high yield and bank loans, emerging market debt and mortgages. Throughout, we assume that our base case scenario will prevail: rates will rise gradually and peak at lower levels than in prior cycles.
Institutional demand should provide a source of stability for long-maturity corporate bonds. We expect incremental buying from pension funds and insurance companies that are focused on meeting their liabilities and likely to find the higher all-in yields attractive. The short end of the curve has received considerable interest from retail and institutional buyers, and is likely to be supported until the yield on cash becomes a more attractive alternative. However, the belly of the curve, which has benefited from significant mutual fund flows, is expected to be more vulnerable.
Investment grade corporate credit When Treasury rates have risen in past cycles, investment grade credit spreads have exhibited a range of responses— sometimes spreads have widened, and sometimes they’ve contracted, depending on the macroeconomic environment at the time. For example, spreads widened during the 1994 period of Fed tightening; in 1999 spreads widened but eventually tightened in the face of higher rates; and during the 2004 period, spreads tightened (Exhibit 11). Although we can’t reliably predict how spreads will move in the next rising rate cycle, we do know that this period will have its own distinctive characteristics, largely because the cycle will begin at a very low level of interest rates.
As we position our portfolios, we are closely tracking market technicals and fund flows. As rates rise and investor sentiment changes, we look to stay nimble and uncover new pockets of opportunities. — Lisa Coleman, CFA Head of Global Investment Grade Corporate Credit
In past rising rate cycles, credit spreads have sometimes widened and sometimes contracted EXHIBIT 11: CREDIT SPREAD MOVEMENT DURING CENTRAL BANK POLICY SHIFTS Periods of Fed tightening
Recession
IG OAS (rhs)
10-yr Treasury yield
Fed Funds target rate
IG OAS (basis points)
300
12 10
250
8
200 6 150 4
100
2
50 0 Dec-85
Dec-87
Dec-89
Dec-91
Dec-93
Dec-95
Dec-97
Dec-99
Dec-01
Dec-03
Dec-05
Dec-07
Source: Barclays, Bloomberg, Moody’s, NBER; data as of May 20, 2014. *IG option-adjusted spread (OAS) represents Barclays U.S. Corporate index back to June 1989 and Moody’s BBB OAS data pre-1989.
6 | Rising rates: Preparing for the next cycle
Dec-09
Dec-11
Dec-13
0
Percent
350
High yield/bank loans
Emerging market debt
As floating rate instruments, bank loans can offset interest rate risk and mitigate the price volatility inherent in a fixed income allocation. In a rising rate environment, these attributes become increasingly valuable.
A sudden move in U.S. Treasuries could spark a sell-off in emerging market debt. But as we anticipate a gradual rise in interest rates, we expect that EMD will continue to perform well, attracting solid demand among investors. Emerging market debt will remain an important source of yield, income and diversification for fixed income investors.
Since 1994, when bank loans began to be widely syndicated, they have solidly outperformed investment grade credit in the three major periods of rising rates: Loans (%) February 1994–February 1995
10.39
Bonds (%) 0.01
June 1999–May 2000
3.93
2.11
June 2004–June 2006
12.66
6.55
We expect loans to perform well in the next rising rate environment, as investors look for protection from the effects of Fed rate hikes. With the interest rate floors on bank loans averaging 90 bps over Libor, it would take three 25 bps increases in Libor for rates to move through the floor, causing coupons to reset. Still, we would expect demand for the asset class to offset any potential negative price move. In the high yield sector, we anticipate that moderate spread tightening will partially offset the move higher in rates. It is likely that high yield bonds will see some price decline as interest rates rise, although rate increases will generally occur in an environment of improving economic fundamentals and growth prospects. Our near-term outlook calls for a continued low default rate for high yield bonds. We are positioning our portfolios to reflect our constructive view of credit fundamentals by being overweight B rated bonds, allocating sufficiently to floating rate bank loans where appropriate, and ensuring that we are adequately compensated for credit risk. In our high yield bond strategy, we are maintaining a roughly neutral duration to the index of about four years, while holding an 8% allocation to senior loans.
EMD is made up of several sub-sectors that may perform quite differently in a rising rate environment: hard currency sovereign, hard currency corporate and local currency sovereign, where the impacts of both rate and foreign currency moves come into play. Historically, many investors have viewed local currency debt as more resilient to rising rates, but in recent years local rates and U.S. rates have become more closely correlated. One sector that has continued to outperform is EM high yield (both sovereign and corporate), as the large spread cushion offers some insulation from rising rates. As Exhibit 12 (next page) illustrates, EM high yield debt has repeatedly outperformed EM investment grade debt during recent periods of rising rates. As the universal benefit of historically low interest rates disappears, investors will need to be more discerning in evaluating shifting correlations between individual EMD sub-sectors and U.S. rates. Country differentiation will also be very important. Countries with high external deficits, such as Turkey and South Africa, are more vulnerable, as rising rates drive up the cost of financing their deficits. In anticipation of rising rates, we would favor a mix of high yield credit with lower correlation to U.S. rates as well as countries with solid external balances. In addition, we would use futures to actively manage our duration exposure. — Pierre-Yves Bareau Head of Emerging Markets Debt
As always, research is critical, because not all issues are created equal. Across most asset classes this truism applies, but it has special relevance to issues from highly levered firms, including bank loans. Fundamental analysis offers the surest means not only of minimizing credit risk but optimizing the benefit of overall asset diversification. — Jim Shanahan Co-Head of High Yield/Loans/Distressed Debt
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Emerging market high yield debt has repeatedly outperformed EM investment grade debt during recent periods of rising rates EXHIBIT 12: EMERGING MARKET SOVEREIGN SPREADS AND TREASURY RATES EM sovereign spreads—IG
900
EM sovereign spreads—HY
800 700 Basis points
600 500
HY: 13.8% IG: 6.5%
400 300
380 bps additional “spread cushion”
HY: -9.3% IG: -12.6%
HY: 11.8% IG: 1.6%
HY: -2.9% IG: -4.6%
200 100 Jan-10
Apr-10
Jul-10
Oct-10
Jan-11
Apr-11
Jul-11
Oct-11
Jan-12
Apr-12
Jul-12
Oct-12
Jan-13
Apr-13
Jul-13
Oct-13
Jan-14
Apr-14
Jul-14
3.9
Percent
3.4
U.S. 10-year Treasury yield
2.9 2.4 1.9 1.4 Jan-10
Apr-10
Jul-10
Oct-10
Jan-11
Apr-11
Jul-11
Oct-11
Jan-12
Apr-12
Jul-12
Oct-12
Jan-13
Apr-13
Jul-13
Oct-13
Jan-14
Apr-14
Jul-14
Source: J.P. Morgan; data as of July 31, 2014. EM sovereign spreads are the JPMorgan EMBI Global Index spreads. Shaded areas are periods of rising rates. Figures in boxes are returns for HY and IG indexes during the rising rate periods.
Mortgages In constructing and managing a mortgage portfolio, we aim to add each holding at a level that is attractive relative to its intrinsic value. Part of that process involves choosing mortgage bonds that position us well for the eventual renormalization of interest rates. We seek out mortgages that exhibit better convexity than newer issues. Better convexity leads to average life and duration stability as interest rates change. Newer issues, which are a significant percentage of the Barclays MBS index, have higher levels of negative convexity, making them particularly sensitive to interest rate movement. With volatility near historical lows, investors are receiving less compensation for owning negative convexity. In a bear bond market, these bonds should extend at an increasing rate, damaging investor returns. Agency CMO floaters backed by specific collateral, such as high loan-to-value (LTV) loans, can potentially offer a yield advantage over short agency debentures while protecting the portfolio from rising interest rates. These securities reset periodically, typically to Libor plus a discount margin. High LTV loans, made through a government-sponsored program to
8 | Rising rates: Preparing for the next cycle
homeowners who were under water at the time of mortgage origination, are agency-backed and provide longer cash flows. They tend to be less rate-sensitive than to-be-announced (TBA) mortgage-backed securities. Higher coupons and well-seasoned collateral may allow investors to minimize extension risk. While this collateral is “in the money” (meaning homeowners have the financial incentive to refinance), there are clues in the collateral to help project the speed at which that may happen. Agency interest-only (IO) mortgages can be a natural fit for higher rates, as they offer negative duration and generally benefit from slower prepayment speeds. Pricing is largely a function of volatility and projected speeds, with low volatility and slower projected speeds defining a near-optimal scenario for IO mortgage values. Currently, we don’t see value beyond what investors have priced into this sub-sector of the mortgage market. — Doug Swanson U.S. CIO, Value Driven
Conclusion: Preparation as normalization nears The Fed has started to prepare the markets for a renormalization of interest rates, and we have spent a good deal of time thinking about how best to position portfolios during the next rate hiking cycle. After about seven years of zero interest rate policy and a substantial expansion of the Fed’s balance sheet, it would be somewhat dismissive to expect an entirely smooth Fed exit. Some market turbulence should be anticipated. However, there are strong reasons not to panic either. Policy rates will be raised because slack is diminishing and continued economic growth looks sustainable. Although government bond yields are set to head higher, they will not rise to such an extent as to wreck the recovery. Furthermore, in the absence of pernicious inflation, self-correcting mechanisms will keep yields on 10-year Treasuries not far from what is already priced in the forward interest rate market. These mechanisms include some slowdown in the interest rate-sensitive sectors of the economy, a Fed that will keep real interest rates negative to low for a while and an ample supply of liquidity provided by global central banks. In this environment, the broader-based sectors of fixed income markets can and will continue to look attractive, as long as one is selective as across-the-board spread compression abates, and gains are increasingly driven by investors’ ability to recognize and select value in specific segments of the fixed income markets.
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NOT FOR RETAIL DISTRIBUTION: This communication has been prepared exclusively for Institutional/Wholesale Investors as well as Professional Clients as defined by local laws and regulation. The opinions, estimates, forecasts, and statements of financial markets expressed are those held by J.P. Morgan Asset Management at the time of going to print and are subject to change. Reliance upon information in this material is at the sole discretion of the recipient. Any research in this document has been obtained and may have been acted upon by J.P. Morgan Asset Management for its own purpose. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as advice or a recommendation relating to the buying or selling of investments. Furthermore, this material does not contain sufficient information to support an investment decision and the recipient should ensure that all relevant information is obtained before making any investment. Forecasts contained herein are for illustrative purposes, may be based upon proprietary research and are developed through analysis of historical public data. J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. This communication may be issued by the following entities: in the United Kingdom by JPMorgan Asset Management (UK) Limited; in other EU jurisdictions by JPMorgan Asset Management (Europe) S.à r.l.; in Switzerland by J.P. Morgan (Suisse) SA; in Hong Kong by JF Asset Management Limited, or JPMorgan Funds (Asia) Limited, or JPMorgan Asset Management Real Assets (Asia) Limited; in India by JPMorgan Asset Management India Private Limited; in Singapore by JPMorgan Asset Management (Singapore) Limited, or JPMorgan Asset Management Real Assets (Singapore) Pte Ltd; in Australia by JPMorgan Asset Management (Australia) Limited; ; in Taiwan by JPMorgan Asset Management (Taiwan) Limited and JPMorgan Funds (Taiwan) Limited; in Brazil by Banco J.P. Morgan S.A.; in Canada by JPMorgan Asset Management (Canada) Inc., and in the United States by J.P. Morgan Investment Management Inc., JPMorgan Distribution Services Inc., and J.P. Morgan Institutional Investments, Inc. member FINRA/SIPC. 270 Park Avenue, New York, NY 10017 © 2014 JPMorgan Chase & Co. | II_Rising rates: Preparing for the next cycle
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