Rising Rates: Creating Opportunities?

Around the Curve

Rising Rates: Creating Opportunities?

Investors responded to average hourly earnings surprising to the upside by taking yields higher. But at this juncture we believe recessionary fears are overblown.


Yields on 10- and 30-year Treasuries have climbed roughly 50 and 40 basis points (bps), respectively, since mid-December 2017. Investors responded to average hourly earnings surprising to the upside by taking yields higher; the concern is that the U.S. economy is on the verge of overheating, and the Federal Reserve (Fed) will need to hike interest rates more aggressively than initially projected in the middle of 2018. The 10- and 30-year Treasury yield charts below highlight how rapid the recent rise has been; the March 21 Fed meeting had little effect on their trajectory. At this juncture we believe recessionary fears are overblown (see Chart 1)
 

Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

While yields have risen rapidly in the U.S., investors need to consider whether the yield spike is an anomaly and where there are now opportunities.
 

A Look at Inflation

To address whether the yield spike is an anomaly, we suggest returning to the Phillips curve. The Phillips curve describes the historically inverse relationship between the unemployment rate and inflation—and ultimately rising rates. The tradeoff runs in both directions. Inflation is approximated by the Fed's preferred core personal consumption expenditures deflator (PCE).

A recent thoughtful analysis by the Institute of International Finance (IIF) indicates that when accounting for the impact of currency and oil prices, a continued decline in the unemployment rate would only create a small increase in the core PCE. This is one of the factors that have contributed to the current environment of low-inflationary growth.

We believe that markets have overreacted to the fear that better unemployment numbers will drive inflation significantly higher (see Chart 2).

 

Sources: Haver Analytics, Institute of International Finance. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

Rising Treasury Yields

In our view, the price decline in Treasury yields is due to fears of an overheating economy. However, the chart below suggests that sentiment may be premature. Furthermore, the Fed remained committed to modest tightening at its March 21 meeting; had it switched to a more aggressive pace this year, we would have been more concerned about an imminent recession. Instead, this moderate pace should take out some of the remaining market excesses.
 

Investment Opportunities

Yet, the back up in Treasury yields has also created simultaneous tactical opportunities in longer-dated U.S. Treasuries, local- and hard-currency emerging market debt, and high yield corporate spreads. We believe current valuations on local-currency emerging market debt in particular reflect significant mispricing and therefore offer an attractive entry point for investors. In terms of tactical high-quality sources of duration, we think that U.S. Treasuries continue to offer relative value to other markets, such as Germany, the U.K., and Japan.

When the independent analysis of inflation is coupled with our proprietary recession indicators, long exposure to emerging markets and lower-quality credit assets, as well as tactical positions in longer-duration U.S. Treasuries may efficiently capitalize on the price risk of unfounded fears of rising rates and excessive inflation.

 


Spread is the difference in yield between two different types of fixed income securities.

basis point (bps) is one one-hundredth of one percent (1/100% or 0.01%).

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Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.

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IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.