Investors should pause before running to the international bond market

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Bank notes of different currencies, including Euro, U.S. Dollar, Turkish Lira or Brazilian Reais, are photographed in Frankfurt, Germany, in this illustration picture taken May 7, 2017. Picture taken May 7, 2017. REUTERS/Kai Pfaffenbach/Illustration Thomson
Reuters

The U.S. dollar declined against most major currencies in the
first half of 2017, leading some investors to wonder whether a
key attraction of U.S. bonds is likely to fade away—and whether
they should consider investing in international developed market
bonds instead.

However, we don’t believe recent dollar weakness heralds the end
of the dollar bull market, and with interest rates in the U.S.
still considerably higher than in most other major economies, we
continue to suggest underweighting international developed market
bonds in your fixed income portfolio.

Bull market pause

Coming into 2017, consensus expectations called for the U.S.
dollar to continue to rally on the prospect of stronger growth
and higher interest rates. In general, a rising dollar is good
for foreign holders of dollar-denominated bonds, because the
dollars they will receive when the bond is sold or matures will
buy more of their own currency.

As it happened, the dollar got a sharp boost after the November
presidential election on expectations that fiscal stimulus, in
the form of tax cuts and increased government spending on
infrastructure would boost growth. There was also a lot of talk
at the time about a “border adjustment tax” that, if implemented,
would likely have sent the dollar sharply higher.  However,
soon after the new session of Congress convened in January, it
became apparent that few, if any, of these policy changes would
be passed in 2017 amid partisan conflict.


Screen Shot 2017 07 14 at 10.15.39 AMThe Schwab Center for Financial
Research

Meanwhile, conditions in Europe were the mirror image. Sentiment
about the economic outlook picked up as political risks
diminished after the French elections. Since the dollar index
that many investment vehicles track is heavily weighted to the
euro, by the end of June, the dollar had completely retraced the
6% upswing from the election to the first of the year.


Screen Shot 2017 07 14 at 10.15.59 AMThe Schwab Center for Financial
Research

Despite the dollar’s setback, we believe there is the potential
for rebound in the second half of the year now that expectations
have adjusted. The major driver behind the dollar’s 30% rise
between 2014 and early this year was the wide divergence between
U.S. monetary policy and policies of other major central banks
(typically, higher interest rates attract foreign capital and
boosts the exchange rate). The Federal Reserve began its policy
tightening in 2014 when it began to taper its bond purchases.
Since then, it has raised short-term interest rates four times
and will likely begin to shrink its balance sheet later this
year, which in theory could create upward pressure on bond
yields. In contrast, the European Central Bank (ECB) is still
expanding its balance sheet with bond purchases of 60 billion
euros per month and won’t likely begin to taper those purchases
until next year. The Bank of Japan (BOJ) also continues to expand
its bond holdings.


Screen Shot 2017 07 14 at 10.16.17 AMThe Schwab Center for Financial
Research

Despite the likelihood that central bank balance sheet expansion
in Europe will come to an end over the next year as deflation
concerns ebb, U.S. policy is well ahead of the ECB’s and BOJ’s.
The difference is likely to expand further in the second half of
the year if the Fed allows some of its bond holdings to mature
without replacing them, causing the balance sheet to shrink.

Interest rate differences also still favor the dollar. While
interest rates have moved up globally on easing fears of
deflation, the spreads between U.S. interest rates and those of
other major currencies remain wide, for both short and long-term
rates. After adjusting for inflation, yields in the U.S. are much
higher than in most other major countries.


Screen Shot 2017 07 14 at 10.16.28 AMThe Schwab Center for Financial
Research

In fact, after adjusting for inflation U.S. 10-year government
bond yields are at the widest spread versus German government
bond yields since 2008.


Screen Shot 2017 07 14 at 10.16.39 AMThe Schwab Center for Financial
Research

International developed market bond outlook

We expect interest rates to trend higher around the globe in the
second half of the year, but most likely not at the rapid rate
seen so far this year. Given our view that the dollar will firm
up as the year goes on, we continue to believe it makes sense to
underweight international developed market bonds in a fixed
income portfolio. With yields well below those in the potential
for a dollar rebound, the risk/reward favors limiting exposure.


Source: einnews.com