Fixed Income Insights

The shifting global economic landscape has created an environment where market valuations may not fully reflect the potential impact of current stresses in credit markets.

What are the implications for the treasury market of US balance sheet dynamics?

• US public sector budgets have undoubtedly deteriorated, and this may have increased the term premium and maintained upwards risks, although treasury yields are still probably being driven more forcefully by interest rate expectations
• In the long term, the deficit is set to continue widening driven by rising outlays rather than dwindling revenues
• One of the drivers of a long-term deterioration in the government deficit could be growing inequality. In addition, external conditions can also push the US government to run a deficit
• From an investment standpoint, we think that US monetary policy is tight and close enough to the point where the economy is set to slow markedly, bring inflation down to target and allow cuts in the Fed Funds rate next year

Developing stresses in global credit

• Tighter policy has not yet led to widespread credit stress across global markets, although defaults in Europe and Asia have accelerated, the former as a result of energy prices and the latter due to the China real estate funding crisis
• Our expectation is for default rates to rise, with a significant acceleration in Europe and continued stress in the China real estate market
• Meanwhile, emerging market external sovereign bonds are undergoing deleverage and improving credit fundamentals. As a consequence, sovereign external ratings have an average skew towards a positive outlook for the first time in a decade