Contrary to consensus expectations, the U.S. dollar declined against most major currencies in the first half of the year and bond yields have moved up sharply outside the U.S. These moves have prompted questions about the relative attractiveness of foreign bonds.
We continue to favor an underweight position in international developed market bonds due to wide interest rate spreads between the U.S. and other major countries and the likelihood of a rebound in the dollar in the second half of the year.
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.
The U.S. Dollar Index has declined since the beginning of the year
Note: U.S. Dollar Index (USDX) is an index (or measure) of the value of the U.S. dollar relative to a basket of foreign currencies.
Source: Bloomberg, daily data as of 7/10/17. Past performance is no guarantee of future results.
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.
Euro-area confidence has helped to lift the euro
Source: European Commission and Bloomberg. Data as of 6/30/2017.
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.
Total assets of major central banks have grown during the past decade
Source: Federal Reserve Board, European Central Bank and Bank of Japan. Data as of 7/5/17.
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.
U.S. yields are higher than yields in other G-8 countries
Source: Bloomberg. Data as of 7/10/17.
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.
The spread between 10-year U.S. and German real yields has widened this year
Note: This data is calculated using the difference between the generic 10-year yield and the core or headline Consumer Price Index (CPI) for Germany and the U.S.
Source: Bloomberg. Real 10-year yields German (RR10CDE Index) and U.S. (RR10CUS Index). Monthly data as of 5/31/2017.
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.