The Federal Reserve could resume its interest rate-hiking programme later this year or in 2020 even though the market is currently forecasting a cut being the most likely move, according to Fidelity International’s Steve Ellis. 
In March, the US central bank surprised investors when it performed a U-turn on plans to continue gradually moving interest rates towards more normal levels.
While the Fed had expected to make two rate increases this year and another in 2020, its updated ‘dot plot’ showed officials now believe that no more interest rate increases will be needed in 2019 while seeing a single rate increase in 2020 and none in 2021.
Ellis, the fixed income chief investment officer at Fidelity International, described this as being a “significant shift” for the central bank after it had persistently stuck to its hawkish stance and raised benchmark interest rates nine times since December 2015.
The Fed’s ‘dot plot’ – March 2019
Source: Federal Reserve
The CIO added that with the US 10-year Treasury yield sitting at around 2.5 per cent and the market pricing in some chance of cuts this year, there is “limited room” for a further rally.
“We favour a tactical short position, expecting US rates catch up to the equity bounce. Investors should be cautious of risks around a still unresolved trade dispute between the US and China, and late-cycle dynamics,” he added.
“A 'goldilocks' scenario of rising stocks and broadly stable government bond yields began to be challenged in February. Looking ahead, there is a risk that improvements in financial conditions cushion against the weakness in economic data and encourage central banks to revisit their policy settings sooner than expected and shift their stance again.”
Fidelity’s quantitative models suggest that mean reversion and growth momentum signals have been the most successful at projecting yield changes over the past year.
These metrics are currently tipping a short duration bias, which is how Fidelity’s bond portfolios are positioning.
“However, beyond the nearer term, the combination of late-cycle economic risk, high levels of global debt and ongoing secular demand for retirement income make us comfortable to retain moderate levels of duration in most sub-asset classes within portfolios,” he added.
Government bonds
Turning to fixed income sub-asset classes and Ellis said that he expects a further rate hike from the Federal Reserve this year or in 2020, assuming that US economic growth remains above trend and inflation pressures continue to be firm. This is in contrast to the market, which is pricing in no further hikes for the coming 12 months.
Performance of government bonds over 20yrs
Source: FE Analytics
“The fundamental economic outlook is more important for the direction of Treasuries,” he said. “Overall, we see 10-year yields staying in a 2.5-3.0 per cent range through the year, but currently favour a tactical short as US rate markets play catch-up to the jump in stocks.”
In the eurozone, Fidelity expects the European Central Bank to maintain its cautious stance and keep policy rates unchanged for at least 12 months. This could keep 10-year bunds anchored at their relatively low and stable levels.
The team is also neutral on UK government bonds: “Gilt valuations are expensive and the economic picture cloudy, and with ongoing Brexit uncertainty, we expect the Bank of England to stay on the side-lines in 2019.”
Inflation-linked
Fidelity’s analysis suggests there has been the last negative monthly contribution from falling oil prices. This means US CPI should remain around its current levels for the next six months (assuming no further declines in oil) before picking up in the latter stages of the year.
The asset management house had been long US inflation-linked bonds since the beginning of 2019 but has moved to a more neutral stance.
Investment-grade
Moving to corporate debt, Ellis said: “High valuations and a lack of ‘safe-havens’ amid a plethora of risks characterised US investment grade for most of 2018.
“The future direction will be swayed by macro trends and Fed policy. If economic data is solid enough to support a further rate hike this year, it’s unlikely that spreads can tighten much more, driving our shift to a neutral stance.”
The fixed income team have a positive on the backdrop for European corporates but expect to reduce its exposure to the continent’s investment-grade market if there are any further tightening of spreads in response to a slowing European economy.
High yield
Fidelity is also neutral on high yield bonds. It notes that the asset class has weak valuation support but this is tempered by the view that a recession is unlikely this year.
In addition, the firm thinks that carry should cushion high yields’ total returns while its quantitative models indicate favourable seasonal and momentum factors.
While the group is neutral on US high yield at the moment, it is looking to tweak this positioning to increase the average quality of its exposure and marginally reduce risk.
Emerging market debt
One area where Fidelity has a positive view is emerging market debt, given that it sees tailwinds such as a more dovish Fed and China’s move to stimulate its economy.
That said, Ellis noted some risks facing the asset class – especially from politics. He highlighted numerous elections in 2019, including in Argentina, Nigeria, South Africa, India and Indonesia, that could be potential risks.
However, the bond CIO concluded: “As the US dollar weakens, countries such as Turkey, Mexico, Indonesia and South Africa may look to unwind the rate hikes from last year and ease financial conditions.
“If this is done responsibly it should support local currency bonds and not lead to a major weakening of emerging market currencies.”