Fixed Income: A few opportunities left

• U.S. Treasuries and liquid MBS look interesting, especially at the short end of the U.S. yield curve
• We are more cautious on European government bonds, especially of the countries at the core of the Eurozone
• Positive absolute return potential exists for corporate credit across regions. Selective opportunities remain in emerging markets

Fixed Income: A few opportunities left

Despite moderate rate rises, it remains too early to count out fixed income

Call it a tug of war between fears and fundamentals . While President Trump keeps markets in suspense, the U.S. economy looks robust to us and, more importantly, to the Fed. Until December 2019, we expect two more 25-basis-point (bp) interest-rate hikes, driving 2-year interest rates gradually up to 2.75%. This makes 2-year U.S. Treasuries quite an attractive investment on a risk-adjusted basis. Whereas the short end of the yield curve seems well contained, macroeconomic uncertainties make longer-term Treasury rates more susceptible to occasional yield spikes. Overall, we expect 10-year U.S. Treasury rates to grind slightly higher to 3%. In contrast to some of our peers, we do not expect a sell-off in long-dated Treasuries nor a full inversion of the yield curve over the coming 12 months. We also stay constructive for liquid dollar-denominated mortgage-backed securities (MBS) as the Fed comes closer to the end of its balance-sheet unwinding. Nevertheless, supply of MBS assets could remain a drag for some time. Collateralized loan obligations (CLO) and shorter U.S. municipal bonds also look appealing.

For most Eurozone government bonds , we see negative expected total returns , due to the prolongation of accommodative monetary policies by the European Central Bank (ECB) . We expect deposit rates to increase by only 15bps and no hike of the refinancing rate in 2019. This looks set to keep 2-year Bund yields in negative territory. From a strategic perspective, we turned cautious on Italy. Political uncertainty, the implied tail risks and concerns over Italian banks continue to weigh on sovereign spreads . However, we expect political uncertainty and the resulting volatility to create a number of trading opportunities in sovereign bonds across the Eurozone. We expect no key-rate change in Japan over the next 12 months. We expect yields on 2-year government bonds to stay at around or maybe just slightly below 0%. In the UK, we see the Bank of England (BoE) decreasing policy accommodation further. Brexit uncertainties are likely to generate some volatility in Gilts ahead of the deadline of March 29, 2019, when the UK is scheduled to leave the European Union (EU).

For corporate credit, we continue to expect positive absolute returns across all regions, but the environment is getting more challenging. The re-emergence of cash as an attractive asset class in the United States will have some crowding-out effect on corporate credit. We expect U.S. investment-grade spreads to only widen slightly. Higher leverage in various BBB credits, a rising downgrade-to-upgrade ratio (currently 2:1), high currency-hedge costs and the attractive yield on cash will weigh on the asset class. But let's not turn too negative. While we see various individual deteriorating credit stories, we do not expect a wave of BBB-rated companies to move into high yield (HY) . Opportunities exist in U.S. high yield. After the recent spread widening, the asset class looks attractive again. It should benefit from low default rates , fairly high yields and stable corporate fundamentals. Equity-market volatility, Fed uncertainty and recession concerns are likely to keep a lid on spread tightening potential.

European investment grade has suffered in 2018, not just from concerns over financials and Italy's protracted budget negotiations but also from the announced end of QE by the ECB. The extent of recent market moves looks unjustified to us. We think that spreads will tighten again. In European high yield, we see attractive entry opportunities. Low default expectations and attractive relative value support the asset class.

Finally, let's look at EM . We continue to see selective opportunities. Markets may have overreacted to negative news flow on countries such as Mexico, Turkey and Argentina. We particularly like shorter-dated bonds. On the sovereign side, we like Central and Eastern Europe (including Turkey and Russia) and Africa but underweight Latin America. In general, we favor hard-currency over local-currency emerging-market sovereign bonds. For Asian credit, we expect spreads to stay around current levels. We see selective opportunities in China. However, this segment is highly dependent on ongoing trade negotiations between China and the United States. A strong U.S. dollar and higher Treasury yields also remain risk factors.

How 10-year Treasury yields got where they are

U.S. Treasury yields have moved in line with an improving economy. They are unlikely to move much further, until the economic outlook becomes clearer.

U.S. real rates from a historical perspective

Real U.S. interest rates remain very low. The rate at which monetary policy is neutral appears lower, too, reflecting various structural changes.

Currencies: A relatively quiet place

After many currency pairs have left 2018 at about the same level as they entered it, we expect the same in 2019

As the year ends, most markets have been turbulent, but the foreign-exchange markets have remained rather calm. And this is despite the fact that currencies are said to have a good nose for political changes, of which there have been plenty in the past year. In fact, the last few years have been very stable for exchange rates by historical standards. Against the euro , the U.S. dollar has moved in a corridor of 1.05-1.25 for almost four years, in contrast to 2014 when it slipped from 1.40 to 1.05 within one year. Nor do we expect any leaps now and see the dollar at the end of 2019 at 1.15 against the euro. This apparent standstill, however, hides the many underlying forces pulling at the exchange rate. At present, however, they are largely neutralize each other. What these forces are is well known: the U.S. twin deficit , the transatlantic interest-rate differential and the growth-rate gap between the United States and Europe. Interesting, however, is not the absolute levels of these differences but the changed expectations regarding their development. In 2018, the positive element of surprise on the last two factors was clearly in the United States' favor. 2019 could be a tighter call. Although it is unlikely that the ECB will tighten the monetary reins faster than previously announced, it is increasingly likely that the Fed will pause on hikes earlier than expected. Expectations on Fed rate hikes are already declining anyway – just one hike is priced in for 2019. But this expectation could shift in either direction. As far as growth is concerned, revisions on both continents are more likely to be down than up.

Main currency pairs are relatively stable

Measured against other asset classes and its own history, the currency market has been rather quiet.